Applying IFRS Standards, 4th Edition 原版PDF

A P P LY I N G
IFRS ®
Standards
FOURTH EDITION
RUTH PICKER
EY
KERRY CLARK
EY
JOHN DUNN
University of Strathclyde
DAVID KOLITZ
University of Exeter Business School
GILAD LIVNE
University of Exeter Business School
JANICE LOFTUS
University of Adelaide
LEO VAN DER TAS

EY
Tilburg University
Copyright © 2016 John Wiley & Sons, Ltd
Copyright © 2013 Ruth Picker, Ken Leo, Janice Loftus, Victoria Wise, Kerry Clark
Copyright © 2009 Keith Alfredson, Ken Leo, Ruth Picker, Janice Loftus, Kerry Clark, Victoria Wise
Copyright © 2007, 2005 Keith Alfredson, Ken Leo, Ruth Picker, Paul Pacter, Jennie Radford,
Victoria Wise
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Library of Congress Cataloging-in-Publication Data
Names: Picker, Ruth.
Title: Applying IFRS / Ruth Picker,
Ernst & Young, Kerry Clark, Ernst & Young, John Dunn, University of
Strathclyde, David Kolitz, University of Exeter Business School, Gilad
Livne, University of Exeter Business School, Janice Loftus, The University
of Adelaide, Leo van der Tas, Ernst & Young.
Description: Fourth edition. | Chichester, West Sussex, United Kingdom: John
Wiley & Sons, [2016] | Includes bibliographical references and index.
Identifiers: LCCN 2015048910 | ISBN 9781119159223 (pbk.)
Subjects: LCSH: Accounting—Standards. | Financial statements—Standards.
Classification: LCC HF5626 .P45 2016 | DDC 657/.30218—dc23 LC record available at http://lccn.loc.
gov/2015048910
ISBN 9781119159223 (pbk)
ISBN 9781119250777 (ebk)
A catalogue record for this book is available from the British Library
Set in 9.5pt/ITC Giovanni Std by Aptara Inc., India
Printed in Great Britain by TJ International, Padstow, Cornwall
FROM THE PROFESSION
EY is delighted to support Applying IFRS Standards, fourth edition. With International Financial Reporting
Standards (IFRS®) now being mandated, or permitted, for the financial reporting of listed entities in
most parts of the world, it has become the global language of accounting. This means that comparing
financial statements from companies across the globe has become much easier, fostering capital markets
and reducing the cost of capital. It also has led to reductions in training costs and greater mobility of
accounting staff and professionals across countries. You, as accountancy students and professionals, will
benefit greatly from being able to carry your knowledge and experience from country to country without
always having to study local accounting standards each time you cross a border.
Business and capital markets are developing continuously. So must financial reporting. The Interna-
tional Accounting Standards Board (IASB®), the IFRS Standards setter, recently issued a number of impor-
tant new standards. The new IFRS 9 Financial Instruments addresses the issues that arose during the global
credit crisis and, among others, answers calls for better loan loss provisions by banks and more practical
hedge accounting rules. IFRS 15 Revenue from Contracts with Customers modernises and greatly enhances
the guidance on revenue recognition. Both new standards are covered in this new edition of Applying IFRS
Standards as well as the key highlights of the new standard for lease accounting.
Applying IFRS Standards aims to help you master the complex world of IFRS Standards; as such, it is truly
global in the wealth of insights and examples it provides, as well as abstracts from financial statements
of companies across the globe. I am sure this book will be instructive not only to those learning about
financial reporting standards for the first time, but also to accountancy professionals keeping abreast of
developments in IFRS Standards and trying to find their way in applying IFRS Standards to transactions
and events.
Now that IFRS Standards have been adopted in most parts of the world, it is important to interpret and
apply the standards consistently to make it a truly single global set of accounting standards. I hope and
trust this book will help in achieving a common and consistent understanding and application of IFRS
Standards.
Leo van der Tas

Global Leader — IFRS Services, Global Professional Practice
EY
London
May 2016
ACADEMIC PERSPECTIVE
BRIEF CONTENTS
Part 1 CONCEPTUAL FRAMEWORK 1
1 The IASB and its Conceptual Framework 3
Part 2 ELEMENTS 19
2 Owners’ equity: share capital and reserves 21
3 Fair value measurement 49
4 Revenue from contracts with customers 73
5 Provisions, contingent liabilities and contingent assets 95
6 Income taxes 123
7 Financial instruments 155
8 Share-based payment 199
9 Inventories 219
10 Employee benefits 245
11 Property, plant and equipment 275
12 Leases 321
13 Intangible assets 355
14 Business combinations 379
15 Impairment of assets 417
Online chapter A Exploration for and evaluation of mineral resources
Online chapter B Agriculture
PART 3 PRESENTATION AND DISCLOSURES 447

16 Financial statement presentation 449
17 Statement of cash flows 485
18 Operating segments 517
19 Other key notes disclosures 537
PART 4 ECONOMIC ENTITIES 559

20 Consolidation: controlled entities 561
21 Consolidation: wholly owned subsidiaries 577
22 Consolidation: intragroup transactions 605
23 Consolidation: non-controlling interest 635
24 Translation of the financial statements of foreign entities 679
Online chapter C Associates and joint ventures
Online chapter D Joint arrangements
ACADEMIC PERSPECTIVE
CONTENTS
Preface ix 3.5 Application to liabilities 62
About the authors xi 3.6 Application to measurement of an
List of Acronyms xiii entity’s own equity 65
3.7 Application to financial instruments
Part 1 with offsetting positions 65
3.8 Disclosure 65
CONCEPTUAL FRAMEWORK 1 Summary 68
1 The IASB and its Conceptual Framework 3 Discussion questions 68
1.1 The International Accounting References 68
Standards Board (IASB®) 4 Exercises 69
1.2 The purpose of a conceptual framework 6 Academic perspective 71
1.3 Qualitative characteristics of useful
financial information 7 4 Revenue from contracts with customers 73
1.4 Going concern assumption 9 4.1 Introduction 74
1.5 Definition of elements in financial statements 10 4.2 Scope 74
1.6 Recognition of elements of financial statements 12 4.3 Identify the contract with the customer 75
1.7 Measurement of the elements of 4.4 Identify the performance obligations 76
financial statements 13 4.5 Determine the transaction price 78
1.8 Concepts of capital 14 4.6 Allocate the transaction price 81
1.9 Future developments 14 4.7 Satisfaction of performance obligations 82
Summary 15 4.8 Contract costs 84
Discussion questions 15 4.9 Other application issues 85
References 15 4.10 Presentation and disclosures 87
Exercises 15 Summary 89
Academic perspective 17 Discussion questions 89
References 90
Part 2 Exercises 90
Academic perspective 92
ELEMENTS 19
2 Owners’ equity: share capital and reserves 21 5 Provisions, contingent liabilities
2.1 Equity 22 and contingent assets 95
2.2 For-profit companies 23 5.1 Introduction to IAS 37 96
2.3 Key features of the corporate structure 23 5.2 Scope 96
2.4 Different forms of share capital 24 5.3 Definition of a provision 97
2.5 Contributed equity: issue of share capital 26 5.4 Distinguishing provisions from other liabilities 97
2.6 Contributed equity: subsequent 5.5 Definition of a contingent liability 97
movements in share capital 28 5.6 Distinguishing a contingent liability
2.7 Share capital: subsequent decreases from a provision 98
in share capital 32 5.7 The recognition criteria for provisions 98
2.8 Reserves 34 5.8 Measurement of provisions 100
2.9 Disclosure 38 5.9 Application of the definitions, recognition
Summary 40 and measurement rules 104
Discussion questions 40 5.10 Contingent assets 111
References 40 5.11 Disclosure 111
Exercises 40 5.12 Comparison between IFRS 3 and IAS 37 in
Academic perspective 46 respect of contingent liabilities 113
5.13 Expected future developments 115
3 Fair value measurement 49 Summary 115
3.1 Introduction 50 Discussion questions 116
3.2 The definition of fair value 51 References 116
3.3 The fair value framework 53 Exercises 116
3.4 Application to non-financial assets 59 Academic perspective 120
CONTENTS v
6 Income taxes 123 8.7 Modifications to terms and conditions on which
6.1 The nature of income tax 124 equity instruments were granted 208
6.2 Differences between accounting 8.8 Cash-settled share-based payment transactions 209
profit and taxable profit 124 8.9 Disclosure 212
6.3 Accounting for income taxes 126 Summary 214
6.4 Calculation of current tax 127 Discussion questions 214
6.5 Recognition of current tax 131 References 214
6.6 Payment of tax 131 Exercises 214
6.7 Tax losses 132 Academic perspective 217
6.8 Calculation of deferred tax 133
9 Inventories 219
6.9 Recognition of deferred tax liabilities
9.1 The nature of inventories 220
and deferred tax assets 139
9.2 Measurement of inventory upon
6.10 Change of tax rates 142
initial recognition 221
6.11 Other issues 142
9.3 Determination of cost 221
6.12 Presentation in the financial statements 143
9.4 Accounting for inventory 224
6.13 Disclosures 144
9.5 End-of-period accounting 227
Summary 148
9.6 Assigning costs to inventory on sale 231
Discussion questions 148
9.7 Net realisable value 234
References 148
9.8 Recognition as an expense 236
Exercises 148
9.9 Disclosure 236
Summary 237
7 Financial instruments 155 Discussion questions 237
7.1 Introduction 156 References 238
7.2 What is a financial instrument? 158 Exercises 238
7.3 Financial assets and financial liabilities 159 Academic perspective 243
7.4 Distinguishing financial liabilities
from equity instruments 160 10 Employee benefits 245
7.5 Compound financial instruments 163 10.1 Introduction to accounting for employee benefits 246
7.6 Interest, dividends, gains and losses 164 10.2 Scope and purpose of IAS 19 246
7.7 Financial assets and financial liabilities: scope 164 10.3 Defining employee benefits 246
7.8 Derivatives and embedded derivatives 166 10.4 Short-term employee benefits 246
7.9 Financial assets and financial liabilities: 10.5 Post-employment benefits 253
categories of financial instruments 168 10.6 Accounting for defined contribution
7.10 Financial assets and financial liabilities: post-employment plans 254
recognition criteria 171 10.7 Accounting for defined benefit
7.11 Financial assets and financial post-employment plans 255
liabilities: measurement 171 10.8 Other long-term employee benefits 263
7.12 Financial assets and financial liabilities: offsetting 181 10.9 Termination benefits 266
7.13 Hedge accounting 181 Summary 268
7.14 Disclosures 188 Discussion questions 268
Summary 194 References 268
Discussion questions 194 Exercises 269
References 194 Academic perspective 273
Exercises 194
Academic perspective 197 11 Property, plant and equipment 275
11.1 The nature of property, plant and equipment 276
8 Share-based payment 199 11.2 Initial recognition of property, plant
Introduction 200 and equipment 277
8.1 Application and scope 200 11.3 Initial measurement of property,
8.2 Cash-settled and equity-settled share-based plant and equipment 278
payment transactions 201 11.4 Measurement subsequent to initial recognition 283
8.3 Recognition 201 11.5 The cost model 283
8.4 Equity-settled share-based payment transactions 202 11.6 The revaluation model 289
8.5 Vesting 204 11.7 Choosing between the cost model and
8.6 Treatment of a reload feature 207 the revaluation model 299
vi CONTENTS
11.8 Derecognition 300 15 Impairment of assets 417
11.9 Disclosure 301 15.1 Introduction to IAS 36 418
11.10 Investment properties 303 15.2 When to undertake an impairment test 418
Summary 305 15.3 Impairment test for an individual asset 420
Discussion questions 312 15.4 Cash-generating units — excluding goodwill 426
References 313 15.5 Cash-generating units and goodwill 430
Exercises 313 15.6 Reversal of an impairment loss 432
Academic perspective 319 15.7 Disclosure 433
12 Leases 321 Summary 434
Introduction 322 Discussion questions 438
12.1 What is a lease? 322 References 438
12.2 Classification of leases 323 Exercises 439
12.3 Classification guidance 324 Academic perspective 444
12.4 Accounting for finance leases by lessees 330
Online chapter A Exploration for and evaluation of
12.5 Accounting for finance leases by lessors 336 mineral resources
12.6 Accounting for finance leases by Online chapter B Agriculture
manufacturer or dealer lessors 341
12.7 Accounting for operating leases 342 Part 3
12.8 Accounting for sale and leaseback transactions 346
PRESENTATION AND DISCLOSURES 447
12.9 Changes to the leasing standards 348
Summary 349 16 Financial statement presentation 449
Discussion questions 349 Introduction 450
Exercises 349 16.1 Components of financial statements 450
16.2 General principles of financial statements 451
13 Intangible assets 355 16.3 Statement of financial position 452
Introduction 356 16.4 Statement of profit or loss and other
13.1 The nature of intangible assets 358 comprehensive income 457
13.2 Recognition and initial measurement 360 16.5 Statement of changes in equity 463
13.3 Measurement subsequent to initial recognition 364 16.6 Notes 466
13.4 Retirements and disposals 367 16.7 Accounting policies, changes in accounting
estimates and errors 468
13.5 Disclosure 367
16.8 Events after the reporting period 473
Summary 371
Summary 475
References 373
References 476
Exercises 373
Academic perspective 376 Exercises 476
14.1 The nature of a business combination 380
17 Statement of cash flows 485
14.2 Accounting for a business combination — Introduction and scope 486
basic principles 381 17.1 Purpose of a statement of cash flows 486
14.3 Accounting in the records of the acquirer 383 17.2 Defining cash and cash equivalents 486
14.4 Recognition and measurement of assets 17.3 Classifying cash flow activities 487
acquired and liabilities assumed 383 17.4 Format of the statement of cash flows 489
14.5 Goodwill and gain on bargain purchase 385 17.5 Preparing a statement of cash flows 491
14.6 Shares acquired in the acquiree 392 17.6 Other disclosures 506
14.7 Accounting in the records of the acquiree 392 Summary 509
14.8 Subsequent adjustments to the initial accounting Discussion questions 509
for a business combination 395 References 509
14.9 Disclosure — business combinations 398 Exercises 509
Summary 400 Academic perspective 515
References 406 18 Operating segments 517
Exercises 407 18.1 Objectives of financial reporting by segments 518
Academic perspective 414 18.2 Scope 518
CONTENTS vii
18.3 A controversial standard 518 22 Consolidation: intragroup transactions 605
18.4 Identifying operating segments 520 Introduction 606
18.5 Identifying reportable segments 522 22.1 Rationale for adjusting for intragroup
18.6 Applying the definition of reportable transactions 606
segments 524 22.2 Transfers of inventory 607
18.7 Disclosure 524 22.3 Intragroup services 613
18.8 Applying the disclosures in practice 527 22.4 Intragroup dividends 614
18.9 Results of the post-implementation 22.5 Intragroup borrowings 616
review of IFRS 8 531 Summary 617
Summary 532 Discussion questions 625
Discussion questions 532 Exercises 626
References 532
Exercises 532
23.1 Non-controlling interest explained 636
19 Other key notes disclosures 537 23.2 Effects of an NCI on the consolidation
process 638
Introduction 538
23.3 Calculating the NCI share of equity 644
19.1 Related party disclosures 538
23.4 Adjusting for the effects of intragroup transactions 656
19.2 Earnings per share 543
23.5 Gain on bargain purchase 658
Summary 554
Summary 660
References 555
Exercises 672
Exercises 555
24 Translation of the financial statements
Part 4 of foreign entities 679
24.1 Translation of a foreign subsidiary’s
ECONOMIC ENTITIES 559 statements 680
24.2 Functional and presentation currencies 680
24.3 The rationale underlying the functional
Introduction 562 currency choice 680
20.1 Consolidated financial statements 562 24.4 Identifying the functional currency 683
20.2 Control as the criterion for consolidation 564 24.5 Translation into the functional currency 684
20.3 Preparation of consolidated financial statements 569 24.6 Changing the functional currency 689
20.4 Business combinations and consolidation 570 24.7 Translation into the presentation currency 689
20.5 Disclosure 572 24.8 Consolidating foreign subsidiaries — where
Summary 574 local currency is the functional currency 691
Discussion questions 574 24.9 Consolidating foreign subsidiaries — where
Exercises 575 functional currency is that of the parent
entity 698
21 Consolidation: wholly owned 24.10 Net investment in a foreign operation 699
subsidiaries 577 24.11 Disclosure 700
21.1 The consolidation process 578 Summary 700
21.2 Consolidation worksheets 579 Discussion questions 701
21.3 The acquisition analysis: determining References 701
goodwill or bargain purchase 580 Exercises 701
21.4 Worksheet entries at the acquisition date 583
21.5 Worksheet entries subsequent to Online chapter C Associates and joint ventures
the acquisition date 588 Online chapter D Joint arrangements
21.6 Revaluations in the records of the
subsidiary at acquisition date 595 Glossary 707
21.7 Disclosure 595 Index 717
Summary 598
Exercises 598
viii CONTENTS
PREFACE
With International Financial Reporting Standards (IFRS®) now being mandated for listed companies in
100+ countries across the globe, it has become a truly global set of standards for financial reporting. IFRS
Standards have also become the example for national accounting standards. The credit crisis has shown
that a stable, globally accepted set of financial reporting standards is important to maintain transparency
in financial communication by companies to their constituents.
An understanding of the IFRS Standards is therefore paramount for all those involved in financial
reporting or preparing to attain such a role. It provides not just technical knowledge and in-depth under-
standing of the financial reporting process, but does so in a global business environment. Applying IFRS
Standards, fourth edition, has been written to meet the needs of accountancy students and practitioners in
understanding the complexities of IFRS Standards.
This publication is the fourth edition of the book. It has now established itself as a text that is used by
academics and practitioners throughout the world. We have welcomed the comments and suggestions
received from various people and have tried to ensure that these are reflected in this edition.
What’s new in this edition?

The fourth edition addresses the major changes to a number of accounting standards and the release of
new IFRS Standards, in particular:
• the IASB’s Conceptual Framework for Financial Reporting
• IFRS 9 Financial Instruments
• IFRS 15 Revenue from Contracts with Customers
• IFRS 16 Leases.
The chapters covering these topics reflect these changes and discuss the consequences.
An important new feature has been introduced for the first time in this edition. Academic perspec-
tives can be found at the end of all chapters in the first three parts of the book (i.e. chapters 1 to
19). These academic perspectives summarise and highlight certain findings from published research in
accounting and other fields that pertain to a chapter’s topic. Referring to these Perspectives should give
the reader a basic understanding of questions that accounting researchers have attempted to address.
Note, however, that the academic perspectives do not furnish a comprehensive review of related liter-
ature. Rather, they provide a starting point for further reading and exploration of relevant academic
research.
Applying IFRS Standards fourth edition, also comes equipped with discussion questions and exercises at
the end of each chapter, specifically designed to test the reader’s understanding of the content. A wealth of
additional learning materials can also be found at www.wiley.com/college/picker, including:
• Four additional chapters entitled: Exploration for and evaluation of mineral resources; Agriculture;
Associates and joint ventures; Joint arrangements
• Instructor slides
• Testbank
• Additional exercises
• Solutions manual
• Access to the IFRS Learning Resources
In writing this book, we have endeavoured to ensure that the following common themes flow throughout
the text:
• Accounting standards are underpinned by a conceptual framework. Accounting standards are not simply
a rulebook to be learnt by heart. An understanding of the conceptual basis of accounting, and
the rationale behind the principles espoused in particular standards, is crucial to their consistent
application in a variety of practical applications.
• The International Accounting Standards Board (IASB®) financial reporting standards are principles-based.
Although a specific standard is a stand-alone document, the principles in any standard relate to and are
interpreted in conjunction with other standards. To appreciate the application of a specific standard,
an understanding of the reasoning within other standards is required. We have endeavoured where
applicable to refer to other accounting standards that are connected in principle and application.
In particular, extensive references are made to the Basis for Conclusions documents accompanying
each standard issued by the IASB. This material, although not integral to the standards, explains the
reasoning process used by the IASB and provides indicators of changes in direction being proposed by
the IASB.
• Accounting standards have a practical application. The end product of the standard-setting process must
be applied by accounting practitioners in a variety of organisational structures and practical settings.
While a theoretical understanding of a standard is important, practitioners should be able to apply
the relevant standard. The author of each chapter has demonstrated the practical application of the
PREFACE ix
accounting standards by providing case studies, examples and journal entries (where relevant). The
references to practical situations require the reader to pay close attention to the detailed information
discussed, given that such a detailed examination is essential to an understanding of the standards.
Having only a broad overview of the basic principles is insufficient.
Writing a book like this is impossible without the help and input from many people. Much of the
knowledge and insights reflected in this book have been gained through discussions and debates with
many colleagues and with staff associated with the standard-setting bodies, particularly at the IASB. We
thank them for sharing their perspectives and experience. We would like to thank the following people
in particular. A team of people from EY’s Global IFRS team in London, consisting of Angela Covic, Pieter
Dekker, Steinar Kvifte, Victoria O’Leary, Alexandra Poddubnaya, Serene Seah-Tan and Charlene Teo, wrote
and reviewed individual chapters of the book. Richard Barker from Saïd Business School, Oxford Univer-
sity reviewed the chapters in Part 4. Erik Roelofsen from Rotterdam School of Management, Erasmus Uni-
versity Rotterdam and PwC reviewed the Academic Perspectives. Elisabetta Barone from Brunel Business
School updated the testbank. We would also like to thank Natalie Forde from Cardiff Business School and
other anonymous reviewers who have provided valuable feedback and recommendations during the devel-
opment of the fourth edition. In addition, we extend our thanks to the people at Wiley and professional
freelancers for their help realising this edition, including Juliet Booker, Steve Hardman, Georgia King,
Joyce Poh and Joshua Poole as well as Jennifer Mair and Paul Stringer. Last but not least, writing a book
takes huge commitment, and this has left less time for family and friends. We thank them also for their
support and understanding.
Finally, in a time when the world, with its increasing sophistication, seems to produce situations and
pronouncements that have added complexity, we hope that this book assists in the lifelong learning pro-
cess that ourselves and the readers of this book are continuously engaged in.
Ruth Picker
Kerry Clark
John Dunn
David Kolitz
Gilad Livne
Janice Loftus
Leo van der Tas
May 2016
x PREFACE
ABOUT THE AUTHORS
Ruth Picker
Ruth Picker BA, FCA, FSIA, FCPA, was Global Leader, Global IFRS Services, Global Professional Practice,
with EY between 2009 and 2013. Ruth has over 30 years’ experience with EY and has held various leader-
ship roles during this time. Up until June 2009, Ruth was Managing Partner — Melbourne and the Oceania
Team Leader of Climate Change and Sustainability Services. Prior to this role, Ruth was a senior partner in
the Technical Consulting Group, Global IFRS and the firm’s Professional Practice Director (PPD) respon-
sible for directing the firm’s accounting and auditing policies with the ultimate authority on accounting
and auditing issues.
Ruth’s authoritative insight and understanding of accounting policy and regulation was acknowledged
through her appointment to the International Financial Reporting Interpretations Committee (IFRIC®),
the official interpretative arm of the International Accounting Standards Board (IASB®). She was a member
of IFRIC between 2006 and 2013.
Ruth has conducted numerous ‘Directors’ Schools’ for listed company boards. These schools were
designed by Ruth and are aimed at enhancing the financial literacy of listed company board members.
She is a frequent speaker and author on accounting issues and has been actively involved in the Australian
accounting standard-setting process, being a past member and former deputy chair of the Australian
Accounting Standards Board (AASB) and having served on the Urgent Issues Group for 3 years. She has
been a long-standing lecturer and Task Force member for the Securities Institute of Australia, serving that
organisation for 17 years.
Her written articles have been published in numerous publications, and she is frequently quoted in the
media on accounting and governance issues.
Kerry Clark
Kerry Clark BCom, CA, CPA, is an Associate Partner in EY’s Financial Accounting Advisory Services team
in Calgary, Canada. Kerry provides accounting guidance to clients and staff advising on various financial
reporting matters under International Financial Reporting Standards (IFRS® Standards) and United States
generally accepted accounting principles and has over 25 years of experience with EY.
Kerry is a member of CPA Canada’s Oil and Gas Industry Task Force, the Canadian Association of Petro-
leum Producers’ IFRS Committee, EY’s internal expert network on the new revenue recognition and leases
standards and EY’s Global Oil and Gas Industry Network.
Kerry’s accounting experience spans a variety of industries, with a specific focus over the past several
years on financial reporting issues in the energy industries, including oil and gas, infrastructure and util-
ities in Canada. Prior to this Kerry was a key member of EY’s Technical Consulting Group, Global IFRS
based in Melbourne, Australia, where she was responsible for advising clients on the application of IFRS
Standards to complex transactions with a specific focus on the communications, entertainment and tech-
nology industry sectors.
Kerry frequently assists clients in understanding the financial reporting implications of complex trans-
actions such as complicated infrastructure construction and partnership arrangements, leases, acquisitions
and joint arrangements. She has been involved in the authoring of many EY publications and Charter
magazine articles and assisted Ruth Picker in conducting ‘Directors’ Schools’ for listed company boards.
She has also spoken on accounting issues in many different forums in both Canada and Australia.
John Dunn
John Dunn is a lecturer at the University of Strathclyde in Glasgow, where he teaches financial accounting
and auditing. He has published widely on those topics and others. He is a qualified accountant with exten-
sive experience of examining for professional bodies.
David Kolitz
David Kolitz, BComm (Natal), BCom (Hons) (SA), MCom (Wits) is Senior Lecturer in the Business School at
the University of Exeter. He was previously Associate Professor and Assistant Dean in the Faculty of Commerce,
Law and Management at the University of the Witwatersrand, Johannesburg. He is an experienced accounting
academic and the lead author/co-author of three other books in the area of Financial Accounting.
Gilad Livne
Gilad Livne, PhD, CPA, is a professor of accounting at the University of Exeter Business School. Previously
Gilad served on the accounting faculty of the London Business School and Cass Business School. Gilad
ABOUT THE AUTHORS xi

received his MSc and PhD in accounting at the University of California at Berkeley, and BA (Accounting
and Economics) in Tel Aviv University.
Gilad’s teaching involves financial statement analysis, international accounting as well as advanced
financial accounting courses. Gilad has taught on Undergraduate, MBA, Executive MBA, Sloan, Ph.D., and
MSc programmes. In addition to teaching at Cass and LBS, Gilad has also taught at HEC (Paris), New
Economic School (Moscow), Lancaster University, University of Lausanne (Switzerland), Oulu University
(Finland) and on various company-specific programmes. Gilad has also consulted and appeared on TV
and various radio programmes.
Gilad’s research looks into auditor independence, international accounting, fair value accounting, and
compensation. Gilad currently serves on a number of editorial boards of accounting journals. His research
has been published in several journals including European Accounting Review, Journal of Banking and Finance,
Journal of Business Finance and Accounting, Journal of Corporate Finance, and Review of Accounting Studies.
Janice Loftus
Janice Loftus BBus, MCom (Hons) FCPA is an associate professor in accounting at the University of Adelaide,
Australia. Her teaching interests are in the area of financial accounting and she has written several study
guides for distance learning programmes. Janice’s research interests are in the areas of financial reporting
and social and environmental reporting. She co-authored Accounting Theory Monograph 11 on solvency
and cash condition with Professor M.C. Miller. She has numerous publications on international financial
reporting standards, risk reporting, solvency, earnings management, social and environmental reporting,
and developments in standard setting in Australian and international journals. Janice co-authored Financial
Reporting, Understanding Australian Accounting Standards and Accounting: Building Business Skills published by
John Wiley & Sons Australia. Prior to embarking on an academic career, Janice held several senior accounting
positions in Australian and multinational corporations.
Leo van der Tas

Leo van der Tas (PhD, RA) is the Global IFRS Leader at EY in London since 2013, before which he was
the Global IFRS Technical Director at EY in London. In that role he is responsible for the IFRS Standards
policy of EY and consistency of IFRS Standards implementation within the EY network. He is senior tech-
nical partner at EY in the Netherlands. He was a member of the IFRIC (and predecessor Standing Interpre-
tations Committee of the IASB) between 1997 and 2006 and a member of the IFRS Foundation Advisory
Council between 2009 and 2013.
Leo has been part-time full professor of financial reporting at Tilburg University, the Netherlands, since
2010 and before that part-time full professor at Erasmus University Rotterdam, the Netherlands, since
1993. He chaired the committee for permanent education in financial reporting of the Dutch Institute of
Accountants (NIVRA) until 2010.
Leo has been a member of the Consultative Working Group of the Standing Corporate Reporting Com-
mittee of the European Securities and Market Authority (ESMA) in Paris, France, since 2010. From 2007 to
2012 he was a member of the Advisory Committee on Financial Reporting of the Netherlands Authority
for the Financial Markets (AFM) in Amsterdam, the Netherlands.
He has published many books and articles in the area of international accounting and is a frequent
speaker and teacher on the subject.
He was seconded to the European Commission in Brussels, Belgium, for a period of 2 years to assist in
the development of the Commission’s policy in the area of European accounting harmonisation.
xii ABOUT THE AUTHORS

ACRONYMS
AFS Available-for-sale
AGM Annual general meeting
ASC Accounting Standards Codification
BCVR Business combinations value reserve
CEO Chief Executive Officer
CGU Cash-generating unit
CODM Chief Operating Decision Maker
COO Chief Operating Officer
DBL(A) Defined benefit liability (asset)
DBO Defined benefit obligation
ED Exposure draft
EFRAG European Financial Reporting Advisory Group
EPS Earnings per share
FAS Financial Accounting Standards
FASB US Financial Accounting Standards Board
FIFO First-in, first-out
FV Fair value
FVOCI Fair value through other comprehensive income
FVPL Fair value through profit or loss
GAAP US generally accepted accounting principles
IAS® International Accounting Standards
IASB® International Accounting Standards Board
IASC International Accounting Standards Committee, predecessor of the IASB
IDC Initial direct costs
IFRIC® International Financial Reporting Interpretations Committee, now the IFRS®
Interpretations Committee
IFRS® International Financial Reporting Standards
IPO Initial public offering
LIBOR London interbank offered rate
MLP Minimum lease payments
NCI Non-controlling interest
OCI Other comprehensive income
PV Present value
R&D Research and development
ROA Return on assets
SAC Standards Advisory Council
SARs Share appreciation rights
SFAS US Statement of Financial Accounting Standards
SPPI Solely payments of principal and interest
TSR Total shareholder return
US GAAP see GAAP
ACRONYMS xiii
Part 1
Framework
Conceptual
1 The IASB and its Conceptual Framework 3
1 The IASB and its
Conceptual Framework
LEARNING After studying this chapter, you should be able to:

OBJECTIVES
1 describe the organisational structure of the key players in setting International Financial
Reporting Standards (IFRS® Standards)
2 describe the purpose of a conceptual framework — who uses it and why
3 explain the qualitative characteristics that make information in financial statements useful
4 discuss the going concern assumption underlying the preparation of financial statements
5 define the basic elements in financial statements — assets, liabilities, equity, income and
expenses
6 explain the principles for recognising the elements of financial statements
7 distinguish between alternative bases for measuring the elements of financial statements
8 outline concepts of capital.
CHAPTER 1 The IASB and its Conceptual Framework 3

INTRODUCTION
The purpose of this book is to identify and explain the major concepts and principles of International
Financial Reporting Standards (IFRS® Standards) and to help you develop skills in applying them in busi-
ness contexts. You may be familiar with the accounting treatment for various transactions, such as the
purchase of inventory. The text will build on that knowledge and consider the principles and techniques
required or permitted by IFRS Standards in accounting for a range of transactions, events and circumstances.
This first chapter provides an outline of the International Accounting Standards Board (IASB®) and its role
in setting international accounting standards, which are generally referred to as IFRS Standards. It also explains
that the IASB develops those IFRS Standards on the basis of some fundamental principles. While IFRSs take
precedence, the concepts and principles expounded in the Conceptual Framework for Financial Reporting (the
Conceptual Framework) are generally reflected in the requirements of IFRS Standards. IFRS Standards are
principles-based standards, rather than rules-based standards, even though the volume of guidance under
IFRS Standards has expanded considerably over the years. This means that professional judgement is needed in
applying IFRS Standards as they rely more on concepts and principles, such as a requirement that a value be
measured reliably, rather than on objective prescriptions, such as quantitative tests for classification of leases.
The Conceptual Framework establishes the qualitative characteristics financial information needs to have in
order to be useful, as well as definitions and recognition criteria for the elements of financial statements. These
principles underlie the exercise of professional judgement in applying IFRS Standards. The Conceptual Frame-
work is also an important source of guidance to standard setters in the development of new standards and to
preparers of financial statements in the absence of an applicable accounting standard. Accordingly, study of
the Conceptual Framework provides a useful foundation to understanding and applying IFRS Standards.
LO1 1.1 THE INTERNATIONAL ACCOUNTING STANDARDS

BOARD (IASB)
The purpose of this section is to provide an understanding of the structure of the IASB and its role in the
determination of IFRS Standards. Much of this information has been obtained from the website of the
IASB, www.ifrs.org. To keep up to date with what the IASB is doing, this website should be regularly visited.
1.1.1 Formation of the IASB

In 1972, at the 10th World Congress of Accountants in Sydney, Australia, a proposal was put forward for the
establishment of an International Accounting Standards Committee (IASC). In 1973, the IASC was formed
by 16 national professional accountancy bodies from nine countries — Canada, the United Kingdom,
the United States, Australia, France, Germany, Japan, the Netherlands and Mexico. By December 1998,
the membership of the IASC had expanded and the committee had completed its core set of accounting
standards.
However, the IASC was seen as having a number of shortcomings:
• It had weak relationships with national standard setters; this was due in part to the fact that the
representatives on the IASC were not representative of the national standard setters but rather of
national professional accounting bodies.
• There was a lack of convergence between the IASC standards and those adopted in major countries,
even after 25 years of trying.
• The board was only part time.
• The board lacked resources and technical support.
In 1998, the committee responsible for overseeing the operations of the IASC began a review of the
IASC’s operations. The results of the review were recommendations that the IASC be replaced with a
smaller, full-time International Accounting Standards Board. In 1999, the IASC board approved the con-
stitutional changes necessary for the restructuring of the IASC. A new International Accounting Standards
Committee Foundation was established and its trustees appointed. By early 2001, the members of the IASB
and the Standards Advisory Council (SAC) were appointed, as were technical staff to assist the IASB.
The IASB initially adopted the International Accounting Standards (IAS® Standards), with some mod-
ifications, as issued by the IASC (e.g. IAS 2 Inventories). As standards were revised or newly issued by the
IASB, they were called International Financial Reporting Standards (e.g. IFRS 8 Operating Segments). So the
term International Financial Reporting Standards includes both IFRS Standards and IAS Standards.
1.1.2 The standard-setting structure of the IASB

Available on the IASB website is a document entitled IASB and the IASC Foundation: Who We Are and
What We Do. This document is available in ten languages. The IASB is an independent standard-setting
board. The IFRS Interpretations Committee (formerly IFRIC) issues interpretations of and guidance on the
4 PART 1 Conceptual Framework

requirements of IFRS Standards in relation to accounting for specific transactions or events. Compliance
with IFRS Standards includes compliance with IFRIC® Interpretations.
The IASB and IFRS Interpretations Committee are appointed and overseen by a geographically and pro-
fessionally diverse group of trustees (IFRS Foundation Trustees) who are publicly accountable to a moni-
toring board made up of public authorities, which currently comprises representatives from the Japanese
and, US capital market regulators and IOSCO (International Organization of Securities Commissions), as
well as a representative from the European Commission. The IFRS Foundation Trustees appoint an IFRS
Advisory Council, which provides strategic advice to the IASB and informs the IFRS Foundation Trustees.
This structure can be seen diagrammatically in figure 1.1.
Monitoring Board
of public capital market authorities
appoints, monitors report to
Trustees of the IFRS Foundation

(Governance)
appoint inform oversee, review effectiveness,

informs
appoint and finance
IFRS Advisory Council Standard setting
International Accounting Standards Board (IASB)

provides strategic (IFRSs/IFRS for SMEs)
advice
IFRS Interpretations Committee

(IFRICs)
SME Implementation Group
Operations
Education Initiative, IFRS Taxonomy (XBRL), Content Services
FIGURE 1.1 Institutional structure of international standard setting

Source: IASB (2016).
As of July 2015, the Constitution envisages that the IASB comprises 16 members but the actual number
of members is currently14. The IFRS Foundation has issued a proposal to reduce the number of IASB Board
members to 13. The members are experts with a mix of recent practical experience in setting accounting
standards, preparing, auditing, or using financial statements and accounting education. While the mix of
members is not based on geographical criteria, the trustees endeavour to ensure that the IASB is not dom-
inated by any particular constituency or geographical interest.
The trustees approved the publication of the booklet IASB and IFRS Interpretations Committee Due Process
Handbook in 2013. It is available on the IASB’s website. The due process for issuing IFRSs comprises the
following six stages:
1. Setting the agenda. The IASB considers the relevance and reliability of the information that could be pro-
vided, the existing guidance (if any), the potential for enhanced convergence of accounting practice, the
quality of the standard to be developed and any resource constraints.
2. Planning the project. The IASB decides whether it should undertake the project by itself or jointly with
another standard setter such as the US Financial Accounting Standards Board (FASB).
3. Developing and publishing the discussion paper. The IASB may issue a discussion paper; however, this is not
mandatory.
4. Developing and publishing the exposure draft (ED). The IASB must issue an ED. This is a mandatory step.
5. Developing and publishing the standard. The IASB may re-expose an ED, particularly where there are major
changes since the ED was first released in stage 4.

As part of stages 4 and 5, the IASB may hold regular meetings with interested parties, including other
standard-setting bodies, to help understand unanticipated issues related to the practical implementa-
tion and potential impact of the ED or IFRS respectively.
6. Procedures involving consultation and evaluation after an IFRS has been issued. The IASB may carry out post-
implementation reviews of each new IFRS.
The IASB has full discretion over its technical agenda and over the assignment of projects, potentially to
national standard setters. In preparing the IFRSs, the IASB has complete responsibility for all technical mat-
ters including the preparation and issuance of standards and exposure drafts, including any dissenting opin-
ions on these, as well as final approval of interpretations developed by the IFRS Interpretations Committee.
IASB meetings are normally held every month and last between three and five days. The meetings
are open to the public. Interested parties can attend the meetings in person, or may listen and view the
meeting via the IASB webcast. Subsequent to each meeting, the decisions are summarised in the form of a
publication called IASB Update which is available on the IASB website.
1.1.3 IFRS Interpretations Committee

The IFRS Interpretations Committee reviews newly identified financial reporting issues that are not specif-
ically dealt with in IFRSs, and issues for which unsatisfactory or conflicting interpretations have emerged
or may emerge. The IFRS Interpretations Committee endeavours to reach a consensus on appropriate
accounting treatment and provides authoritative guidance on the issue concerned. The interpretations
issued by the committee are referred to as IFRIC Interpretations, taking their name from the previous
name given to the committee, the International Financial Reporting Interpretations Committee (IFRIC).
When approved by the IASB, IFRIC Interpretations have equivalent status to standards issued by the IASB;
that is, although IFRIC Interpretations are not accounting standards, they form part of IFRSs such that
compliance with IFRSs means compliance with both accounting standards issued by the IASB and IFRIC
Interpretations approved by the IASB. More recently the IFRS Interpretations Committee has been asked by
the IASB to help with the drafting of minor amendments to standards and with the Annual Improvement
Projects. The latter are annual packages of changes to standards that are minor or narrow in scope.
1.1.4 Advisory bodies

The IASB has formal advisory bodies that provide a means for the Board to consult and engage with inter-
ested parties from a range of backgrounds and geographical areas. These advisory bodies include the:
• IFRS Advisory Council
• Capital Markets Advisory Committee
• Emerging Economies Group
• Global Preparers Forum
• SME Interpretations Group.
Working groups may be established for major projects to provide the IASB with access to additional
expertise as required; for example, the Employee Benefits Working Group and the Insurance Working
Group. Further information about advisory bodies, including reports and summaries of discussions, can
be obtained from the IASB’s website.
LO2 1.2 THE PURPOSE OF A CONCEPTUAL FRAMEWORK

In 1989, the IASC, the predecessor to the IASB, adopted the Framework for the Preparation and Presentation
of Financial Statements (the Framework). The Framework borrowed heavily from the Statements of Financial
Accounting Concepts developed by the FASB in the 1970s. This document was superseded by the Concep-
tual Framework for Financial Reporting (the Conceptual Framework) in 2010, developed jointly by the IASB
and the FASB.
The purpose of a conceptual framework is to provide a coherent set of principles:
• to assist standard setters to develop a consistent set of accounting standards for the preparation of
financial statements
• to assist preparers of financial statements in the application of accounting standards and in dealing
with topics that are not the subject of an existing applicable accounting standard
• to assist auditors in forming an opinion about compliance with accounting standards
• to assist users in the interpretation of information in financial statements.
The Conceptual Framework issued by the IASB provides guidance to preparers in the application of IFRSs.
The role of the Conceptual Framework in providing guidance for dealing with accounting issues that are
not addressed by an IFRS is explicitly reinforced in IFRSs. IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors requires preparers to consider the definitions, recognition criteria and measurement
concepts in the Conceptual Framework when developing accounting policies for transactions, events or con-
ditions in the absence of an IFRS that specifically applies or that applies to similar circumstances. The
requirements of IAS 8 are considered in more detail in chapter 16.

Based upon feedback from the agenda consultation in 2011 it became clear to the IASB that an update
of the Conceptual Framework was needed. A discussion paper was issued in 2013 and an exposure draft in
2015. In the remainder of the chapter the existing Conceptual Framework is described. An overview of pro-
posed changes can be found in section 1.9.
This chapter is based upon the IASB’s current Conceptual Framework which is rather patchy as it com-
prises four chapters, two of which (chapters 1 and 3) are final, one (chapter 2) is work in progress, and
one (chapter 4) comprises the leftover bits of the old Framework that have not been amended yet:
• Chapter 1: The objective of general purpose financial reporting
• Chapter 2: The reporting entity (in progress, to be added by the IASB)
• Chapter 3: The qualitative characteristics of useful financial reporting
• Chapter 4: The Framework (1989): the remaining text (comprising underlying assumption, definition
and recognition of elements of financial statements, measurement and concepts of capital).
1.2.1 The objective of financial reporting

The IASB’s Conceptual Framework deals only with the objective of general purpose financial reporting; that
is, financial reporting intended to meet the information needs common to a range of users who are unable
to command the preparation of reports tailored to satisfy their own particular needs.
Paragraph OB2 of the IASB Conceptual Framework states the objective of general purpose financial
reporting:
The objective of general purpose financial reporting is to provide financial information about the reporting
entity that is useful to present and potential equity investors, lenders and other creditors in making decisions
about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt
instruments, and providing or settling loans and other forms of credit.
This objective reflects several value judgements made by the IASB about the role of financial state-
ments, which are described in the Basis for Conclusions on Chapter 1: The objective of general purpose financial
reporting. The Basis for Conclusions includes the following arguments:
• Financial statements should reflect the perspective of the entity rather than the perspective of the
entity’s equity investors. The focus is then on the entity’s resources and the changes in them rather
than on the shareholders as owners of the entity. Shareholders are providers of resources as are those
who provide credit resources to the entity. Under the entity perspective, the reporting entity is deemed
to have substance of its own, separate from that of its owners (paragraph BC1.8).
• The key users of financial statements are capital providers — existing and potential investors and
lenders. An entity obtains economic resources from capital providers in exchange for claims on
those resources. Because of these claims, capital providers have the most critical and immediate
need for economic information about the entity. These parties also have common information
needs. The focus on these users of information, as opposed to other potential users such as
government, regulatory bodies, employees and customers, is a narrowing of the user groups in
comparison to the groups considered in the former version of the IASB Conceptual Framework
(paragraphs BC1.9–1.12).
Before the objective of general purpose financial reporting can be implemented in practice, the basic
qualitative characteristics of financial reporting information need to be specified. Further, it is necessary to
define the basic elements — assets, liabilities, equity, income and expenses — used in financial statements.
1.2.2 The reporting entity

Chapter 2 of the Conceptual Framework is reserved for the reporting entity. In March 2010, the IASB released
an exposure draft titled Exposure Draft ED/2010/2 Conceptual Framework for Financial Reporting — The
Reporting Entity. However, before finalising this chapter, the Board decided to include it in the exposure
draft of a new Conceptual Framework, which was released in 2015 (refer to section 1.9).
LO3 1.3 QUALITATIVE CHARACTERISTICS OF USEFUL

FINANCIAL INFORMATION
What characteristics should financial information have in order to be included in general purpose finan-
cial reporting? The following section discusses both the qualitative characteristics of useful information
and the constraint on providing useful information. The qualitative characteristics are divided into funda-
mental qualitative characteristics and enhancing qualitative characteristics.
1.3.1 Fundamental qualitative characteristics

For financial information to be decision useful, it must possess two fundamental qualitative characteristics:
• relevance
• faithful representation.

Relevance
Paragraphs QC6 to QC10 of the IASB’s Conceptual Framework elaborate on the qualitative characteristic of
relevance. Information is relevant if:
• it is capable of making a difference in the decisions made by the capital providers as users of financial
information
• it has predictive value, confirmatory value or both. Predictive value occurs where the information
is useful as an input into the users’ decision models and affects their expectations about the future.
Confirmatory value arises where the information provides feedback that confirms or changes past or
present expectations based on previous evaluations
• it is capable of making a difference whether the users use it or not. It is not necessary that the
information has actually made a difference in the past or will make a difference in the future.
Information about the financial position and past performance is often used as the basis for predicting
future financial position and performance and other matters in which users are directly interested, such as
future dividends and wage payments, future share prices, and the ability of the reporting entity to pay its debts
when they fall due. The predictive ability of information may be improved if unusual or infrequent transac-
tions and events are reported separately in the statement of profit or loss and other comprehensive income.
Materiality is an entity-specific aspect of the relevance of information. Information is material if its
omission or misstatement could influence the decisions that users make about a specific reporting entity
(paragraph QC11).
Small expenditures for non-current assets (e.g. tools) are often expensed immediately rather than depre-
ciated over their useful lives to save the clerical costs of recording depreciation and because the effects on
performance and financial position measures over their useful lives are not large enough to affect decisions.
Another example of the application of materiality is the common practice by large companies of rounding
amounts to the nearest thousand units of currency (e.g. euros or dollars) in their financial statements.
Materiality is a relative matter — what is material for one entity may be immaterial for another. A
$10 000 error may not be important in the financial statements of a multimillion-dollar company, but it
may be critical to a small business. The materiality of an item may depend not only on its relative size
but also on its nature. For example, the discovery of a $10 000 bribe may be a material event even for a
large company. Judgements as to the materiality of an item or event are often difficult. Management make
judgements based on their knowledge of the company and on past experience. Auditors make their own
judgements about materiality when auditing the financial statements.
Faithful representation
Paragraphs QC12 to QC16 of the IASB’s Conceptual Framework elaborate on the concept of faithful rep-
resentation. Faithful representation is attained when the depiction of an economic phenomenon is com-
plete, neutral, and free from material error. This results in the depiction of the economic substance of the
underlying transaction. Note the following in relation to these characteristics:
• A depiction is complete if it includes all information necessary for faithful representation.
• Neutrality is the absence of bias intended to attain a predetermined result. Providers of information
should not influence the making of a decision or judgement to achieve a predetermined result.
• As information is provided under conditions of uncertainty and judgements must be made, there is not
necessarily certainty about the information provided. It may be necessary to disclose information about
the degree of uncertainty in the information in order that the disclosure attains faithful representation.
As explained in paragraph BC3.23 of the Basis for Conclusions on Chapter 3: Qualitative characteristics of
useful financial information, the boards noted that there are various notions as to what is meant by reli-
ability. The boards believe that the term ‘faithful representation’ provides a better understanding of the
quality of information required (paragraph BC3.24).
The two fundamental qualitative characteristics of financial information may give rise to conflicting guid-
ance on how to account for phenomena. For example, the measurement base that provides the most relevant
information about an asset will not always provide the most faithful representation. The Conceptual Frame-
work (paragraphs QC17–QC18) explains how to apply the fundamental qualitative characteristics. Once the
criterion of relevance is applied to information to determine which economic information should be con-
tained in the financial statements, the criterion of faithful representation is applied to determine how to
depict those phenomena in the financial statements. The two characteristics work together. Either irrelevance
(the economic phenomenon is not connected to the decision to be made) or unfaithful representation (the
depiction is incomplete, biased or contains error) results in information that is not decision useful.
1.3.2 Enhancing qualitative characteristics

The Conceptual Framework (paragraph QC19) identifies four enhancing qualitative characteristics:
• comparability
• verifiability
• timeliness
• understandability.

These characteristics are complementary to the fundamental characteristics. The enhancing character-
istics distinguish more useful information from less useful information. In relation to these enhancing
qualities, note:
• Comparability is the quality of information that enables users to identify similarities in and differences
between two sets of economic phenomena. Making decisions about one entity may be enhanced if
comparable information is available about similar entities; for example, if profit per share is calculated
using the same accounting policies.
• Verifiability is a quality of information that helps assure users that information faithfully represents the
economic phenomena that it purports to represent. Verifiability is achieved if different independent
observers could reach the same general conclusions that the information represents the economic
phenomena or that a particular recognition or measurement model has been appropriately applied.
• Timeliness means having information available to decision makers before it loses its capacity to
influence decisions. If such capacity is lost, then the information loses its relevance. Information may
continue to be timely after it has been initially provided, for example, in trend analysis.
• Understandability is the quality of information that enables users to comprehend its meaning.
Information may be more understandable if it is classified, characterised and presented clearly and
concisely. Users of financial statements are assumed to have a reasonable knowledge of business and
economic activities and to be able to read a financial report.
Alternative accounting policies exist in the treatment of many items, such as property, plant and equip-
ment; investment properties; and financial instruments. The IASB have expressed their position regarding
the consistency of accounting methods in accounting standard IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors, which states that an entity must select and apply its accounting policies in
a consistent manner from one period to another. Consistency of practices between entities is also desired.
Any change made in an accounting policy by an entity must be disclosed by stating the nature of the
change, the reasons the change provides reliable and more relevant information, and the effect of the
change in monetary terms on each financial statement item affected. For example, a change in policies
may be disclosed in a note such as this:
During the year, the company changed from the first-in first-out to the weighted average cost method of
accounting for inventory because the weighted average cost method provides a more relevant measure of the
entity’s financial performance. The effect of this change was to increase cost of sales by $460 000 for the current
financial year.
Note that the need for consistency does not require a given accounting method to be applied throughout
the entity. An entity may very well use different inventory methods for different types of inventory and
different depreciation methods for different kinds of non-current assets. (Different inventory costing and
depreciation methods are discussed in chapters 9 and 11, respectively.) Furthermore, the need for consistency
should not be allowed to hinder the introduction of better accounting methods. Consistency from year
to year or entity to entity is not an end in itself, but a means for achieving greater comparability in the
presentation of information in general purpose financial reporting. The need for comparability should not
be confused with mere uniformity or consistency. It is not appropriate for an entity to continue to apply
an accounting policy if the policy is not in keeping with the qualitative characteristics of relevance and
faithful representation.
1.3.3 Cost constraint on useful financial reporting

Paragraphs QC35 to QC37 of the Conceptual Framework note that cost is the constraint that limits the
information provided by financial reporting. The provision of information incurs costs. The benefits of
supplying information should always be greater than the costs. Costs include costs of collecting and pro-
cessing information, costs of verifying information, and costs of disseminating information. The non-pro-
vision of information also imposes costs on the users of financial information as they seek alternative
sources of information.
LO4 1.4 GOING CONCERN ASSUMPTION

The Conceptual Framework retains the going concern assumption. Financial statements are prepared under
the assumption that the entity will continue to operate for the foreseeable future. Past experience indicates
that the continuation of operations in the future is highly probable for most entities. Thus, it is assumed
that an entity will continue to operate at least long enough to carry out its existing commitments. This
assumption is called the going concern assumption or sometimes the continuity assumption.
Adoption of the going concern assumption has important implications in accounting. For example, it
is an assumption used by some to justify the use of historical costs in accounting for non-current assets
and for the systematic allocation of their costs to depreciation expense over their useful lives. Because it
is assumed that the assets will not be sold in the near future but will continue to be used in operating
activities, current market values of the assets are sometimes assumed to be of little importance. If the entity

continues to use the assets, fluctuations in their market values cause no gain or loss; nor do they increase
or decrease the usefulness of the assets. The going concern assumption also supports the inclusion of some
assets, such as prepaid expenses and acquired goodwill, in the statement of financial position (balance
sheet) even though they may have little, if any, sales value.
If management intends to liquidate the entity or to cease trading, or has no realistic alternative than to
do so, the going concern assumption is set aside. In that case the financial statements are prepared on a
different basis, but IFRS provides no guidance on what that basis would be. Paragraph 25 of IAS 1 Presenta-
tion of Financial Statements prescribes disclosures when an entity does not prepare financial statements on
a going concern basis, including the basis on which it prepared the financial statements (see chapter 16).
LO5 1.5 DEFINITION OF ELEMENTS IN FINANCIAL

STATEMENTS
The Conceptual Framework identifies and defines the elements of financial statements; namely assets, liabil-
ities, equity, income and expenses.
1.5.1 Assets
An asset is defined in paragraph 4.4(a) of the Conceptual Framework as:
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.
This definition identifies three essential characteristics of an asset:
1. The resource must contain future economic benefits; that is, it must have the potential to contribute,
directly or indirectly, to the flow of cash and cash equivalents to the entity. An asset can cause future
economic benefits to flow to the entity in a number of ways:
• it can be exchanged for another asset
• it can be used to settle a liability
• it can be used singly or in combination with other assets to produce goods or services to be sold by
the entity.
2. The entity must have control over the future economic benefits in such a way that the entity has the
capacity to benefit from the asset in the pursuit of the entity’s objectives, and can deny or regulate the
access of others to those benefits.
3. There must have been a past event; that is, an event or events giving rise to the entity’s control over the
future economic benefits must have occurred.
An asset may have other characteristics, but the Conceptual Framework does not consider them essential
for an asset to exist. For instance, assets are normally acquired at a cost incurred by the entity, but it is not
essential that a cost is incurred in order to determine the existence of an asset. Similarly, it is not essential
that an asset is tangible, that is, has a physical form (see paragraph 4.11 of the Conceptual Framework).
Assets such as brands, copyrights and patents represent future economic benefits without the existence
of any physical substance. Such assets may be classified as intangible assets. Furthermore, assets can be
exchanged normally for other assets, but this does not make exchangeability an essential characteristic of
an asset. Finally, it is not essential that an asset is legally owned by the reporting entity. Control by the
entity often results from legal ownership, but the absence of legal rights or ownership does not preclude
the existence of control; for example, a lease (see paragraph 4.12 of the Conceptual Framework).
1.5.2 Liabilities
A liability is defined in paragraph 4.4(b) of the Conceptual Framework as:
a present obligation of the entity arising from past events, the settlement of which is expected to result in an
outflow from the entity of resources embodying economic benefits.
There are a number of important aspects concerning this definition:
• A legal debt constitutes a liability, but a liability is not restricted to being a legal debt. Its essential
characteristic is the existence of a present obligation, being a duty or responsibility of the entity to act or
perform in a certain way. A present obligation may arise as an obligation imposed by notions of equity or
fairness (referred to as an ‘equitable’ obligation), and by custom or normal business practices (referred to
as a ‘constructive’ obligation), as well as those resulting from legally enforceable contracts. For example, an
entity may decide as a matter of policy to rectify faults in its products even after the warranty period has
expired. Hence, the amounts that are expected to be spent in respect of goods already sold are liabilities.
It is not sufficient for an entity merely to have an intention to sacrifice economic benefits in the future.
A present obligation needs to be distinguished from a future commitment. A decision by management
to buy an asset in the future does not give rise to a present obligation. An obligation normally arises
when the asset is delivered, or the entity has entered into an irrevocable agreement to buy the asset, with
a substantial penalty if the agreement is revoked.

• A liability must result in the giving up of resources embodying economic benefits that require settlement
in the future. The entity must have little, if any, discretion in avoiding this sacrifice. This settlement in
the future may be required on demand, at a specified date, or when a specified event occurs. Thus, a
guarantee under a loan agreement is regarded as giving rise to a liability in that a sacrifice is required
when a specified event occurs, for example, default under the loan.
Settlement of a present obligation may occur in a number of ways:
– by paying cash
– by transferring other assets
– by providing services
– by replacing that obligation with another obligation
– by converting that obligation to equity
– by a creditor waiving or forfeiting their rights.
• A final characteristic of a liability is that it must have resulted from a past transaction or event. For
example, the acquisition of goods and the work done by staff give rise to accounts payable and wages
payable respectively. Wages to be paid to staff for work they will do in the future is not a liability as
there is no past transaction or event and no present obligation.
1.5.3 Equity
Paragraph 4.4(c) of the Conceptual Framework defines equity as:
the residual interest in the assets of the entity after deducting all its liabilities.
Defining equity in this manner shows clearly that it cannot be defined independently of the other ele-
ments in the statement of financial position. The characteristics of equity are as follows:
• Equity is a residual, that is, something left over. In other words:
Equity = Assets − Liabilities
• Equity increases as a result of profitable operations, that is, the excesses of income over expenses,
and by contributions by owners. Similarly, equity is diminished by unprofitable operations and by
distributions to owners (drawings and dividends).
• Equity is influenced by the measurement system adopted for assets and liabilities and by the concepts
of capital and capital maintenance adopted in the preparation of general purpose financial statements.
(These aspects are discussed later in the chapter.)
• Equity may be subclassified in the statement of financial position, for example, into contributed funds
from owners, retained earnings, other reserves representing appropriations of retained earnings, and
reserves representing capital maintenance adjustments.
1.5.4 Income
The Conceptual Framework defines income in paragraph 4.25(a) as:
Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets
or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity
participants.
Note that this definition of income is linked to the definitions of assets and liabilities. The definition of
income is wide in its scope, in that income in the form of inflows or enhancements of assets can arise from
providing goods or services, investing in or lending to another entity, holding and disposing of assets, and
receiving contributions such as grants and donations. To qualify as income, the inflows or enhancements
of assets must have the effect of increasing equity, excluding capital contributions by owners. Depending
on the concept of capital maintenance used (see section 1.8), certain increases in equity from revaluations
of assets must be excluded from income as well.
Another important aspect of the definition is that, if income arises as a result of an increase in eco-
nomic benefits, it is necessary for the entity to control that increase in economic benefits. If control does
not exist, then no asset exists. Income arises once control over the increase in economic benefits has been
achieved and an asset exists, provided there is no equivalent increase in liabilities. For example, in the
case of magazine subscriptions received in advance, no income exists on receipt of the cash because an
equivalent obligation has also arisen for services to be performed through supply of magazines to sub-
scribers in the future.
Income can also exist through a reduction in liabilities that increases the entity’s equity. An example of
a liability reduction is if a liability of the entity is ‘forgiven’. Income arises as a result of that forgiveness,
unless the forgiveness of the debt constitutes a contribution by owners.
Under the Conceptual Framework, income encompasses both revenue and gains. A definition of revenue is
contained in paragraph 7 of IAS 18 Revenue as follows:
[T]he gross inflow of economic benefits during the period arising in the course of the ordinary activities of an
entity when those inflows result in increases in equity, other than increases relating to contributions from equity
participants.

Thus revenue represents income which has arisen from ‘the ordinary activities of an entity’. On the other
hand, gains represent income that does not necessarily arise from the ordinary activities of the entity; for
example, gains on the disposal of non-current assets or on the revaluation of marketable securities. Gains
are usually disclosed in the statement of profit or loss and other comprehensive income net of any related
expenses, whereas revenues are reported at a gross amount. As revenues and gains are both income, there
is no need to regard them as separate elements under the Conceptual Framework.
1.5.5 Expenses
Paragraph 4.25(b) of the Conceptual Framework contains the following definition of expenses:
Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions
of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions
to equity participants.
To qualify as an expense, a reduction in an asset or an increase in a liability must have the effect of
decreasing the entity’s equity. The purchase of an asset does not decrease equity and therefore does not
create an expense. An expense arises whenever the economic benefits in the asset are consumed, expire or
are lost. Like income, the definition of expenses is expressed in terms of changes in assets, liabilities and
equity. This concept of expense is broad enough to encompass items that have typically been reported in
financial statements as ‘losses’, for example, losses on foreign currency transactions, losses from fire, flood,
and so on, or losses on the abandonment of a research project. Losses are expenses that may not arise in
the ordinary course of the entity’s activities.
LO6 1.6 RECOGNITION OF ELEMENTS OF FINANCIAL

STATEMENTS
There are recognition criteria to be followed in the preparation and presentation of financial statements
in practice. These criteria have been set down as part of the Conceptual Framework. Recognition means the
process of incorporating in the statement of financial position or statement of profit or loss and other
comprehensive income an item that meets the definition of an element. In other words, it involves the
inclusion of cash amounts in the entity’s accounting system. Note that an item must satisfy the definition
of an element before it is ‘recognised’.
1.6.1 Asset recognition

The Conceptual Framework states in paragraph 4.44 that an asset should be recognised in the statement of
financial position when it is probable that the future economic benefits will flow to the entity and the
asset has a cost or other value that can be measured reliably. Here, emphasis is placed on criteria for deter-
mining when to record an asset in the entity’s accounting records. An asset is to be recognised only when
both the probability and the reliable measurement criteria are satisfied. The term ‘probability’ refers to the
degree of certainty that the future economic benefits will flow to the entity. The benefits should be more
likely rather than less likely. For example, some development costs are not recognised as an asset because
it is not ‘probable’ that future economic benefits will eventuate.
Even if such probability of future benefits is high, recognition of an asset cannot occur unless some cost
or other value is capable of reliable measurement. Without such a measurement, the qualitative character-
istic of ‘reliability’ will not be achieved. In practice, reliable measurement of internally generated goodwill
has been difficult, and therefore such goodwill has not been recognised as an asset. Similarly, reliable
measurement of an entity’s mineral reserves is difficult. It is argued in the Conceptual Framework that assets
that cannot be measured reliably may nevertheless be disclosed in notes to the financial statements, par-
ticularly if knowledge of the item is considered relevant to evaluating the entity’s financial position, per-
formance and cash flows.
1.6.2 Liability recognition

Paragraph 4.46 of the Conceptual Framework establishes criteria for the recognition of a liability in an entity’s
accounting records. A liability is recognised in the statement of financial position when it is probable that
an outflow of resources embodying economic benefits will result from settling the present obligation and
the amount at which the settlement will take place can be measured reliably.
As with the recognition of assets, ‘probable’ means that the chance of the outflow of economic benefits
being required is likely. The additional need for reliable measurement is an attempt to measure, in mone-
tary terms, the amount of economic benefits that will be sacrificed to satisfy the obligation. Any liabilities
that are not recognised in the accounting records because they do not satisfy the recognition criteria may
be disclosed in notes to the financial statements, if considered relevant. Further discussion of the recognition
of liabilities is provided in chapter 5.

1.6.3 Income recognition
In accordance with paragraph 4.47 of the Conceptual Framework, income is recognised in the statement of
profit or loss and other comprehensive income when an increase in future economic benefits relating to
an increase in an asset or a decrease in a liability can be measured reliably. As with the recognition criteria
for assets and liabilities, probability of occurrence and reliability of measurement are presented as the two
criteria for income recognition in paragraph 4.38. For many entities, the majority of income in the form
of revenues results from the provision of goods and services during the reporting period. There is little
uncertainty that the income has been earned since the entity has received cash or has an explicit claim
against an external party as a result of a past transaction. However, the absence of an exchange transaction
often raises doubts as to whether the income has achieved the required degree of certainty. In situations of
uncertainty, the Conceptual Framework requires the income to be recognised as long as it is ‘probable’ that
it has occurred and the amount can be measured reliably.
As stated previously, income includes both revenues and gains. The standard setters have provided fur-
ther requirements for the recognition of revenues in accounting standard IAS 18 Revenue, which deals
with the recognition of different types of revenue that can arise in an entity. The standard requires all
revenue recognised in the entity’s financial statements to be measured at the fair value of the considera-
tion received or receivable. Separate recognition criteria are then provided for each different category of
revenue. See chapter 4 for a detailed discussion of revenue recognition.
1.6.4 Expense recognition

Just as the income recognition criteria have been developed in the Conceptual Framework as a guide to the
timing of income recognition, the expense recognition criteria have been developed to guide the timing of
expense recognition. The Conceptual Framework defines expenses in terms of decreases in future economic
benefits in the form of reductions in assets or increases in liabilities of the entity (see the definition of expenses in
section 1.5.5). In addition to the probability criteria for expense recognition, the Conceptual Framework states that
expenses are recognised in the statement of profit or loss and other comprehensive income when a decrease in
future economic benefits related to a decrease in an asset or an increase in a liability can be measured reliably
(paragraph 4.49). This means that an expense is recognised simultaneously with a decrease in an asset or an
increase in a liability. An expense is also recognised in the statement of profit or loss and other comprehensive
income when the entity incurs a liability without the recognition of any asset, for example, wages payable.
In years past, the process of recognising expenses was referred to as a ‘matching process’, whereby an
attempt was made to associate each cost with the income recognised in the current period. Costs that
were ‘associated’ with the revenue were then said to be ‘matched’ and written off to expenses. This idea of
matching expenses with income has been dropped in the Conceptual Framework in favour of assessing the
probability of a decrease in economic benefits that can be measured reliably. Matching is no longer the
expense recognition criterion under the Conceptual Framework.
LO7 1.7 MEASUREMENT OF THE ELEMENTS OF FINANCIAL

STATEMENTS
Paragraph 4.54 of the Conceptual Framework states:
Measurement is the process of determining the monetary amounts at which the elements of the financial state-
ments are to be recognised and carried in the balance sheet [statement of financial position] and income state-
ment [statement of profit or loss and other comprehensive income].
Because the concepts of equity, income and expenses are highly dependent on the concepts of assets and
liabilities, measurement of the former depends on measurement of the latter. In other words, emphasis is
placed on measuring assets and liabilities; the measurement of equity, income and expenses then follows.
Measurement is very important in accounting in that it is the process by which valuations are placed on
all elements reported in financial statements. Measurements can have an important effect on the economic
decisions made by users of those financial statements. The Conceptual Framework (paragraph 4.55) points
out that a number of different measurement bases may be used for assets, liabilities, income and expenses
in varying degrees and in varying combinations in financial statements. They include the following, the
most common of which, in practice, is the historical cost basis:
• Historical cost. Under the historical cost measurement basis, an asset is recorded at the amount of cash
or cash equivalents paid or the fair value of the consideration given to acquire it at its acquisition date.
Liabilities are recorded at the amount of the proceeds received in exchange for an obligation, or at the
amount of cash to be paid out in order to satisfy the liability in the normal course of business.
• Current cost. For an asset, current cost represents the amount of cash or cash equivalents that would be
paid if the same or equivalent asset was acquired currently. A liability is recorded at the amount of
cash or cash equivalents needed to settle the obligation currently.

• Realisable or settlement value. For an asset, the realisable value is the amount of cash or cash equivalents
that could be obtained currently by selling the asset in an orderly disposal, or in the normal course of
business. The settlement amount of a liability is the amount of cash or cash equivalents expected to be
paid to satisfy the obligation in the normal course of business.
• Present value. The present value of an asset means the discounted future net cash inflows or net cash
savings that are expected to arise in the normal course of business. The present value of a liability is
the discounted future net cash outflows that are expected to settle the obligation in the normal course
of business.
In relation to measurement principles, the Conceptual Framework merely describes practice rather than
establishing any principles that should be applied in the measurement of elements of financial statements.
The measurement basis most commonly adopted by entities is the historical cost basis, although over time
the IASB has increasingly allowed or mandated the use of fair values. Realisable value is mainly used to
perform impairment tests under the historical cost method and for the measurement of certain types of
inventory such as agricultural or extractive inventory. There is little use of current cost (replacement cost)
in financial statements. The fact that fair value as measurement basis is not even mentioned in the Concep-
tual Framework reflects the need to revise and update this chapter of the Conceptual Framework. The use of
fair value, which is defined 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’ (IFRS 13 Fair Value Meas-
urement paragraph 9) is also referred to in many accounting standards.
LO8 1.8 CONCEPTS OF CAPITAL

Scant attention has been given to the concept of capital in accounting in the last 35 years, but it was a
topic that received considerable focus during the current value debates of the 1960s to the early 1980s. It
was argued then, and now, that before an entity can determine its income for any period, it must adopt
not only a measurement basis for assets and liabilities, but also a concept of capital. Two main concepts of
capital are discussed in the Conceptual Framework, namely financial capital and physical capital.
Under the financial capital concept, capital is synonymous with the net assets or equity of the entity,
measured either in terms of the actual amount of currency by subtracting the total of liabilities from assets,
or in terms of the purchasing power of the amount recorded as equity. Profit exists only after the entity has
maintained its capital, measured as either the financial amount of equity at the beginning of the period,
adjusted for dividends and contributions or the purchasing power of financial amount of equity at the
beginning of the period.
Under the physical capital concept, capital is seen not so much as the equity recorded by the entity but as
the operating capability of the entity’s assets. Profit exists only after the entity has set aside enough capital
to maintain the operating capability of its assets.
A number of different accounting systems have been devised in the past to provide alternatives to the
conventional historical cost system, which is the system predominantly used in practice. These alternatives,
which represent different combinations of the measurement of assets and liabilities and the concept of
capital maintenance, include:
• the general price level accounting system, which had its origins in Germany after World War I when
inflation reached excessive levels — this system modifies the conventional historical cost system for the
effects of inflation and therefore follows a financial capital concept
• current value systems, which attempt to measure the changes in the current values of assets and
liabilities — these systems include measures of the current buying or input prices of net assets, and/
or measures of the current selling or realisable values of net assets. Capital may be measured as either
financial or physical.
LO9 1.9 FUTURE DEVELOPMENTS

In 2015 the IASB released an exposure draft for a new Conceptual Framework. With these proposals the IASB
responds to a widely felt need to fill the gaps in the Conceptual Framework, make it more robust and update
it for developments that have taken place in thinking about financial reporting. This did not take place
without controversy. In 2010 the IASB had decided to remove the notions of stewardship and prudence
from the Conceptual Framework. Stewardship was not considered necessary as the information needs to
assess stewardship were considered no different from the information needs for other economic decisions
of users, in particular investors. Prudence was believed to be implying some bias in making judgements
and therefore difficult to reconcile with a fundamental qualitative characteristic of financial information,
i.e. faithful representation. The proposed Conceptual Framework, however, brings back both notions, after
heavy lobbying from some constituents. Arguments provided to bring back stewardship are that there
may well be information needs specific to stewardship that are not necessarily covered by other economic
decisions of investors, such as buy, hold and sell decisions. The notion of prudence is brought back in,

but with a very specific meaning, i.e. that caution must be exercised when making judgements under con-
ditions of uncertainty and it is necessary to achieve neutrality. The proposed Conceptual Framework also:
• provides guidance on the reporting entity and acknowledges the need for combined financial
statements
• contains new definitions of asset and liability
• includes some concepts of measurement
• still distinguishes profit and loss and other comprehensive income without providing the concept
of how to distinguish between the two or whether and when to reclassify amounts in other
comprehensive income to profit and loss (also referred to as ‘recycling’).
SUMMARY
This chapter has provided an overview of the structure of the IASB and the process of setting IFRSs,
including IFRIC Interpretations. The adoption of IFRSs in many parts of the world has increased the
importance of developments in international standards setting.
The Conceptual Framework describes the basic concepts that underlie financial statements prepared in
conformity with IFRSs. It serves as a guide to the standard setters in developing accounting standards and
in resolving accounting issues that are not addressed directly in an accounting standard.
The Conceptual Framework identifies the principal classes of users of an entity’s general purpose financial
statements and states that the objective of financial statements is to provide information — about the
financial position, performance and changes in financial position of an entity — that is useful to existing
and potential investors, lenders and other creditors in making decisions about providing resources to the
entity. It specifies the fundamental qualities that make financial information useful, namely relevance and
faithful representation. The usefulness of financial information is enhanced by comparability, verifiability,
timeliness and understandability, and constrained by cost.
The Conceptual Framework also defines the basic elements in financial statements (assets, liabilities,
equity, income and expenses) and discusses the criteria for recognising them. The Conceptual Framework
identifies alternative measurement bases used in practice and describes alternative concepts of capital
maintenance.
Discussion questions
1. Describe the standard-setting process of the IASB.
2. Identify the potential benefits of a globally accepted set of accounting standards.
3. Outline the fundamental qualitative characteristics of financial reporting information to be considered
when preparing general purpose financial statements.
4. Discuss the importance of the going concern assumption to the practice of accounting.
5. Discuss the essential characteristics of an asset as described in the Conceptual Framework.
6. Discuss the essential characteristics of a liability as described in the Conceptual Framework.
7. Discuss the difference, if any, between income, revenue and gains.
8. Distinguish between the financial and physical concepts of capital and their implications for the
measurement of profit.
References
IFRS Foundation 2013, IASB and IFRS Interpretations Committee Due Process Handbook, www.ifrs.org.
IFRS Foundation and International Accounting Standards Board 2015, IASB and the IASC Foundation:
Who We Are and What We Do, www.ifrs.org.
International Accounting Standards Board 2016, Conceptual Framework for Financial Reporting, www.ifrs.org.
Exercises STAR RATING ★ BASIC ★★ MODER ATE ★★★ DIFFICULT
Exercise 1.1 MEASURING INVENTORIES OF GOLD AND SILVER

★ IAS 2 Inventories allows producers of gold and silver to measure inventories of these commodities at selling
price even before they have sold them, which means a profit is recognised at production. In nearly all
other industries, however, profit is recognised only when the inventories are sold to outside customers.
What concepts in the Conceptual Framework might the standard setters have considered with regard to
accounting for gold and silver production?

Exercise 1.2 RECOGNISING A LOSS FROM A LAWSUIT
★ The law in your community requires store owners to shovel snow and ice from the pavement in front
of their shops. You failed to do that, and a pedestrian slipped and fell, resulting in serious and costly
injury. The pedestrian has sued you. Your lawyers say that while they will vigorously defend you in the
lawsuit, you should expect to lose $25 000 to cover the injured party’s costs. A court decision, however, is
not expected for at least a year. What aspects of the Conceptual Framework might help you in deciding the
appropriate accounting for this situation?
Exercise 1.3 NEED FOR THE CONCEPTUAL FRAMEWORK VS. INTERPRETATIONS

★ Applying the Conceptual Framework is subjective and requires judgement. Would the IASB be better off to
abandon the Conceptual Framework entirely and instead rely on a very active interpretations committee that
develops detailed guidance in response to requests from constituents?
Exercise 1.4 ASSESSING PROBABILITIES IN ACCOUNTING RECOGNITION

★ The Conceptual Framework defines an asset as a resource from which future economic benefits are expected
to flow. ‘Expected’ means it is not certain, and involves some degree of probability. At the same time the
Conceptual Framework establishes, as a criterion for recognising an asset, that ‘it is probable that any future
economic benefit associated with the item will flow to or from the entity.’ Again, an assessment of proba-
bility is required. Is there a redundancy, or possibly some type of inconsistency, in including the notion of
probability in both the asset definition and recognition criteria?
Exercise 1.5 PURCHASE ORDERS

★ An airline places a non-cancellable order for a new aeroplane with one of the major commercial aircraft
manufacturers at a fixed price, with delivery in 30 months and payment in full to be made on delivery.
(a) Under the Conceptual Framework, do you think the airline should recognise any asset or liability at the
time it places the order?
(b) One year later, the price of this aeroplane model has risen by 5%, but the airline had locked in a fixed,
lower price. Under the Conceptual Framework, do you think the airline should recognise any asset (and
gain) at the time when the price of the aeroplane rises? If the price fell by 5% instead of rising, do you
think the airline should recognise any liability (and loss) under the Conceptual Framework?
Exercise 1.6 DEFINITIONS OF ELEMENTS AND RECOGNITION CRITERIA

★ Explain how you would account for the following items/situations, justifying your answer by reference to
the Conceptual Framework’s definitions and recognition criteria:
(a) A trinket of sentimental value only.
(b) You are guarantor for your friend’s bank loan:
(i) You have no reason to believe your friend will default on the loan.
(ii) As your friend is in serious financial difficulties, you think it likely that he will default on the loan.
(c) You receive 1000 shares in X Ltd, trading at $4 each, as a gift from a grateful client.
(d) The panoramic view of the coast from your café’s windows, which you are convinced attracts customers
to your café.
(e) The court has ordered your firm to repair the environmental damage it caused to the local river system.
You have no idea how much this repair work will cost.
Exercise 1.7 ASSETS

★ Lampeter Cosmetics has spent $220 000 this year on a project to develop a new range of chemical-free
cosmetics. As yet, it is too early for Lampeter Cosmetics’ management to be able to predict whether this
project will prove to be commercially successful. Explain whether Lampeter Cosmetics should recognise
this expenditure as an asset, justifying your answer by reference to the Conceptual Framework asset definition
and recognition criteria.
Exercise 1.8 ASSET DEFINITION AND RECOGNITION

★ On 28 May 2013, $20 000 cash was stolen from Ming Lee Ltd’s night safe. Explain how Ming Lee should
account for this event, justifying your answer by reference to relevant Conceptual Framework definitions and
recognition criteria.

ACADEMIC PERSPECTIVE — CHAPTER 1
The Conceptual Framework highlights the decision useful- characteristic of accounting information. The relatively small
ness property of accounting numbers and identifies cer- magnitude observed for earnings response coefficients from
tain underlying qualities that enhance it. It is therefore an the extant research (Kothari, 2001) may be then attributed to
important question, in the light of the large resources society the fact that earnings lag behind share prices. Another, not
expends on accounting regulation and profession, whether mutually exclusive, explanation for the low magnitude of the
published financial statements do in fact provide useful infor- earnings response coefficient is that the quality of accounting
mation. In attempting to address this question, accounting standards is poor (Lev and Zarowin, 1999).
research largely has focused on the ‘value relevance’ property Research that followed includes Easton and Harris (1991)
of accounting numbers as a way to operationalise criteria who refine the specification used in Kormendi and Lipe
such as relevance and faithful representation (or, as previ- (1987) to show that prices and returns are also related to
ously known, reliability). There may be a number of ways earnings levels as well as earnings changes. Kothari and
to assess the value relevance and reliability of specific num- Sloan (1992) argue that the earnings response coefficient is
bers or disclosures, but a popular approach in the archival a function of news about future growth in earnings that is
empirical academic literature has been to examine the asso- contained in current earnings. As is suggested by Kormendi
ciation between specific disclosures and stock prices or stock and Lipe (1987), the earnings response coefficient may also
returns. Extensive reviews that go well beyond the scope of be smaller when earnings changes are transitory. In par-
this section are offered by, for example, Barth et al. (2001) ticular, losses are transitory because they cannot continue for
and Kothari (2001). a long time; in such a case the reporting entity will go out of
Modern empirical accounting research traces its origin to business or be purchased by another company. Hayn (1995)
the seminal paper of Ball and Brown (1968) which shows provides evidence on the earnings response coefficient in
that stock returns and earnings surprises tend to move in loss firms that is consistent with this idea.
the same direction. From this evidence one can infer that Surprisingly, only in recent years have accounting
earnings and share prices impound similar information, researchers started to look at the value relevance of earnings
although causality (i.e., whether accounting numbers shape in the much larger debt markets. Easton et al. (2009) find
stock prices and trading decisions) is more difficult to show. that bond returns and earnings are positively associated, and
Beaver’s (1968) seminal paper on trading volume around more so for negative earnings surprises. This is explained
earnings announcements provides more persuasive evidence by the sensitivity of investors in bonds to bad news, as this
that earnings announcements furnish useful news to market may affect the return on their investments (whereas increases
participants. Specifically, he documents a spike in trading in firm value normally benefit equity investors). They also
activity around earnings announcements, suggesting infor- find that trading activity in bonds increases around earnings
mation conveyed in these announcements leads investors to announcements, evidence that extends the findings of Beaver
revise their prior beliefs and hence trade. Notwithstanding (1968) to debt markets. Overall, therefore, the accounting
the centrality of the value relevance strand in accounting literature has provided evidence that accounting numbers
research, it is not without shortcomings. Criticisms of the are capable of, and likely are, providing information that is
value relevance literature can be found in Holthausen and useful to investors.
Watts (2001) and the interested reader should bear these The qualitative characteristic that received most scrutiny
in mind. In particular, many academics stress the role of in more recent accounting research is probably faithful rep-
accounting in contracting, such as in debt and compensa- resentation. Faithful representation requires the accounting
tion. However, contracting is not a consideration in the Con- treatment to be unbiased and neutral. In particular, it negates
ceptual Framework. the concept of conservatism that requires estimates to be
Of the extensive research that links earnings to stock prices cautious in that, if a range of estimates is available for an
and returns, we mention here only a few important papers. item of assets or income, a lower estimate should be selected.
Kormendi and Lipe (1987) link returns to earnings surprises The opposite holds for liabilities and expenses. It should be
(or, earnings innovations) by regressing stock returns on noted that historically conservatism has been one of the
earnings surprises. The coefficient on the earnings surprise is fundamental principles in accounting (Watts, 2003) and the
called the earnings response coefficient (ERC). If the surprise requirement for neutral and unbiased treatment is very new.
is permanent and value relevant, then $1 of a surprise should That many standards, old and new, are nevertheless conserv-
translate into more than $1 of return. Kormendi and Lipe ative may be surprising given standard setters’ insistence on
(1987) show that greater earnings persistence translates to a neutrality as per the Conceptual Framework of 2010 (although
larger ERC. this may change in the future). However, as Watts (2003)
Using changes in earnings as a proxy for new information argues, conservatism reduces political cost for standard set-
can shed light on how informative earnings are when they ters and so when they promulgate specific standards they still
are announced. Because earnings may not be timely, in the require conservatism in measurement procedures. Consistent
sense that news from other sources is already impounded with this argument, Barker and McGeachin (2015) find
in prices before the earnings are announced (Beaver et al. many examples in accounting standards promulgated by the
1980), changes in annual or quarterly earnings may be IASB that show that IAS and IFRS are, in practice, conserva-
only weakly related to returns. Therefore, a smaller earnings tive. Basu (1997) operationalised the concept of conserva-
response coefficient may indicate a lack of timeliness (rather tism to predict that bad news is incorporated into earnings
than weaker persistence), which is an enhancing qualitative at a faster rate than good news. Employing negative share

returns as a proxy for bad news he finds that in a regression Barth, M.E., Beaver, W.H., and Landsman, W.R., 2001. The
of earnings on returns and negative returns the coefficient relevance of the value relevance literature for financial
on negative returns is positively associated with earnings. accounting standard setting: another view. Journal of
This implies that negative returns (bad news) reduce earn- Accounting and Economics, 31(1), 77–104.
ings more than positive returns (good news) increase earn- Basu, S., 1997. The conservatism principle and the
ings, thus confirming his conjecture. Basu (1997) has been a asymmetric timeliness of earnings. Journal of Accounting and
highly influential paper. It has spawned a very large number Economics, 24(1), 3–37.
of studies that investigate the relation between conservatism Beaver, W., 1968. The information content of annual
and an array of economic phenomena. As of writing this earnings announcements. Journal of Accounting Research,
section, Basu (1997) has been cited more than 3000 times Supplement, 67–92.
(source: Google Scholar). Beaver, W., Lambert, R., and Morse, D., 1980. The
Other qualitative characteristics may be less amenable information content of security prices. Journal of Accounting
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pose a novel approach to the operationalisation of compa- Research, 49(4), 895–931.
rability. The underlying concept in their paper is that two Easton, P., and Harris, T., 1991. Earnings as an explanatory
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time series of earnings and stock returns for each firm in on the role of accounting earnings in the bond market.
their sample to regress the former on the latter. The regres- Journal of Accounting Research, 47(3), 721–766.
sion coefficients are then used to calculate expected earnings Hayn, C., 1995. The information content of losses. Journal of
given an economic event, which is proxied by returns. Com- Accounting and Economics, 20(2), 125–153.
parability is defined with respect to the difference between Holthausen, R.W., and Watts, R.L., 2001. The relevance of the
expected earnings between any two firms within the same value relevance literature for financial accounting standard
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Part 2
Elements
2 Owners’ equity: share capital and reserves 21 15 Impairment of assets 417
3 Fair value measurement 49
Visit the companion website to access additional
4 Revenue from contracts with customers 73 chapters online at: www.wiley.com/college/picker
5 Provisions, contingent liabilities and contingent assets 95 Online chapter A Exploration for and
6 Income taxes 123 evaluation of mineral resources
7 Financial instruments 155 Online chapter B Agriculture
8 Share-based payment 199
9 Inventories 219
10 Employee benefits 245
11 Property, plant and equipment 275
12 Leases 321
13 Intangible assets 355
2 Owners’ equity:
share capital and
reserves
ACCOUNTING IAS 1 Presentation of Financial Statements
STANDARDS IAS 32 Financial Instruments: Presentation
IN FOCUS

OBJECTIVES
1 describe the essence of the equity section in the statement of financial position
2 describe in general terms what a for-profit company is
3 outline the key features of the corporate structure
4 discuss the different forms of share capital
5 account for the issue of both no-par and par value shares
6 account for share placements, rights issues, options, and bonus issues
7 discuss the rationale behind and accounting treatment of share buy-backs
8 outline the nature of reserves and account for movements in retained earnings, including
dividends
9 prepare note disclosures in relation to equity, as well as a statement of changes in equity.
CHAPTER 2 Owners’ equity: share capital and reserves 21

LO1 2.1 EQUITY
The purpose of this chapter is to introduce the element of equity in financial statements, describe its
various components and the accounting for transactions that give rise to these components.
Equity is part of the statement of financial position, or balance sheet. From an algebraic standpoint it
is the difference between total assets and liabilities. The IASB®’s Conceptual Framework (IASB 2010 para-
graph 4.4(c)) defines it as a residual, implying shareholders’ financial interest in a company is confined
to the excess, if any, of its assets over its liabilities.1 This definition largely stems from the notion that
shareholders’ claims on a firm’s assets are typically inferior to other stakeholders’ rights (e.g. creditors). It
is important to note that the figure for equity reported in the balance sheet is based on accounting con-
ventions (as explained throughout this book) and is typically quite different from the real worth of the
company to its owners.2
The main components of the equity section of the statement of financial position are contributed capital
(e.g. share capital) and reserves (e.g. retained earnings). The specific element of capital will differ depending
on the nature of the organisation, whether a sole proprietorship, partnership or company. Reserves com-
prise equity attributable to the owners of the entity other than amounts directly contributed by the owners.
An example of the equity section of the statement of financial position of a for-profit entity is shown in
figure 2.1. It contains an extract from the consolidated balance sheet of Tesco as at 22 February 2014. The
accounts were prepared in accordance with IFRS® Standards. Note that the sum of share capital and share
premium represents the amount of cash the company raised upon issuing its shares. For example, total
share capital and premium for Tesco as at 22 February 2014 is £5485m. An alternative term to ‘share pre-
mium’ that is used, in particular by US firms, is ‘additional paid-in capital’. The second component, the
reserves, is all the other line items, with the exception of non-controlling interest. In the case of Tesco 2014
total reserves is £9230m. US firms do not use the term ‘retained earnings’; instead they use ‘accumulated
other comprehensive income’. Non-controlling interests represents the ownership interests of non-Tesco
shareholders in other companies that Tesco controls, but does not hold 100% of the voting rights. (This is
discussed in detail in Chapter 23.)
22 February 2014 23 February 2014

£m £m
Share capital 405 403

Share premium 5 080 5 020
All other reserves (498 ) 685
Retained earnings 9 728 10 535
Equity attributable to owners of the parent 14 715 16 643
Non-controlling interests 7 18
Total equity 14 722 16 661
FIGURE 2.1 Owners’ equity of Tesco

Source: Tesco plc (2014, p. 71).
In contrast to a multi-shareholders company like Tesco, with a sole proprietor, having a single owner
means there is little reason for distinguishing between capital (potentially the initial investment in the
business) and profits retained in the business for investment purposes. Nevertheless, many single-owned
companies could still adopt a similar presentation.
Traditionally with partnerships, the rights and responsibilities of the partners are specified in a partnership
agreement. This document details how the profits or losses of the partnership are to be divided between
the partners, including rules relating to distributions on dissolution of the partnership. In accounting for
partnerships, a distinction is generally made for each partner between a capital account, to which amounts
invested by a partner are credited, and a current account or retained earnings account, to which a partner’s
share of profits are credited and from which any drawings are debited. As with a sole proprietorship, there
generally is no real distinction between capital contributed and profits retained (unless there is some
other specification in the partnership agreement, which is unlikely). Both amounts represent the ongoing
investment by the partners. On dissolution of the partnership, the distribution to partners is unaffected by
whether an equity balance is capital or retained earnings.
With companies, the focus of this chapter, the situation is different because their formation is generally
governed by legislation, and there is normally a clear distinction made between contributed capital and
profits retained in the entity. For example, the amount of dividend a company can pay may be restricted to
what is reported in retained earnings.
1 See
also chapter 1.
2 IAS
1 employs the term ‘owners’ to mean ‘shareholders’. In this chapter, the two terms are used interchangeably.
22 PART 2 Elements
LO2 2.2 FOR-PROFIT COMPANIES
Generally, companies can be distinguished by the nature of the ownership, and the rights and responsi-
bilities of the shareholders. In particular, some companies are not-for-profit and some are for-profit. The
focus of this chapter, however, is on for-profit companies.
For-profit companies may be:
• listed — their shares are traded on a stock exchange
• unlisted — the shares are traded through brokers and financial institutions
• limited by guarantee — the members undertake to contribute a guaranteed amount in the event of the
company going into liquidation
• unlimited — members are liable for all the debts of the company
• no-liability — members are not required to pay any calls on their shares if they do not wish to
continue being shareholders in the company.
The exact rights and responsibilities of shareholders in relation to the different forms of companies will
differ according to the relevant companies legislation and other laws specific to the country or countries in
which the company operates.
Many global companies list on a number of stock exchanges. Nokia, for example, is now quoted on the
NASDAQ, OMX Helsinki and the New York Stock Exchange, but in the past was also listed in Stockholm
(Stockholmsborsen) and Frankfurt (Wertpapierborse).
LO3 2.3 KEY FEATURES OF THE CORPORATE STRUCTURE

The choice of the company as the preferred form of organisational structure brings with it certain advan-
tages, such as limited liability to shareholders. It also comes with certain disadvantages, such as making the
entity subject to increasing government regulation including the forced and detailed disclosure of infor-
mation about the company. Some features of the company structure that affect the subsequent accounting
for a company are described below.
2.3.1 The use of share capital

The ownership rights in a company are generally represented by shares; that is, the share capital of a com-
pany comprises a number of units or shares. Each share represents a proportional right to the net assets of
the company and, within a class of shares, all shares have the same equal rights. These shares are generally
transferable between parties. As a result, markets have been established to provide investors with an ability
to trade in shares. A further advantage of transferability is that a change in ownership by one shareholder
selling shares to a new investor does not have an effect on the continued existence and operation of the
company.
Besides the right to share equally in the net assets, and hence the profits or losses of a company, each
share typically has other rights, including:
• the right to vote for directors of the company. This establishes the right of shareholders to have a say
as owners in the strategic direction of the company. Where there are a large number of owners in
a company, there is generally a separation between ownership and management. The shareholders
thus employ professional managers (the directors) to manage the organisation; these managers
then provide periodic reports to the shareholders on the financial performance and position of the
company. Some directors are executive directors, being employed as executives in the company,
while others have non-executive roles. The directors are elected at the annual general meeting of
the company, and shareholders exercise their voting rights to elect the directors. The shareholders
may vote in person, or by proxy. In relation to the latter, a shareholder may authorise another party
to vote on their behalf at the meeting; the other party could be the chairperson of the company’s
board.
• the right to share in assets on the winding-up or liquidation of the company. The rights and
responsibilities of shareholders in the event of liquidation are generally covered in legislation
specific to each country, as are the rights of creditors to receive payment in preference to
shareholders. However, if upon liquidation the assets are insufficient to pay the outstanding
liabilities, shareholders of limited liability companies will receive no consideration for their shares
(also see section 2.3.2).
• the right to share proportionately in any new issues of shares of the same class. This right is sometimes
referred to as the pre-emptive right. It ensures that a shareholder is able to retain the same
proportionate ownership in a company, and that this ownership percentage cannot be diluted by
the company issuing new shares to other investors, possibly at prices lower than the current fair
value. However, the directors may be allowed to make limited placements of shares under certain
conditions.

2.3.2 Limited liability
When shares are issued, the maximum amount payable by each shareholder is set. Even if a company
incurs losses or goes into liquidation, the company cannot require a shareholder to provide additional
capital. In some countries, shares are issued with a specific amount stated on the share certificate, this
amount being called the par value of the share. For example, a company may issue 1 million shares each
with a par value of $1. The company then receives share capital of $1 million.
Par value shares may also be issued at a premium. For example, where a company requires share capital
of $2 million, 1 million $1 shares may be issued at a premium of $1 per share; in this case, each share-
holder is required to pay $2 per share. Similarly, par value shares may be issued at a discount. For example,
where a company issues $1 shares at a discount of 20c, the company requires each shareholder to initially
pay 80c per share. The only real purpose of the par value is to establish the maximum liability of the share-
holder in relation to the company, and so owners may be required to contribute a further 20c per share
upon liquidation, or at a later stage, as agreed with the company. Legislation in some countries restricts
the issue of shares at a discount, and also establishes the subsequent uses of any share premium received
on a share.
Note that the par value does not represent a fair or market value of the share. At the issue date, it would
be expected that the par value, plus the premium or minus the discount, would represent the market value
of the share. In some countries the use of par value shares has been replaced by the issue of shares at a
specified price with no par value. For example, a company may issue 1000 shares in 2012 at $3 per share,
and in 2015 it may issue another 1000 shares at $5 per share. At the end of 2015, the company then has
2000 shares and a share capital of $8000. The issue price becomes irrelevant subsequent to the issue. The
variables are the number of shares issued and the amount of share capital in total. The liability of each
shareholder is limited to the issue price of the shares at the time of issue.
The feature of limited liability protects shareholders by limiting the contribution required of them,
which in turn places limitations on the ability of creditors to access funds for the repayment of company
debts. To protect creditors, many countries have enacted legislation that prohibits companies from dis-
tributing capital to shareholders in the form of dividends. Dividends are then payable only from retained
profits, not out of capital (see section 2.8.1). Other forms of legislation require that assets exceed liabilities
immediately before a dividend is ‘declared’.
LO4 2.4 DIFFERENT FORMS OF SHARE CAPITAL

Shares are issued with specific rights attached. Shares are then given different names to signify differences
in rights.
2.4.1 Ordinary shares

The most common form of share capital is the ordinary share or common stock. These shares have no
specific rights to any distributions of profit by the company, and ordinary shareholders are often referred to
as ‘residual’ equity holders in that these shareholders obtain what is left after all other parties’ claims have
been met. An example of a company that has only one class of share is Nokia and each share entitles its
holder to one vote (Nokia Corporation 2013, p. 16). Further information on its shares as at 31 December
2009 to 2013 was provided in its 2013 annual report in the notes to the financial statements of the parent
company. Part of this information is shown in figure 2.2.
FIGURE 2.2 Share capital, Nokia Corporation
Shares and share capital

Nokia has one class of shares. Each Nokia share entitles the holder to one vote at General Meetings of
Nokia.
On December 31, 2013, the share capital of Nokia Corporation was EUR 245 896 461.96 and the total
number of shares issued was 3 744 994 342. On December 31, 2013, the total number of shares included
32 567 617 shares owned by Group companies representing approximately 0.9% of the share capital and
the total voting rights.
Under the Articles of Association of Nokia, Nokia Corporation does not have minimum or maximum share
capital or a par value of a share.
24 PART 2 Elements
FIGURE 2.2 (continued)
Share capital and shares

December 31, 2013 2013 2012 2011 2010 2009
Share capital, EURm 246 246 266 246 246

Shares (1000) 3 744 994 3 744 956 3 744 956 3 744 956 3 744 956
Shares owned by the Group (1 000) 32 568 33 971 34 767 35 826 36 694
Number of shares excluding shares
owned by the Group (1 000) 3 712 427 3 710 985 3 710 189 3 709 130 3 708 262
Average number of shares
excluding shares owned by the
Group during the year (1 000),
basic 3 712 079 3 710 845 3 709 947 3 708 816 3 705 116
Average number of shares excluding
shares owned by the Group
during the year (1 000), diluted 3 712 079 3 710 845 3 709 947 3 713 250 3 721 072
Number of registered shareholders1 225 587 250 799 229 096 191 790 156 081
1 Each account operator is included in the figure as only one registered shareholder.
Key ratios December 31, 2013,

IFRS (calculation see page 98) 2013 2012 2011 2010 2009
Earnings per share for profit

attributable to equity holders of
the parent, EUR
Earnings per share, basic −0.17 −0.84 −0.31 0.50 0.24
Earnings per share, diluted −0.17 −0.84 −0.31 0.50 0.24
P/E ratio neg. neg. neg. 15.48 37.17
(Nominal) dividend per share, EUR1 0.37 0.00 0.20 0.40 0.40
Total dividends paid, EURm2 1 386 0.00 749 1 498 1 498
Payout ratio neg. 0.00 neg. 0.80 1.67
Dividend yield, % 6.36 0.00 5.30 5.17 4.48
Shareholders’ equity per share, EUR3 1.74 2.14 3.20 3.88 3.53
Market capitalization, EURm3 21 606 10 873 13 987 28 709 33 078
1 Dividend
to be proposed by the Board of Directors for fiscal year 2013 for shareholders’ approval at the Annual
General Meeting convening on June 17, 2014.
2 Calculated for all the shares of the company as of the applicable year-end.
3
Shares owned by the Group companies are not included.
Source: Nokia Corporation (2013, p. 90).
Returns to shareholders
As already noted, the shareholders of ordinary shares have no specific rights to dividends, being residual
equity holders. Whether a dividend is paid depends on the decisions made by the directors. Regulations
in some countries may specify from which equity accounts the dividends can be paid, or whether the
company has to meet solvency tests before paying dividends. In some cases, the directors may be allowed
to propose a dividend at year-end, but this proposal may have to be approved by the shareholders in the
annual general meeting.
2.4.2 Preference shares

Another form of share capital is the preference share. As the name implies, holders of preference shares
generally have a preferential right to dividends over the ordinary shareholders. Note firstly that the name
of the instrument does not necessarily indicate the rights associated with that instrument. As is discussed
in chapter 7, some preference shares are in substance not equity but liabilities, or they may be compound
instruments being partially debt and partially equity, sometimes referred to as hybrid, or compound,
securities. Secondly, the rights of preference shareholders may be very diverse. Some preference shares have
a fixed dividend; for example, a company may issue preference shares at $10 each with a 4% dividend per

annum, thus entitling the shareholder to a 40c dividend per annum. Other common features of preference
shares are:
• cumulative versus non-cumulative shares. Where a preference share is cumulative, if a dividend is not
declared in a particular year, the right to the dividend is not lost but carries over to a subsequent year.
The dividends are said to be in arrears. With non-cumulative shares, if a dividend is not paid in a
particular year, the right to that dividend is lost.
• participating versus non-participating shares. A participating share gives the holder the right to share in
extra dividends. For example, if a company has issued 8% participating preference shares and it pays
a 10% dividend to the ordinary shareholders, the preference shareholders may be entitled to a further
2% dividend.
• convertible versus non-convertible shares. Convertible preference shares may give the holder
the right to convert the preference shares into ordinary shares. The right to convert may be
at the option of the holder of the shares or at the option of the company itself. As explained in
chapter 7, convertible preference shares may need to be classified into debt and equity
components.
• redeemable preference shares. Redeemable preference shares are shares that may be converted into cash
under certain pre-specified conditions. As explained in chapter 7, if the terms of the issue are such
that the shares are redeemed at the discretion of the shareholder, the issue of the preference shares
is treated as a liability. However, if the terms are such that the decision to redeem is at the issuer’s
discretion, it will be reported as equity.
LO5 2.5 CONTRIBUTED EQUITY: ISSUE OF

SHARE CAPITAL
Once a business has decided to form a public company, it will commence the procedures necessary to
issue shares to the public. The initial offering of shares to the public to invest in the new company is
called an initial public offering (IPO). To arrange the sale of the shares, the business that wishes to float
the company usually employs a promoter, such as a stockbroker or a financial institution, with expert
knowledge of the legal requirements and experience in this area. Once the promoter and the managers
of the business agree on the structure of the new company, a prospectus is drawn up and lodged with the
regulating authority. The prospectus contains information about the current status of the business and its
future prospects.
In order to ensure that the statements in the prospectus are accurate, a process of due diligence is
undertaken by an accounting firm. To ensure that the sale of shares is successful, an underwriter may be
employed. The role of the underwriter is to advise on such matters as the pricing of the issue, the timing
of the issue and how the issue will be marketed. One of the principal reasons for using an underwriter is
to ensure that all the shares are sold, as the underwriter agrees to acquire all shares that are not taken up
by the public.
2.5.1 Issue costs

The costs of issuing the shares can then be quite substantial and could amount to 10% of the amount
raised. The costs include those associated with preparing and printing the relevant documentation and
marketing the share issue, as well as the fees charged by the various experts consulted which could include
accountants, lawyers and taxation specialists. Accounting for these costs is covered in paragraph 37 of IAS
32 Financial Instruments: Presentation. It requires the offsetting issuance cost from the proceeds of the issued
share capital, unless the issue is aborted, in which case the costs are expensed.
The costs are then treated as a reduction in share capital such that the amount shown in share capital
immediately after the share issue is the net amount available to the company for operations. The accounting
for share issue costs is demonstrated in the next section.
Any costs associated with the formation of the company that cannot be directly related to the issue of
the shares, such as registration of the company name, are expensed as the cost is incurred. These outlays do
not meet the definition of an asset as there are no expected future economic benefits associated with these
outlays that can be controlled by the company.
As discussed in 2.3.2, shares may be issued with a stated par value, or as no-par shares. Shares with stated
par value may be issued at a premium, or a discount. These possibilities are illustrated next.
2.5.2 Issue of no-par shares

Illustrative example 2.1 shows the recording of issuing no-par shares.
26 PART 2 Elements
ILLUSTRATIVE EXAMPLE 2.1 Issue of no-par shares
Quebec Ltd issues 500 no-par shares for cash at $10 each, incurring share issue costs of $450. Quebec
Ltd records on its share register the number of shares issued, and makes the following journal entry:
Cash Dr 5 000
Share Capital Cr 5 000
(Issue of 500 $10 shares)
Share Capital Dr 450

Cash Cr 450
(Share issue costs)
2.5.3 Issue of par value shares

When shares certificates specify the par value, the share issue proceeds are compared to the par value. If
proceeds exceed par value, shares are said to be issued at a premium. If proceeds fall below par value, then
they are issued at a discount.
Shares issued at a premium
Where shares are issued at a premium, the excess over the par value is credited to an equity account which
may be called share premium, additional paid-in capital, or share capital in excess of par. The share pre-
mium is then a component of contributed equity.
ILLUSTRATIVE EXAMPLE 2.2 Issue of par value shares at a premium
Bhutan Ltd issues 5000 shares of $1 par value at a premium of $2 per share. Issuance costs (lawyers,
accountants, registration, etc.) amount to $500. The journal entry is:
Cash Dr 14 500
Share Premium Cr 9 500
(Issue of shares at a premium after deducting issuance costs)
Shares issued at a discount

Where shares are issued at a discount, the account used in relation to the discount can be the same as
that used for a premium, or it can be a separate discount account. The accounting treatment will vary
depending on the regulations governing discounts in particular jurisdictions.
ILLUSTRATIVE EXAMPLE 2.3 Issue of par value shares at a discount
Iran Ltd issues 5000 shares of $2 par value at a 50c discount. Issuance costs are $500. The net cash received
therefore is $7000 (5000 × $1.5 − $500). The journal entry is:
Cash Dr 7 000
Discount on Shares Dr 3 000
(Issue of shares at a discount)
2.5.4 Oversubscriptions
An issue of shares by a company may be so popular that it is oversubscribed (see illustrative example 2.4);
that is, there are more applications for shares than shares to be issued. Some investors may then receive
an allotment of fewer shares than they applied for, or may not be allotted any shares at all. In most cases,
therefore, excess application monies are simply refunded to the applicants.

ILLUSTRATIVE EXAMPLE 2.4 Oversubscription of shares
China Ltd was incorporated on 1 July 2015. The directors offered to the general public 100 000 ordinary
shares for subscription at an issue price of $2. The company received applications for 200 000 shares
and collected $400 000. The directors then decided to issue 150 000 shares, returning the balance of
application money to the unsuccessful applicants.
The appropriate journal entries are:
Cash Dr 400 000

Application Reserve (Equity) Cr 400 000
(Money received on application)
Application Reserve Dr 300 000

(Issue of shares)
Application Reserve Dr 100 000

Cash Cr 100 000
(Refund of excess application money)
LO6 2.6 CONTRIBUTED EQUITY: SUBSEQUENT

MOVEMENTS IN SHARE CAPITAL
Having floated the company, the directors may at a later stage decide to make changes to the share capital.
For example, at its annual general meeting in March 2011, Pöyry plc, a global consulting and engineering
company based in Finland, authorised its Board of Directors to issue new shares. This authorisation is
shown in figure 2.3.
Authorisation to issue shares

The Annual General Meeting (AGM) on 10 March 2008 authorised the Board of Directors to
decide to issue new shares and to convey the Company’s own shares held by the Company in one
or more tranches. The share issue can be carried out as a share issue against payment or without
consideration on terms to be determined by the Board of Directors and in relation to a share issue
against payment at a price to be determined by the Board of Directors.
A maximum of 11 600 000 new shares can be issued. A maximum of 5 800 000 own shares held by
the Company can be conveyed. The authorisation is in force for three years from the decision of the AGM.
At the end of 2010 totally 226 727 shares have been issued. After these directed share issues, the
maximum number of shares that may be conveyed is 5 573 273 shares.
The Board of Directors proposes that the General Meeting on 10 March 2011 authorise to decide
to issue new shares and to convey the Company’s own shares held by the Company in one or
more tranches. The share issue can be carried out as a share issue against payment or without
consideration on terms to be determined by the Board of Directors and in relation to a share issue
against payment at a price to determined by the Board of Directors. A maximum of 11 800 000 new
shares can be issued. A maximum of 5 900 000 own shares held by the company can be conveyed.
The authorisation shall be effective for a period of 18 months.
FIGURE 2.3 An authorisation to increase share capital, Pöyry plc

Source: Pöyry plc (2011, p. 65).
The example in figure 2.3 shows an authorisation for an increase in share capital, but share capital may
be either increased or decreased. This section of the chapter discusses the methods a company may use to
increase its share capital. Section 2.7 examines how a company may decrease its share capital.
2.6.1 Placements of shares

Rather than issue new shares through an issue to the public or current shareholders, the company may
decide to place the shares with specific investors such as life insurance companies and pension funds. The
advantages to the company of a placement of shares are:
• speed — a placement can be effected in a short period of time
28 PART 2 Elements
• price — because a placement is made to other than existing shareholders, and to a market that is
potentially more informed and better funded, the issue price of the new shares may be closer to the
market price at the date of issue
• direction — the shares may be placed with investors who approve of the direction of the company, or
who will not interfere in the formation of company policies
• prospectus — in some cases, a placement can occur without the need for a detailed prospectus to be
prepared.
There are potential disadvantages to the existing shareholders from private placements in that the current
shareholders will have their interest in the company diluted as a result of the placement. In some coun-
tries, the securities regulations place limits on the amounts of placements of shares without the approval
of existing shareholders. Further disadvantages to current shareholders can occur if the company places the
shares at a large discount. Again, securities laws are generally enacted to ensure that management cannot
abuse the placement process and that current shareholders are protected.
ILLUSTRATIVE EXAMPLE 2.5 Placement of shares
Thailand Ltd placed 5000 no-par ordinary shares at $5 each with Turkey Ltd.
The entry in the journals of Thailand Ltd is:
Cash Dr 25 000
(Placement of shares)
2.6.2 Rights issues

A rights issue is an issue of new shares with the terms of issue giving existing shareholders the right to an
additional number of shares in proportion to their current shareholding; that is, the shares are offered pro
rata. For example, an offer could be made to each shareholder to buy two new shares on the basis of every
10 shares currently held. If all the existing shareholders exercise their rights and take up the shares, there is
no change in each shareholder’s percentage ownership interest in the company. Rights issues are typical in
the context of protecting shareholders from involuntary dilution of their interest, and may also be offered
below market price to encourage shareholders’ participation. This was the case for Santander, as well as
other banks, which in the height of the financial crisis in 2008–09 was forced to support its equity by a
large share issue through a deeply discounted rights issue (Santander’s Rushed Rights Issue is Raising Hackles,
FT.com, 20 November 2008).
Rights issues may be tradeable or non-tradeable. If tradeable, existing shareholders may sell their rights
to the new shares to another party during the offer period. If the rights are non-tradeable, a shareholder is
not allowed to sell their rights to the new shares and must either accept or reject the offer to acquire new
shares in the company.
ILLUSTRATIVE EXAMPLE 2.6 Rights issue
Pakistan Ltd planned to raise $3.6 million from shareholders through a renounceable one-for-six rights
issue. The terms of the issue were 6 million no-par shares to be issued at 60c each, applications to be
received by 15 April 2015. The rights issue was fully taken up. The shares were issued on 20 April 2015.
The journal entries in the company’s records are passed when the rights are exercised:
April 20 Cash Dr 3 600 000

Share Capital Cr 3 600 000
(Issue of shares)
2.6.3 Options
Companies often provide their employees with share-based compensation. In particular, under some of
these arrangements employees are issued shares, or options to shares, that replace cash payment. This may
involve entries to owners’ equity that may increase share premium account or a specific reserve. Chapter 8
discusses the specific requirements for such arrangements.

More generally, a company-issued share option is an instrument that gives the holder the right but not
the obligation to buy a certain number of shares in the company by a specified date at a stated price. For
example, a company could issue options that give an investor the right to acquire shares in the company
at $2 each, with the options having to be exercised before 31 December 2017. The option holder is taking
a risk in that the share price may not reach $2 (the option is ‘out of the money’) or the share price may
exceed $2 (the option is ‘in the money’).
When the options are issued, the issuing entity will receive an initial amount of cash that corresponds
to the fair value of the option at that time. Where the option holder exercises the option, the company
increases its share capital as it issues the shares to the option holder.
To illustrate: assume Beckham Inc. company issues 100 options on 30 June 2016 at $0.25 each to two
investors in equal amounts (i.e. 50 options each). Each option entitles the investors to acquire a share in
the company at a price of $3. The current market price of the company shares is $2.80. Assume that on
30 November 2016 the share price reaches $4 and the investor exercises the option. The journal entries
required are shown below. The par value of each share is $1.3
June 30 Cash Dr 25
Equity* Cr 25
(100 options issued at 25c each)
November 30 Cash Dr 300

Equity Dr 25
Share Capital Cr 100
Share Premium Cr 225
(Exercise of options issued)
*This account may be called ‘Options Reserve’ or simply ‘Other Equity’.
Options generally have to be exercised by a specific date. Assume that in the case of Beckham Inc. the
options had to be exercised by 31 December 2016, and only one investor exercised their rights to acquire
shares. The journal entries required are:
December 31 Cash Dr 150

Equity Dr 12.5
Share Capital Cr 50
Share Premium Cr 112.5
(Issue of shares on exercise of options)
Note that the issue price of those options exercised is treated as part of share capital; in essence, the
investor who exercises the option is paying $3.25 ($0.25 + $3.0) in total for each share (and a total of
50 × $3.25 = $162.5). Also note the specific use of accounts in this example. However, these accounts
may not always be the appropriate ones across all legal jurisdictions and the choice of which accounts are
used may also be affected by taxation implications.
For the options that were not exercised, the entity could transfer the equity balance of $12.5 to
share premium or a reserve account including retained earnings. Again, legal and taxation implications
should be considered in choosing the appropriate accounts to be used. For the example above where
the holder of 50 options did not exercise those options, the journal entry required when the options
lapse would be:
Equity Dr 12.5
Share Premium Cr 12.5
(Transfer of lapsed options)
3 This
is an example of ‘gross-settled’ share options (i.e. when the option is exercised the full amount of shares is
issued). Option contracts that are ‘cash-settled’ are treated as a derivative liability, and hence are not recognised in
equity. If the contract is net ‘equity-settled’ the initial amount raised is treated as a liability, which is subsequently
adjusted to changes in the fair value of the option. Upon exercise, the entity issues shares so as to settle the balance. For
example, if the share price on exercise day is $4, then the total value of outstanding options is $100 (($4 − $3) × 100),
and hence the liability on that day stands at $100. When 25 ($100/$4) new shares are issued to settle the balance, the
issuer debits the liability $100, and credits share capital $25 and share premium $75.
30 PART 2 Elements
2.6.4 Share warrants and compound securities
Other forms of option are company-issued warrants and embedded options to convert debt to equity in a
compound debt-equity instrument. While an option is a freestanding equity instrument, a warrant or an
embedded option in a convertible bond is generally attached to another form of financing. For example,
embedded options may be attached to an issue of debt, and warrants may be given as an incentive to acquire
a large parcel of shares in a future capital raising activity. Warrants may be detachable or non-detachable, but
typically upon exercise require the holder to contribute further funds. If warrants are non-detachable, then
they cannot be traded separately from the shares or debt package to which they were attached. In either case
the warrant or conversion option has a value that needs to be recorded in equity, although where in equity
is not generally prescribed. The measurement and accounting for convertible bonds is described in chapter 7.
2.6.5 Bonus issues (or stock dividend)

A bonus issue is an issue of shares to existing shareholders in proportion to their current shareholdings at
no cost to the shareholders. The company uses its reserves balances or retained earnings to make the issue.
The bonus issue is a transfer from one equity account to another, so it does not increase or decrease the
equity of the company. Instead, it increases the share capital and decreases another equity account of the
company.
The standards do not provide guidance as to how a bonus issue should be measured. Reference to fair
value of the bonus issue may be unwarranted, as firm valuation remains intact. Furthermore when all
shareholders receive equal bonus (on a pro rata basis), each shareholder’s wealth is unaffected although
the value of each share is smaller following the bonus. This suggests that the charge to the other equity
account should be recoded at the par value. To illustrate: assume a company has a share capital consisting
of 500 000 shares, $1 par value each. If it makes a 1-for-20 bonus issue from its retained earnings, it will
issue 25 000 shares pro rata to its current shareholders. The journal entry required is:
Retained Earnings Dr 25 000

(Bonus issue of 25 000 shares from retained
earnings)
Nevertheless, in the case where a company assigns a value to the stock dividend that exceeds the par
value, perhaps by reference to the prevailing share price, the charge to retained earnings, or any other
permissible reserve, will be higher, with a balancing entry to the share premium account. Considering the
previous example, assume the share bonus is valued at $100 000. Then the journal entry for issuing 25 000
bonus shares is:

(Bonus issue of 25 000 shares at $100 000
from retained earnings)
Depending on prevailing law, companies may use other equity accounts instead of retained earnings. In
the example above, issuing the stock dividend at par value could be charged against the share premium
account:
Share Premium Dr 25 000

(Bonus issue of 25 000 shares from retained
earnings)
On occasions where the debit to the share premium account exceeds its opening balance, the difference
between the 25 000 and the opening balance may be debited to retained earnings, or any other reserve
account permitted by the relevant country’s regulations. (See section 2.8 for the discussion of reserves.)
2.6.6 Share split

Rewarding shareholders with bonus shares has the effect of reducing the value of each share, and conse-
quently increases the liquidity and ease with which these shares can be exchanged or traded. A similar
effect on share value is reached via share splits. A share split involves increasing the number of shares

outstanding while proportionally reducing the par value of each share. For example, if a company has
10 000 shares outstanding at 90c each, and carries out a 3-for-1 split, it will report after the split 30 000
shares at 30c each. Total share capital is therefore unchanged and, unlike a share bonus, no charge is required
to any other equity account.
2.6.7 Share-based transactions

A company may acquire assets, including other entities, with the consideration for the acquisition being
shares in the company itself. Accounting for this form of transaction is covered in chapter 14. Accounting for
share-based payments is covered in chapter 8.
LO7 2.7 SHARE CAPITAL: SUBSEQUENT DECREASES

IN SHARE CAPITAL
A company may decrease the number of shares issued by buying back some of its own shares. The extent
to which a company may buy back its own shares and the frequency with which it may do so are generally
governed by specific laws within a jurisdiction as well as the company’s own charter. A key feature of such
regulations is the protection of creditors, as the company is reducing equity by using cash that otherwise
would have been available to repay creditors. Companies may undertake a share buy-back to:
• increase earnings-per-share (EPS)
• manage the capital structure by reducing equity
• most efficiently return surplus funds held by the company to shareholders, rather than pay a dividend
or reinvest in other ventures.
Repurchased shares are called treasury shares. IAS 32 (paragraph 33) requires that the amount spent
on buying back treasury shares is deducted from equity. The standard, however, does not prescribe which
element of equity should be reduced.
Consider Harlem Inc. which has issued 500 000 shares at $1 par value each over a period of years. Fur-
ther assume the total equity of Harlem Inc. consists of:
Share Capital $ 500 000

Share Premium 270 000
Retained Earnings 230 000
$1 000 000
If Harlem Inc. now buys back 50 000 shares for $2.20 per share, the amount of treasury shares is $110 000.
This is recorded as follows:
Treasury Shares Dr 110 000

Cash Cr 110 000
(Share buy-back 50 000 shares at
$2.20 per share)
The equity section will now report:
Share Capital $ 500 000

Share Premium 270 000
Retained Earnings 230 000
Treasury Shares (110 000)
$ 890 000
Note that the treasury shares account is a contra-equity account, as it appears in equity, but with a nega-
tive sign.
Following the repurchase, treasury shares may be (i) kept by the company; (ii) reissued and (iii) cancelled.
The accounting treatment for these different possibilities is described below.
2.7.1 Treasury shares kept in the company

As long as the treasury shares are kept in the company, the equity reports a deduction of $110 000, as
illustrated above. Treasury shares are not regarded as issued for the purpose of voting, dividends and other
rights that come along with ordinary shares.
32 PART 2 Elements
2.7.2 Treasury shares are reissued
Companies may reuse treasury shares to satisfy demand for options that have been exercised (e.g. in
employee share option schemes), or resell them in the open market or to other investors. Since the pro-
ceeds on such resell may differ from the original cost of the treasury shares, a gain or a loss may arise.
However, IAS 32 (paragraph 33) disallows the recognition of such gain or loss in the income statement.
Instead, it should be recognised directly in reserves.
Assume Harlem Inc. resells on the open market 10 000 treasury shares at $3 each. This generates a gain
of $0.80 per share, or a total gain of $8000. A typical entry to record this would be:
Cash Dr 30 000
Treasury Shares Cr 22 000
(Resell of 10 000 treasury shares at
$3.00 per share)
If, on the other hand, Harlem Inc. resells 10 000 treasury shares at $1.40 a share, a loss of $8000 is gen-
erated. This will be recorded as follows:
Cash Dr 14 000
(Re-sell of 10 000 treasury shares at
$1.40 per share)
Again, on occasions where the debit to the share premium account exceeds its opening balance, the dif-
ference may be debited to retained earnings, or any other reserve account permitted by the relevant country’s
regulations. (See section 2.8 for the discussion of reserves.)
2.7.3 Treasury shares are cancelled

A repurchase of shares that is followed by a cancellation is equivalent from an economic perspective to a
redistribution of wealth to owners. According to this view, when treasury shares are cancelled, a suitable
reduction to retained earnings should be made. However, depending on the legal jurisdiction, other dis-
tributable reserves can be used (see section 2.8 for the discussion of reserves in equity). In addition, the original
share capital should be cancelled. Assume that prior to the purchase of the 100 000 treasury shares Harlem
Inc. also had an asset revaluation surplus reserve of $20 000 that can be used for this purpose. The cancel-
lation of 50 000 shares is therefore recorded as:
Share Capital Dr 50 000

Revaluation Surplus Dr 20 000
(Cancellation of 50 000 treasury shares with
$1 par value each that were purchased at
$2.20 each)
Corporate law in some countries requires the maintenance of capital, as a means of protecting credi-
tors (this is the case, for example, in the UK). This implies that a new non-distributable reserve in equity
is also established at the amount of cancelled share capital. Employing the previous example, this can be
recorded as follows:

Revaluation Reserve Dr 20 000
Capital Redemption Reserve Cr 50 000
(Cancellation of 50 000 treasury shares with
$1 par value each that were purchased at
$2.20 each)

Creditors’ protection is obtained through the larger debit to retained earnings, implying Harlem Inc.’s
ability to further pay cash dividends in the future is reduced (by an additional $50 000).
An example of a repurchase of shares is that undertaken by Pöyry plc in 2011. The authorisation for the
company to acquire its own shares is shown in figure 2.4.
Authorisation to acquire the company’s own shares

The AGM on 11 March 2010 authorised the Board of Directors to decide on acquiring maximum
of 5 800 000 own shares with distributable funds. The company’s own shares can be acquired in
accordance with the decision of the Board of Directors either through public trading or by public
offer at their market price at the time of purchase.
The authorisation is effective for a period of 18 months. The Board has not exercised the
authorisation during 2010.
The Board of Directors proposes that the General Meeting on 10 March 2011 authorise the
Board of Directors to decide on the acquisition of a maximum of 5 900 000 of the Company’s own
shares by using distributable funds. It is proposed that the authorisation be effective for a period
of 18 months. The authorisation granted to the Board of Directors regarding acquisition of the
Company’s own shares in the previous Annual General Meeting shall expire simultaneously.
FIGURE 2.4 Repurchase of shares, Pöyry plc

Source: Pöyry plc (2011, p. 65).
In Nokia’s 2013 balance sheet (see figure 2.2), the treasury shares are shown as a reduction in total equity
because the share capital of the entity has effectively been reduced by the repurchase of the shares.
LO8 2.8 RESERVES

‘Reserves’ is the generic term for all equity accounts other than contributed equity. A major component
is the retained earnings account. This account accumulates the sum of the periodic income earned by an
entity, and certain other comprehensive income (OCI). IAS 1 requires entities to prepare a Statement of
Comprehensive Income that lists both periodic income and items of OCI (see chapter 16). OCI includes all
income items that certain accounting standards require (or allow) to flow directly through equity, net of
related tax effects. Some notable examples of OCI are:
• remeasurements of financial assets not held for trading and cash flow value hedges (IFRS 9 — see
chapter 7)
• remeasurement of defined benefit pension plans (IAS 19 (Revised) — see chapter 10)
• revaluation of property, plant and equipment (IAS 16 — see chapter 11)
• particular foreign exchange differences (IAS 21 — see chapter 24).
However, not all income items recognized in OCI need to be incorporated into retained earnings. They
may be incorporated into a separate reserve, as discussed in section 2.8.2.
Retained earnings is the primary account from which distributions to owners are made in the form of
dividends. Hence, in general, the retained earnings account will accumulate comprehensive income (that
is not recognised in other reserves) earned over the life of the entity.
2.8.1 Retained earnings

‘Retained earnings’ has the same meaning as ‘retained profits’ and ‘accumulated profit or loss’. The key
change in this account is the addition of the comprehensive income or loss for the current period. The
main other movements in the retained earnings account are:
• dividends declared
• cancellation of shares (see section 2.7.3)
• transfers to and from reserves
• changes in accounting policy and errors (see IAS 8 Accounting Policies, Changes in Accounting Estimates
and Errors, discussed in detail in chapter 16).
Cash dividends. Cash dividends are a distribution from the company to its owners in the form of cash.
It is generally the case, under companies legislation, that dividends can be paid only from profits, and not
from capital. In some jurisdictions, companies must comply with a solvency test before paying dividends.
The purpose in both situations is to protect the creditors, as any money paid to shareholders is money
unavailable for paying creditors.
Scrip dividends. Companies often give shareholders a choice between cash dividend and receiving
more shares in an equivalent value to the cash dividend. As an example, Sean plc declares a 10c per share
dividend during 2015. The market value of its 1m shares is $10m at the time of the declaration. The par
value of each share is $1. As the total cash dividend amounts to $100 000, the dividend is equal to 1%
34 PART 2 Elements
of the market value of its equity ($0.1 × 1m/$10m). Hence, Sean plc offers a 1-for-100 scrip alternative.
Assuming 50% of shareholders opt for the scrip alternative, Sean plc would record these entries:
2015 Retained Earnings Dr 100 000

Dividends Payable Cr 100 000
(Declaration of dividend of $100 000)
Dividends Payable Dr 100 000

Cash Cr 50 000
Retained Earnings Cr 45 000
(Payment of dividend and issue of 5 000 new shares)
The scrip alternative can be thought of as equivalent to a share bonus. Hence, if the share premium
account can be used for the share bonus, it is possible to record the following entries when the dividend
is paid and new shares are issued:
2015 Dividends Payable Dr 100 000

Cash Cr 50 000
(Payment of dividend and issue of 5 000 new shares)
Note that in this case retained earnings are reduced only by the amount of cash dividend.
ILLUSTRATIVE EXAMPLE 2.7 Scrip dividend
Banco Santander SA declared a scrip dividend on 10 April 2015. The terms of the dividend scheme were as
follows. On the announcement date the number of outstanding shares of Santander was 14 060 585 886
and it offered the right to receive one share per 46 shares held. This ratio was based on cash equivalent of
€2 165 000 000 (or €0.154 per share). Santander determined that the relevant share price was €7.076; hence
the scrip ratio is 2 165 000 000/(7.076 × 14 060 585 886) = 1:46 (rounded).
If all shareholders took the scrip alternative, a total of 305 664 910 (= 14 060 585 886/46) new shares
would have been issued. The par value of each share is €0.50, implying a maximum increase in share
capital of €152 832 455. Santander announced it will use its share premium account to charge the
€152 832 455.
Santander also offered to buy back the rights from its shareholders at 7.076/(1 + 46) = €0.151 each.
Source: www.santander.com
Interim and final dividends. Dividends are sometimes divided into interim and final dividends. Interim
dividends are paid during the financial year, while final dividends are declared by the directors at financial
year-end for payment sometime after the end of the reporting period. In some companies, the eventual
payment of the final dividends is subject to approval of the dividend by the annual general meeting. With
the final dividend, there is some debate as to when the company should raise a liability for the dividend,
particularly where payment of the dividend is subject to shareholder approval. Some would argue that
until approval is received there is only a contingent liability, the entity not having a present obligation to
pay the dividend until approval is received. Others argue that there is a constructive obligation existing
at year-end and, given customary business practice, the entity has a liability at the end of the reporting
period.
In this regard, paragraphs 12 and 13 of IAS 10 Events after the Reporting Period state:
12. If an entity declares dividends to holders of equity instruments (as defined in IAS 32 Financial Instruments:
Presentation) after the reporting period, the entity shall not recognise those dividends as a liability at the
end of the reporting period.
13. If dividends are declared after the reporting period but before the financial statements are authorised for
issue, the dividends are not recognised as a liability at the end of the reporting period because no obli-
gation exists at that time. Such dividends are disclosed in the notes in accordance with IAS 1 Presentation of
Financial Statements.
If the dividends are not declared at the end of the reporting period, no liability is recognised at the end
of the reporting period. When shareholder approval is required for dividends declared prior to the end of

the reporting period, a liability should be recognised only once the annual general meeting approves the
dividends, because before that date the entity does not have a present obligation. Until that occurs, the
declared dividend is only a contingent liability. (See chapter 5 for further discussion on provisions and con-
tingencies.) It is expected that companies that prefer to raise a liability at year-end will change their regu-
lations or constitution so that dividends can be declared without the need for shareholder approval.
ILLUSTRATIVE EXAMPLE 2.8 Interim and fi nal dividends
During the period ending 30 June 2015, the following events occurred in relation to Oman Ltd:
2014
Sept. 25 Annual general meeting approves the final dividend of $10 000.
Sept. 30 Oman Ltd pays the final dividend to shareholders.
2015
Jan. 10 Oman Ltd pays an interim dividend of $8 000.
June 30 Oman Ltd declares a final dividend of $12 000, this dividend requiring shareholder
approval at the next AGM.
Required
Prepare the journal entries to record the dividend transactions of Oman Ltd.
Solution
2014
Sept. 25 Retained Earnings Dr 10 000
Dividends Payable Cr 10 000
(Dividend of $10 000 authorised by annual
meeting)
Sept. 30 Dividends Payable Dr 10 000

Cash Cr 10 000
(Payment of dividend)
2015
Jan. 10 Retained Earnings Dr 8 000
Cash Cr 8 000
(Payment of interim dividend)
No entry is required in relation to the final dividend of $12 000. A contingent liability would be recorded
in the notes to the 2015 financial statements.
2.8.2 Other components of equity

In section 2.7 we encountered two special reserves: treasury shares (a contra-equity account) and capital
redemption reserve. Some additional examples of reserves other than retained earnings are shown below.
Asset revaluation reserve
IAS 16 Property, Plant and Equipment allows entities a choice in the measurement of these assets. In par-
ticular, entities may choose between measuring the assets at cost (the cost model) or at fair value (the
revaluation model). If the fair value basis is chosen, revaluation increases are recognised in other com-
prehensive income and accumulated in equity via an asset revaluation surplus. (Details of the accounting
under a fair value basis for property, plant and equipment are covered in chapter 11.)
An asset revaluation surplus, may be used for payment of dividends or be transferred to other reserve
accounts including retained earnings, depending on a jurisdiction’s specific laws. Amounts recognised
directly in the asset revaluation surplus cannot subsequently be recognised in profit or loss for the period
even when the revalued asset is disposed of.
Foreign currency translation differences
Foreign currency translation differences arise when foreign operations are translated from one currency
into another currency for presentation purposes. (Details of the establishment of this account can be found
36 PART 2 Elements
in chapter 24.) The changes in wealth as a result of the translation process are thereby not taken through
profit or loss for the period, and are recognised in profit or loss only if and when the investor disposes of
its interest in the foreign operation.
Fair value differences
Under IFRS 9 Financial Instruments, at initial recognition, financial assets and liabilities are measured at
fair value. Paragraph 5.7.5 of IFRS 9 permits an entity to make an irrevocable election to present in other
comprehensive income changes in the fair value of an investment in an equity instrument that is not held
for trading. Because IFRS 9 (paragraph B5.7.1) does not allow such gains and losses to be transferred into
profit and loss, they should be recorded in other reserves, or directly in retained earnings.
ILLUSTRATIVE EXAMPLE 2.9 Reserves
As an example of the disclosure of reserves, the note disclosure provided by Qantas in its 2011 annual
report is shown in figure 2.5.
23. Capital and reserves Qantas Group

2011 2010
Reserves $m $m
Employee compensation reserve 65 53
Hedge reserve 80 85
Foreign currency translation reserve (60) (29)
85 109
Nature and purpose of reserves

Employee compensation reserve
The fair value of equity plans granted is recognised in the employee compensation reserve over the
vesting period. This reserve will be reversed against treasury shares when the underlying shares vest and
transfer to the employee. No gain or loss is recognised in the Consolidated Income Statement on the
purchase, sale, issue or cancellation of Qantas’ own equity instruments.
Hedge reserve
The hedge reserve comprises the effective portion of the cumulative net change in the fair value of cash
flow hedging instruments related to future forecast transactions.
Foreign currency translation reserve
The foreign currency translation reserve comprises all foreign exchange differences arising from the
translation of the Financial Statements of foreign controlled entities and associates, as well as from
the translation of liabilities that form part of the Qantas Group’s net investment in a foreign controlled
entity.
FIGURE 2.5 Disclosure of reserves

Source: Qantas (2011, p. 81).
As illustrated earlier in the chapter, entities may make transfers between various reserves. For example,
share premium may be used to issue bonus shares. Asset revaluation surplus can be transferred gradually
to retained earnings, when the depreciation on the underlying asset exceeds the historical-cost depreci-
ation. It may also be transferred into retained earnings when the underlying asset is sold.
ILLUSTRATIVE EXAMPLE 2.10 Reserve transfers
During the period ending 30 June 2015, the following events occurred in relation to the company
Malaysia Ltd:
Jan. 1 $10 000 transferred from retained earnings to general reserve
Feb. 18 $4 000 transferred from asset revaluation surplus to retained earnings
June 15 Bonus share dividend of $50 000, half from general reserve and half from retained earnings

Required
Prepare the journal entries to record these transactions.
Solution
2015
Jan. 1 Retained Earnings Dr 10 000
General Reserve Cr 10 000
(Transfer from retained earnings to general reserves)
Feb. 18 Asset Revaluation Surplus Dr 4 000

(Transfer from asset revaluation surplus)
June 15 General Reserve Dr 25 000

(Bonus issue of shares)
LO9 2.9 DISCLOSURE

Disclosures in relation to equity are detailed in IAS 1 Presentation of Financial Statements. The disclosures
relate to specific items of equity as well as the preparation of a statement of changes in equity.
2.9.1 Specific disclosures

IAS 1 provides several disclosure requirements regarding the equity section in the balance sheet. The main
ones appear in paragraphs 54, 79, 106, 136, 137 and 138 and require disclosures regarding:
1. The amount of non-controlling interest within the equity section (paragraph 54(q))
2. The amount of issued capital and reserves attributed to parent company (paragraph 54(r)).
3. By class of shares: The number of shares authorised for issue; the number of shares issued, distinguishing
between those that are fully paid and those that are not; whether shares have par value (and how much)
or not; explaining the change during the year in the number of shares outstanding; the contractual arrange-
ments concerning the shares, including any rights and restrictions; treasury shares and description of each
reserve included in the equity section (paragraph 79).
4. Statement of changes in equity, as discussed in section 2.9.2 (paragraph 106).
5. Puttable instruments classified as equity, including amounts and explanations as to the entity’s objectives in
respect to these instruments and expected cash flows (paragraph 136A).
6. The amounts of dividends proposed or declared, inclusive of preference dividend, which have not been
recognised as a liability (paragraph 137).
2.9.2 Statement of changes in equity

Paragraph 106 of IAS 1 requires the preparation of a statement of changes in equity. This paragraph requires
the statement to show the following:
(a) total comprehensive income for the period, showing separately the total amounts attributable to owners of
the parent and to non-controlling interests;
(b) for each component of equity, the effects of retrospective application or retrospective restatement recognised
in accordance with IAS 8; and
(c) [deleted]
(d) for each component of equity, a reconciliation between the carrying amount at the beginning and the end of
the period, separately disclosing changes resulting from:
(i) profit or loss;
(ii) other comprehensive income; and
(iii) transactions with owners in their capacity as owners, showing separately contributions by and distri-
butions to owners and changes in ownership interests in subsidiaries that do not result in a loss of
control.
These requirements can be met in a number of ways, including using a columnar format. The statement
of changes in equity must contain the information in paragraph 106 of IAS 1. The information required by
paragraph 107 in relation to dividends may be included in the statement of changes in equity or disclosed
in the notes.
Figure 2.6, the statement of changes in equity disclosed in the 2014 annual report of Diageo plc, dem-
onstrates a columnar format for this statement.
38 PART 2 Elements
Retained earnings/(deficit)
Equity
Hedging attributable
Capital and Other to parent Non-
Share Share redemption exchange Own retained company controlling Total
£m capital premium reserve reserve shares earnings Total shareholders interest equity
At 30 June 2012 (restated) 797 1 344 3 146 67 (2 257) 2 491 234 5 588 1 204 6 792
Total comprehensive income (59) 2 606 2 606 2 547 134 2 681
Employee share scheme 25 (34) (9) (9) (9)
Share-based incentive plans 45 45 45 45
Share-based incentive plans in respect of associates 2 2 2 2
Tax on share-based incentive plans 30 30 30 30
Acquisitions 0 0 (21) (21)
Change in fair value of put options (7) (7) (7) (7)
Purchase of non-controlling interests (100) (100) (100) (100) (200)
Dividends paid (1 125) (1 125) (1 125) (100) (1 225)
Transfers 65 65 65 (65) 0
At 30 June 2013 (restated) 797 1 344 3 146 8 (2 232) 3 973 1 741 7 036 1 052 8 088
Total comprehensive income (911) 2 025 2 025 1 114 (187) 927
Employee share scheme (48) (67) (115) (115) (115)
Share-based incentive plans 37 37 37 37
Share-based incentive plans in respect of associates 3 3 3 3
Tax on share-based incentive plans 1 1 1 1
Shares issued 1 0 1 1
Acquisitions 0 0 8 8
Change in fair value of put options 0 0 0
Purchase of non-controlling interests (7) (7) (7) (7)
Dividends paid (19) (19) (19) (18) (37)
Transfers (1 228) (1 228) (1 228) (88) (1 316)
At 30 June 2014 797 1 345 3 146 (903) (2 280) 4 718 2 438 6 823 767 7 590
CHAPTER 2 Owners’ equity: share capital and reserves

FIGURE 2.6 Statement of changes in equity for Diageo plc
Source: Diageo plc (2014, pp. 91).
39
SUMMARY
The corporate form of organisational structure is a popular one in many countries, particularly because of
the limited liability protection that it affords to shareholders. These companies’ operations are financed by
a mixture of equity and debt. In this chapter the focus is on the equity of a corporate entity. The compo-
nents of equity recognised generally by companies are share capital, other reserves and retained earnings.
Share capital in particular is affected by a variety of financial instruments developed in the financial mar-
kets, offering investors instruments with an array of risk–return alternatives. Each of these equity alterna-
tives has its own accounting implications. The existence of reserves is driven by traditional accounting as
well as the current restrictions in some accounting standards for some wealth increases to be recognised
directly in equity rather than in current income. Even though definite distinctions are made between the
various components of equity, it needs to be recognised that they are all equity and differences relate to
jurisdictional differences in terms of restrictions on dividend distribution, taxation effects and rights of
owners. IAS 1 requires detailed disclosures in relation to each of the components of equity.
1. Discuss the nature of a reserve. How do reserves differ from the other main components of equity?
2. A company announces a final dividend at the end of the financial year. Discuss whether a dividend
payable should be recognised.
3. The telecommunications industry in a particular country has been a part of the public sector. As a
part of its privatisation agenda, the government decided to establish a limited liability company called
Telecom Plus, with the issue of 10 million $3 shares. These shares were to be offered to the citizens of
the country. The terms of issue were such that investors had to pay $2 on application and the other
$1 per share would be called at a later time. Discuss:
(a) the nature of the limited liability company, and in particular the financial obligations of acquirers
of shares in the company
(b) the journal entries that would be required if applications were received for 11 million shares.
4. Why would a company wish to buy back its own shares? Discuss.
5. A company has a share capital consisting of 100 000 shares issued at $2 per share, and 50 000 shares
issued at $3 per share. Discuss the effects on the accounts if:
(a) the company buys back 20 000 shares at $4 per share
(b) the company buys back 20 000 shares at $2.50 per share.
6. A company has a share capital consisting of 100 000 shares having a par value of $1 per share and
issued at a premium of $1 per share, and 50 000 shares issued at $2 par and $1 premium. Discuss the
effects on the accounts if:
(a) the company buys back 20 000 shares at $4 per share
(b) the company buys back 20 000 shares at $2.50 per share.
7. What is a rights issue? Distinguish between a tradeable and a non-tradeable issue.
8. What is a private placement of shares? Outline its advantages and disadvantages.
9. Discuss whether it is necessary to distinguish between the different components of equity rather than
just having a single number for shareholders’ equity.
10. For what reasons may a company make an appropriation of its retained earnings?
References
Diageo plc 2014, Annual Report 2014, Diageo, http://www.diageo.com/en-row/investor/Pages/
financialreports.aspx.
International Accounting Standards Board 2010, Conceptual Framework for Financial Reporting, www.ifrs.org.
Nokia Corporation 2013, Annual Report 2013, Nokia Corporation, Finland, www.nokia.com.
Pöyry plc 2011, Annual Report 2010, Pöyry plc, Finland, www.poyry.com.
Qantas 2011, Annual Report 2011, Qantas Airways Limited, Australia, www.qantas.com.au.
Santander 2015, Material Fact: Information on Dividendo Eleccion, www.santander.com.
Tesco plc 2014, Annual Report 2014, Tesco, http://www.tescoplc.com/index.asp?pageid=548.
Exercise 2.1 RESERVES AND DIVIDENDS

★ Prepare journal entries to record the following unrelated transactions of a public company:
(a) payment of interim dividend of €30 000
(b) transfer of €52 000 from the asset revaluation surplus to the general reserve
(c) transfer of €34 000 from the general reserve to retained earnings
(d) issue of 240 000 bonus shares, fully paid, at €2 per share from the general reserve.
40 PART 2 Elements
Exercise 2.2 RIGHTS ISSUE
★ Property Ltd had share capital of 1 million $1 shares, fully paid. As it needed finance for certain con-
struction projects, the company’s management decided to make a non-tradeable rights issue to existing
shareholders of 200 000 new shares at an issue price of $5 per share. The rights issue was to be fully
underwritten by Brokers Ltd. The prospectus was issued on 15 February 2016 and applications closed on
15 March 2016. Costs associated with the rights issue and the eventual issue of the shares were $10 000.
(a) If 80% of the rights were exercised by the due date, provide journal entries made by Property Ltd in
relation to the rights issue and the eventual share issue.
(b) If the rights issue was not underwritten and any unexercised rights lapsed, what would be the required
journal entries?
Exercise 2.3 SHARE ISSUE, OPTIONS

★ Jordan Ltd has the following shareholders’ equity at 1 January 2016:
Share capital — 500 000 shares £1 240 000

Asset revaluation surplus 350 000
Retained earnings 110 000
On 1 March the company decided to make a public share issue to raise £600 000 for new capital devel-
opment. The company issued a prospectus inviting applications for 200 000 £3 shares, payable in full on
application. Shareholders who acquired more than 10 000 shares were allowed to buy options at 50 cents
each. These options enabled the owner to buy shares in Jordan Ltd at £3.50 each, the acquisition having
to occur before 31 December 2016.
By 25 March the company had received applications for 250 000 shares and for 20 000 options. The
shares and options were allotted on 2 April, and money returned to unsuccessful applicants on the same
day. All applicants who acquired options also received shares.
By 31 December 2016, the company’s share price had reached £3.75. Holders of 18 000 options exer-
cised their options in December. The remaining options lapsed.
Required
Prepare the journal entries in the records of Jordan Ltd in relation to the equity transactions in 2016.
Exercise 2.4 ISSUE OF ORDINARY AND PREFERENCE SHARES

★★ Prepare journal entries to record the following transactions for Kahuna Ltd:
2016
April 1 A prospectus was issued inviting applications for 100 000 ordinary shares at an issue price
of €1.50, fully payable on application. The prospectus also offered 100 000 10% preference
shares at an issue price of €2, fully payable on application. The issue was underwritten at a
commission of €4500, being €500 relating to the issue of ordinary shares and the balance for
preference shares. All unsuccessful application monies were to be returned to the applicants.
April 10 Applications closed with the ordinary issue oversubscribed by 40 000 shares and the preference
shares undersubscribed by 15 000 shares.
April 15 100 000 ordinary shares were allotted and applications for 40 000 shares were rejected and
money refunded. 100 000 preference shares were also allotted.
April 20 The underwriter paid for the shares allocated to her, less the commission due.
Exercise 2.5 SHARE ISSUE, OPTIONS

★★ On 30 June 2015, the equity accounts of Boron Ltd consisted of:
175 000 ‘A’ ordinary shares, issued at $2.50 each, fully paid $437 500
50 000 6% cumulative preference shares, issued at $3 and paid to $2 100 000
Options (20 000 at 56c each) 11 200
Accumulated losses (6 250)

As the company had incurred a loss for the year ended 30 June 2015, no dividends were declared for
that year. The options were exercisable between 1 March 2016 and 30 April 2016. Each option allowed the
holder to buy one ‘A’ ordinary share for $4.50.
The following transactions and events occurred during the year ended 30 June 2016:
2015
July 25 The directors made the final call of $1 on the preference shares.
Aug. 31 All call monies were received except those owing on 7500 preference shares.
Sept. 7 The directors resolved to forfeit 7500 preference shares for non-payment of the call.
The constitution of the company directs that forfeited amounts are not to be refunded to
shareholders. The shares will not be reissued.
Nov. 1 The company issued a prospectus offering 30 000 ‘B’ ordinary shares payable in two
instalments: $3 on application and $2 on 30 November 2015. The offer closed on
30 November.
Nov. 30 Applications for 40 000 ‘B’ ordinary shares were received.
Dec. 1 The directors resolved to allot the ‘B’ ordinary shares pro rata with all applicants receiving 75%
of the shares applied for. Excess application monies were allowed to be held. The shares were
duly allotted.
Dec. 5 Share issue costs of $5200 were paid.
2016
April 30 The holders of 15 000 options applied to purchase shares. All monies were sent with the
applications. All remaining options lapsed. The shares were duly issued.
Required
Prepare general journal entries to record the above transactions.
Exercise 2.6 BUY-BACK OF SHARES

★★ Victor Ltd decided to repurchase 10% of its ordinary shares under a buy-back scheme for £5.60 per share.
At the date of the buy-back, the equity of Victor Ltd consisted of:
Share capital — 4 million shares fully paid £4 000 000

General reserve 600 000
Retained earnings 1 100 000
The costs of the buy-back scheme amounted to £3500.

Required
(a) Prepare the journal entries to account for the buy-back. Explain the reasons for the entries made.
(b) Assume that the buy-back price per share was equal to 70p per share. Prepare journal entries to record
the buy-back, and explain your answer.
(c) Assume that, instead of the share capital shown above, Victor Ltd had issued 1 million shares at a par
value of £1 and a share premium of £3 per share. Rework your answers to (a) assuming the repur-
chased shares were subsequently cancelled (ignore costs of buy-back scheme).
Exercise 2.7 SHARES, OPTIONS, DIVIDENDS AND RESERVE TRANSFERS

★★★ The equity of Mondegreen Inc. at 30 June 2015 consisted of:
400 000 ordinary ‘A’ shares issued at $2.00, fully paid $800 000
300 000 ordinary ‘B’ shares issued at $2.00, called to $1.20 360 000
50 000 6% non-cumulative preference shares issued at $1.50, fully paid 75 000
Share options issued at 60c, fully paid 24 000
42 PART 2 Elements
The options were exercisable before 28 February 2016. Each option entitled the holder to acquire two
ordinary ‘C’ shares at $1.80 per share, the amount payable on notification to exercise the option.
The following transactions occurred during the year ended 30 June 2016:
2015
Sept. 15 The preference dividend and the final ordinary dividend of 16c per fully paid share, both
declared on 30 June 2015, were paid. (Dividend is paid only with respect to capital paid.) The
directors do not need any other party to authorise the payment of dividends.
Nov. 1 A one-for-five tradeable rights offer was made to ordinary ‘A’ shareholders at an issue price
of $1.90 per share. The expiry date on the offer was 30 November 2015. The issue was
underwritten at a commission of $3000.
Nov. 30 Holders of 320 000 shares accepted the rights offer, paying the required price per share, with
the renounced rights being taken up by the underwriter. Ordinary ‘A’ shares were duly issued.
Dec. 10 Money due from the underwriter was received.
2016
Jan. 10 The directors transferred $35 000 from retained earnings to a general reserve.
Feb. 28 As a result of options being exercised, 70 000 ordinary ‘C’ shares were issued. Unexercised
options lapsed.
April 30 The directors made a call on the ordinary ‘B’ shares for 80c per share. Call money was payable
by 31 May.
May 31 All call money was received except for that due on 15 000 shares.
June 18 Shares on which the final call was unpaid were transferred to treasury shares reserve.
June 26 Treasury shares were reissued for $1.80 per share. The called balance of the 15 000 B shares
was returned to the former shareholders, less the 20c shortfall per share.
June 27 Refund paid to former holders of cancelled shares.
June 30 The directors declared a 20c per share final dividend to be paid on 15 September 2016.
Required
(a) Prepare general journal entries to record the above transactions.
(b) Prepare the equity section of the statement of financial position as at 30 June 2016.
Exercise 2.8 DIVIDENDS, SHARE ISSUES, SHARE BUY-BACKS, OPTIONS AND MOVEMENTS IN RESERVES
★★★ Hide Ltd, a company whose principal interests are in the manufacture of fine leather shoes and hand-
bags, was formed on 1 January 2013. Prior to the 2016 period, Hide Ltd had issued 110 000 ordinary
shares:
• 95 000 €30 shares were issued for cash on 1 January 2013
• 5000 shares were exchanged on 1 February 2014 for a patent that had a fair value at date of exchange
of €240 000
• 10 000 shares were issued on 13 November 2015 for €50 per share.
At 1 January 2016, Hide Ltd had a balance in its retained earnings account of €750 000, while the gen-
eral reserve and the asset revaluation surplus had balances of €240 000 and €180 000, respectively. The
purpose of the general reserve is to reflect the need for the company to regularly replace certain pieces of
the shoe-making machinery to reflect technological changes.
During the 2016 financial year, the following transactions occurred:
Feb. 15 Hide Ltd paid a €25 000 dividend that had been declared in December 2015. Liabilities for
dividends are recognised when they are declared by the company.
May 10 10 000 shares at €55 per share were offered to the general public. These were fully subscribed
and issued on 20 June 2016. On the same date, another 15 000 shares were placed with major
investors at €55 per share.

June 25 The company paid a €20 000 interim dividend.
June 30 The company revalued land by €30 000, increasing the asset revaluation surplus by €21 000
and the deferred tax liability by €9000.
July 1 The company early adopted IFRS 4 in relation to insurance. The transitional liability on initial
adoption was €55 000 more than the liability recognised under the previous accounting
standard. This amount was recognised directly in retained earnings.
July 22 Hide Ltd repurchased 5000 shares on the open market for €56 per share. The repurchase was
accounted for as treasury shares.
Nov. 16 Hide Ltd declared a 1-for-20 bonus issue to shareholders on record at 1 October 2016. The
general reserve was used to fund this bonus issue.
Dec. 1 The company issued 100 000 options at 20c each, each option entitling the holder to acquire
an ordinary share in Hide Ltd at a price of €60 per share, the options to be exercised by 31
December 2016. No options had been exercised by 31 December 2016.
Dec. 31 Hide Ltd calculated that its profit for the 2016 year was €150 000. It declared a €30 000 final
dividend (which was authorise for payment on that day), transferred €40 000 to the general
reserve, and transferred €30 000 from the asset revaluation surplus to retained earnings.
Share issue costs amount to 10% of the worth of any share issue.
Required
(a) Prepare the general journal entries to record the above transactions.
(b) Prepare the statement of changes in equity for Hide Ltd for the year ended 31 December 2016.
Exercise 2.9 DIVIDENDS, SHARE-ISSUES, OPTIONS, RESERVE TRANSFERS

★★★ Mercury plc’s equity as at 30 June 2016 was as follows:
120 000 ordinary ‘A’ shares, issued at £1.10, fully paid £ 132 000
150 000 ordinary ‘B’ shares, issued at £1.20, called to 70p 105 000
100 000 8% cumulative preference shares, issued at £1, fully paid 100 000
Calls in advance (30 000 shares) 15 000
Share issue costs (11 200)
Total equity £ 658 800
The general journal is used for all entries.

The following events occurred after 30 June 2016:
2016
Sep. 30 The final 10p per share ordinary dividend and the preference dividend, both declared on 25
June 2016, were approved and paid.
Oct. 31 A prospectus was issued inviting offers to acquire one option for every two ordinary ‘A’ shares
held at a price of 80p per option, payable by 30 November 2016. Each option entitles the
holder to one ordinary ‘A’ share at a price of 70p per share and is exercisable in November
2014. Any options not exercised by 30 November 2018 will lapse.
Nov. 30 Offers and monies were received for 50 000 options, and these were issued.
2017
Jan. 15 The final call on ordinary ‘B’ shares was made, payable by 15 February 2017. The call takes
into account that 15 000 were already paid in advance.
Feb. 15 All call monies were received.
April 20 50 000 preference shares were repurchased at £1.10 per share. Following the repurchase
Mercury wrote down Preference Share Capital by £50 000 and charged Retained Earnings by
the balance. Mercury does not need to establish a capital redemption reserve.
44 PART 2 Elements
June 30 The profit for the year was £44 000. The directors decided to transfer £20 000 from the general
reserve to retained profits and declared a 10p per share dividend and the preference dividend,
both payable on 30 September 2017. The dividend has not yet been approved by the annual
general meeting (AGM).
Sept. 30 The final ordinary and preference dividends declared on 30 June 2017 were approved and
paid.
Dec. 15 A 5p per share interim ordinary dividend was declared and paid.
2018
Jan. 31 The directors made a one-for-five tradeable rights offer to ordinary ‘B’ shareholders at an issue
price of £1.50 per share. The offer’s expiry date was 28 February 2018.
Feb. 28 Holders of 120 000 shares accepted the rights offer. Shares were issued, with monies payable by
15 March 2018.
Mar. 15 All monies were received.
June 30 Profit for the year was £56 000. The directors, in lieu of declaring a final dividend, made a
1-for-10 bonus issue from the general reserve to all shareholders. Ordinary ‘A’ shares were
valued at £1.20 each, ordinary ‘B’ shares were valued at £1.60 each and preference shares
were valued at £1.15 each.
Nov. 30 Holders of 40 000 options exercised their options, and 40 000 ordinary ‘A’ shares were issued.
Monies were payable by 20 December 2018.
Dec. 20 All monies were received.
2019
Jan. 10 A 5p per share interim ordinary dividend was declared and paid.
June 30 Profit for the year was £48 000. The directors declared a 10p per share final dividend and
the preference dividend, both payable on 30 September 2019. The dividend has not yet been
approved by the AGM.
Required
(a) Prepare general journal entries and closing entries to record the above transactions and events.
(b) Prepare reconciliations for the following accounts for the period 30 June 2016 to 30 June 2019:
• Share capital (Ordinary ‘A’)
• Share capital (Ordinary ‘B’)
• Share capital (Preference).

Equity transactions can be broadly classified into one of the magnitude in earlier years. Recently, the fraction of firms that
following three categories: (1) issue of shares, inclusive of only pay dividend has become very small. Skinner (2008)
employee share options; (2) share buy-back and (3) cash further reports that share buy-back programmes respond to
dividends. Starting with new share issues the academic lit- variations in earnings more than cash dividends do. That
erature has been largely concerned with attempts by man- is, dividends are quite ‘sticky’ and are largely unrelated to
agers to influence share prices and hence proceeds by the profitability.
means of earnings management and abnormal accruals.1 Accounting researchers have been in particular interested
However, the academic literature has provided conflicting in understanding what dividend and share buy-back pro-
evidence as to the relation between abnormal accruals (a grammes imply about past and future earnings and whether
measure of earnings management) and pricing of new the information content in share buy-back or dividend
share issues. One strand of the literature argues that earn- announcements is incremental to the information content
ings in initial public offerings (IPOs) are inflated by man- of earnings. With respect to share buy-back programmes the
agers because they attempt to increase IPO proceeds or IPO literature has distinguished between two forms. The first is
valuation. Teoh et al. (1998b) provide evidence suggesting called share repurchase tender offer. Here the firm asks share-
that IPO managers inflate earnings and that the market is holders to submit their offer as to how many shares they are
misled by this. They reach this conclusion from observing willing to sell back to the firm and at what price. The firm
subsequent poor share price performance for earnings- then decides which offers to accept. The second method is
inflating firms. Teoh and Wong (2002) report that analysts an open-market buy-back programme. Under this method
systematically fail to detect earnings management in IPOs the company announces its plan to buy shares on the open
and seasoned equity offerings (SEOs) and this may be a con- market and, occasionally, how much cash is set aside for
tributing factor to the post-issue share performance. Teoh this purpose. Bartov (1991) claims that tender offers com-
et al. (1998a) examine SEOs and find evidence consistent with mand a greater amount of cash that is distributed back to
naive reaction of equity investors to earnings management shareholders and hence the information content of these
pre-SEO. Shivakumar (2000), in contrast, shows that stock announcements may differ. For open-market offers he finds
returns at the time when firms announce SEOs are negatively that earnings announced by repurchasing firms before tender
related to previously announced abnormal accruals. His evi- offers outperform analyst expectations more than earn-
dence thus suggests that the SEO announcement prompts ings announced by non-purchasing firms. Hertzel and Jain
investors to revise their assessment of prior earnings, but also (1991) examine tender offers and find that analysts revise
suggests that earnings management misleads market partici- their forecasts of future (short-term) earnings upwards for
pants, at least for some time. A different view developed in firms announcing repurchases. Taken together these studies
the literature suggests that only strong IPOs inflate earnings suggest that share buy-back programmes are triggered by
as a costly signal of quality (Fan, 2007). According to this strong performance in the past but also indicate managers’
theory, earnings management is priced. However, this is not expectations about future performance. These findings not-
because investors are misled, rather because they understand withstanding, it is not clear why managers engage in share
that only good firms can inflate earnings and sustain the buy-back programmes in practice. Survey evidence indicates
potential cost of litigation that earnings inflation may entail. that managers buy-back shares when they feel the share price
When firms issue share options they typically do so in the is too low, or as a means to increase earnings per share, not
context of employee compensation, in particular CEO com- necessarily to convey information about future earnings
pensation. This practice is commonly known as employee (Brav et al., 2005).
stock options, or ESOP. One typical feature of ESOP is The Academic Perspective of chapter 1 discusses the infor-
that the exercise price is set equal to the share price on the mation content, or value relevance, of earnings. A similar issue
grant day. The lower the exercise price, the greater the scope arises with dividends — are they informative? Furthermore,
for managers to make a gain on their options when they are they informative incrementally to earnings? One concern
are exercised. Yermack (1997) finds evidence of positive about the informativeness of dividends is that, unlike share
abnormal stock returns in the two days following the grant repurchases, they are very ‘sticky’ and do not change much,
of ESOP. He argues that this is consistent with managers that suggesting they do not normally convey much news. Addi-
time the terms of the ESOP to gain from lower share price, tionally, managers are reluctant to reduce dividends because
and hence exercise price. Aboody and Kasznik (2000) fur- they expect negative market reaction (Brav et al., 2005).
ther show that managers delay voluntary disclosure of good To investigate the information content of dividends Aha-
news but advance disclosure of bad news before the grant rony and Swary (1980) investigate quarterly dividend and
day. Both studies therefore support the notion that managers earnings announcements made on different dates (i.e., not
manipulate the terms of the ESOP. concurrently). Most dividend announcements follow earn-
Returning money to shareholders can be done via either ings announcements, but consistent with dividend ‘stick-
share buy-back or cash dividend. Skinner (2008) esti- iness,’ only 13% of sample firms change their dividends.
mates that both methods were of similar magnitude in the The authors find that firms announcing dividend increases
mid-2000s, whereas share buy-back used to be smaller in (decreases) experience positive (negative) abnormal stock
1 Earnings
management refers to selection by managers of accounting policies, estimates and other assessments with the intention of meeting
certain objectives.
46 PART 2 Elements
returns (returns that are measured relative to the overall returns: an empirical analysis. Journal of Finance,
market return) on the announcement date. They also find 35, 1–12.
that this was the case regardless of whether the dividend Asquith, P., Healy, P., and Palepu, K., 1989. Earnings and
announcement preceded or followed the earnings announce- stock splits. The Accounting Review, 64(3), 387–403.
ment. Therefore they conclude that changes in dividends do Bartov, E., 1991. Open-market stock repurchases as signals
convey information incrementally to earnings. Healy and for earnings and risk changes. Journal of Accounting and
Palepu (1988) take this line of inquiry further by looking Economics, 14, 275–294.
at specific type of changes: dividend initiations and omis- Brav, A., Graham, J. R., Harvey, C. R., and Michaely, R., 2005.
sions. They find that companies that start paying dividends Payout policy in the 21st century. Journal of Financial
experienced earnings growth prior and after the dividend Economics, 77, 483–527.
initiation. The opposite holds for firms that omit dividend Fan, Q., 2007. Earnings management and ownership
payments. They also find that initiations and omissions pro- retention for initial public offering firms: Theory and
vide incremental predictive power for future earnings over evidence. The Accounting Review, 82, 27–64.
and above changes in prior earnings. However, some of these Healy, P.M., and Palepu, K.G., 1988. Earnings information
results were contested in subsequent studies (see Lie, 2005 conveyed by dividend initiations and omissions. Journal of
for a summary of the follow-up literature as well as some Financial Economics, 21, 149–175.
more recent evidence). Hertzel, M., and Jain, P., 1991. Earnings and risk changes
Another form of dividend is stock dividend, or share around stock repurchase tender offers. Journal of Accounting
bonus. However, unlike normal dividends (or share buy- and Economics, 11, 253–274.
back), share bonus does not use cash and so the value of Lakonishok, J., and Lev, B., 1987. Stock splits and stock
the company should remain unaffected, ignoring relatively dividends: Why, who, and when. The Journal of Finance,
minor administrative expenses. The same argument holds 42(4), 913–932.
for stock splits. Nevertheless, this practice is not unusual and Lie, E., 2005. Operating performance following dividend
therefore begs the question: why do companies engage in decreases and omissions. Journal of Corporate Finance, 12,
it? Intrigued by evidence that such share issues are rewarded 27–53.
by capital markets, Lakonishok and Lev (1987) look at this Shivakumar, L., 2000. Do firms mislead investors
question from the perspective of earnings growth. They by overstating earnings before seasoned equity
find that firms that split their shares experienced a robust offerings? Journal of Accounting and Economics, 29(3),
earnings growth in the 5-year period before the split. But this 339–371.
does not hold for firms using share dividends. Further exam- Skinner, D. J., 2008. The evolving relation between earnings,
ining stock returns they conclude that the aim of stock split dividends, and stock repurchases. Journal of Financial
is to bring high stock prices to a normal level. Asquith et Economics, 87, 582–609.
al. (1989) provide additional evidence suggesting that share Teoh, S. H., Welch I., and Wong, T. J., 1998a. Earnings
split announcements are perceived by the market to be asso- management and the underperformance of seasoned
ciated with permanent earnings growth rather than a transi- equity offerings. Journal of Financial Economics,
tory one. This suggests that managers can communicate their 50, 63–99.
positive outlook of firm performance via splits. Teoh, S. H., Welch I., and Wong, T. J., 1998b. Earnings
management and the long-run market performance
of initial public offerings. Journal of Finance,
References 53(6), 1935–1974.
Teoh, S. H., and Wong, T. J., 2002. Why new issues and high-
Aboody, D., and Kasznik, R., 2002. CEO stock option awards accrual firms underperform: The role of analysts’ credulity.
and the timing of corporate voluntary disclosures. Journal of Review of Financial Studies, 15(3), 863–900.
Accounting and Economics 29, 73–100. Yermack, D., 1997. Good timing: CEO stock option awards
Aharony, J., and Swary, I., 1980. Quarterly dividend and company news announcements. The Journal of Finance,
and earnings announcements and stockholders’ 52, 449–476.

3
Fair value measurement
ACCOUNTING IFRS 13 Fair Value Measurement

STANDARDS
IN FOCUS

OBJECTIVES
1 explain the need for an accounting standard on fair value measurement
2 understand the key characteristics of the term ‘fair value’
3 understand the key concepts used in the fair value framework
4 explain the steps in determining the fair value of non-financial assets
5 understand how to measure the fair value of liabilities
6 explain how to measure the fair value of an entity’s own equity instruments
7 discuss issues relating to the measurement of the fair value of financial instruments
8 prepare the disclosures required by IFRS 13 Fair Value Measurement.
CHAPTER 3 Fair value measurement 49

LO1 3.1 INTRODUCTION
3.1.1 The need for a standard on fair value
Under accounting standards issued by the International Accounting Standards Board (IASB®), there are
various ways in which assets are required to be measured. Many standards specify how assets are to be
initially recognised, and some standards specify or give choices on measurement subsequent to initial rec-
ognition. The two main measures used are cost and fair value, for example:
• Paragraph 15 of IAS 16 Property, Plant and Equipment requires an item of property, plant and equipment
that qualifies for recognition as an asset to be measured initially at its cost.
• Paragraph 24 of IAS 38 Intangible Assets requires intangible assets to be measured initially at cost.
• Paragraph 43 of IAS 39 Financial Instruments: Recognition and Measurement requires financial assets to be
measured at fair value.
• Both IAS 16 and IAS 38 allow entities the choice, subsequent to initial recognition, of measuring assets
using the cost model or the revaluation model.
Other measurement methods used in accounting standards include net realisable value, fair value less
costs of disposal, recoverable amount and value in use.
In relation to the measurement of liabilities, IAS 39 requires financial liabilities to be measured at fair
value, while non-financial liabilities are measured, in accordance with paragraph 36 of IAS 37 Provisions,
Contingent Liabilities and Contingent Assets, at the best estimate of the expenditure required to settle the
present obligation.
Prior to 2011, many accounting standards defined the term ‘fair value’ as:
The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties
in an arm’s length transaction.
Various accounting standards also provided guidance on the measurement of fair value, such as IAS
38 Intangible Assets, which provided a hierarchy of fair value measurement, and IAS 40 Investment Prop-
erty, which contained a discussion of the meaning of ‘a transaction between knowledgeable, willing
parties’. However, despite this, there was generally limited guidance in IFRS® Standards on how to
measure fair value and, in some cases, the guidance was conflicting. To remedy this, the IASB under-
took a convergence project with the US FASB. In May 2009, the IASB issued the exposure draft Fair
Value Measurement.
Three reasons for issuing the exposure draft were given in the Introduction:
(a) to establish a single source of guidance for all fair value measurements required or permitted by IFRSs to
reduce complexity and improve consistency in their application;
(b) to clarify the definition of fair value and related guidance in order to communicate the measurement objec-
tive more clearly;
(c) to enhance disclosures about fair value to enable users of financial statements to assess the extent to which
fair value is used and to inform them about the inputs used to derive those fair values.
Some constituents noted that if the IASB were to advocate its fair value approach on the grounds of rel-
evance, this position is only tenable if the meaning of fair value is both clear and unambiguous and if the
fair value of an asset and liability can be measured with sufficient reliability to justify its use as the primary
basis of asset and liability measurement. An accounting standard on fair value measurement would hope-
fully allay such concerns about the use of fair value to measure assets and liabilities.
In preparing a separate accounting standard on the measurement of fair value, the IASB was not pro-
posing to introduce new requirements for the use of fair value as the required measurement method or
to eliminate current practicability exceptions to the measurement of fair value, such as that in IAS 41
Agriculture.
The Boards’ joint discussions resulted in the issuance of IFRS 13 Fair Value Measurement, in May 2011,
and amendments to ASC (Accounting Standards Codification) 820 and created a generally uniform frame-
work for applying fair value measurement in both IFRS and US GAAP.
3.1.2 The objectives of IFRS 13

A primary goal of IFRS 13 is to increase the consistency and comparability of fair value measurements
used in financial reporting. The objectives of IFRS 13 are succinctly stated in paragraph 1:
• to define fair value
• to set out in a single standard a framework for measuring fair value
• to require disclosures about fair value measurement.
3.1.3 When does IFRS 13 apply?

IFRS 13 applies whenever another accounting standard requires or permits the measurement or disclosure
(i.e. those items that are not measured at fair value, but whose fair value is required to be disclosed) of fair
50 PART 2 Elements
value or measures based on fair value (e.g. fair value less costs of disposal). It also specifies when and what
information about fair value measurement is to be disclosed.
IFRS 13 does not apply to share-based payment transactions within IFRS 2 Share-based Payment;
leasing transactions within the scope of IAS 17 Leases; and measurements that have similarities to, but
are not, fair value, such as net realisable value in IAS 2 Inventories or value in use in IAS 36 Impairment
of Assets.
LO2 3.2 THE DEFINITION OF FAIR VALUE

Fair value is defined in Appendix A of IFRS 13 as:
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date.
The definition of fair value in IFRS 13 is not significantly different from previous definitions in IFRS —
that is, ‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable,
willing parties in an arm’s length transaction’. In both definitions the measurement of fair value is not
based on an actual transaction, but a hypothetical one. In addition, it assumes an orderly transaction, not
a forced transaction or a distress sale.
So, why change the definition of fair value? Paragraph BC30 provides three reasons:
1. The previous definition did not specify whether an entity was buying or selling the asset. As such, it was
uncertain whether fair value was an exit (selling) price or an entry (buying) price. The new definition
requires the use of an exit price.
2. In the previous definition, it was unclear what was meant by ‘settling’ a liability with knowledgeable
parties. Does this mean the creditor or other parties? The new definition requires measurement by refer-
ence to the transfer of a liability to a party who may not be the creditor.
3. There was no explicit statement in the previous definition as to whether the exchange or settlement took
place at the measurement date or at some other date. The new definition specifies that fair value is the
price at the measurement date.
In addition, the revised definition clarifies that fair value is a market-based measurement, not an entity-
specific measurement, and, as such, is determined based on the assumptions that market participants
would use in pricing the asset or liability (paragraph BC31).
3.2.1 Current exit price

Exit price is defined in Appendix A of IFRS 13 as follows:
The price that would be received to sell an asset or paid to transfer a liability.
Paragraph 57 of IFRS 13 notes that, when an entity acquires an asset or assumes a liability in an exchange
transaction, the transaction price is the amount paid by the entity. This is an entry price. In contrast, the
fair value of the asset or liability is the price that would be received to sell the asset or paid to transfer the
liability. This is an exit price.
Importantly, the definition of fair value is that it is an exit price based on the perspective of the entity
that holds the asset or owes the liability.
An exit price is based on expectations about the future cash flows that will be generated by the asset sub-
sequent to the sale of the asset or transfer of the liability. These cash flows may be generated from use of
the asset or from sale of the asset by the acquiring entity. Even if the entity holding the asset intends to use
it rather than sell it, fair value is measured as an exit price by reference to the sale of the asset to a market
participant who will use the asset or sell it.
Similarly, with a liability, an entity may continue to hold a liability until settlement or transfer the lia-
bility to another entity. The fair value in both cases is based on market participants’ expectations about
cash outflows by the entity.
According to paragraph BC44 of the Basis for Conclusions to IFRS 13, the IASB concluded that a current
entry price and a current exit price will be equal when they relate to the same asset or liability on the same
date in the same form in the same market. However, valuation experts informed the IASB that, in a busi-
ness combination, an exit price for an asset or liability acquired or assumed might differ from an exchange
price — entry or exit — if:
• an entity’s intended use for an acquired asset is different from its highest and best use
• a liability is measured on the basis of settling it with the creditor rather than transferring it to a third party.
The equivalence of exit prices and entry prices was questioned by Ernst & Young (2009, p. 5) in their
response to the IASB exposure draft:
The ED seems to minimise any distinction between measurements based on entry prices versus exit prices, based
on a belief that a current entry price and a current exit price are equal when they relate to the same asset or
liability in the same market. In our view, this conclusion is only true for assets and liabilities that trade in
active markets, as it takes competitive market forces to derive a single price. The price in a principal-to-principal

transaction that occurs outside of an active market is the result of a unique negotiation between buyer and seller,
considering the specific attributes of both parties in the transaction, but not other market participants. As such,
an entity may negotiate a different price in a transaction to sell the asset to one party than it would pay to buy
the same asset from another party. In practice, we believe many constituents relate an entry price notion as more
akin to an entity-specific measurement, whereas exit price is clearly a market-based measurement. The Board
should consider such limitations when it evaluates the decision usefulness of fair value measures versus other
measurement objectives, such as value in use.
This distinction between an entry price and exit price is significant and can have important implications
for the initial recognition of assets and liabilities at fair value. Prior to the issuance of IFRS 13, it was
common for entities to use the transaction price as fair value of an asset or liability on its initial recog-
nition. Therefore, an entity must determine whether the transaction price represents the fair value of an
asset or liability at initial recognition and paragraph B4 of IFRS 13 provides certain factors that an entity
should consider in making this determination.
3.2.2 Orderly transactions

The definition of fair value requires that an asset be sold or a liability transferred in an orderly trans-
action. An orderly transaction is not a forced or distressed sale, such as occurs in liquidations. It assumes
that, before the measurement date, there is sufficient time and exposure to a market to allow the usual
marketing activities to take place for that transaction.
Fair value is measured by considering a hypothetical transaction in a market. To determine that fair
value, the entity will make observations in current markets. The markets to be observed must be those
containing orderly transactions. Prices of goods sold in a liquidation or ‘fire sale’ are not appropriate to
include in the measurement. Similarly, prices between entities that are not at arm’s length are not prices
from orderly transactions.
While fair value assumes an orderly transaction, in practice entities may need to consider prices from
such transactions or from markets where there has been a decline in trading. An example relates to 2011
trading activity for Greek sovereign bonds. During that calendar year, the economic situation in Greece had
deteriorated and some had questioned whether the Greek sovereign bonds were still being actively traded.
IFRS 13 is clear that fair value remains a market-based exit price that considers the current market con-
ditions as at the measurement date, even if there has been a significant decrease in the volume and level
of activity for the asset or liability (paragraph 15). Therefore, paragraphs B37–B47 of Appendix B provide
guidance to assist entities in measuring fair value when the volume or level of activity for an asset or a
liability has significantly decreased.
3.2.3 Transaction and transportation costs

Both transaction and transport costs affect the determination of the fair value of an asset or liability. How-
ever, the price used to measure fair value is not adjusted for transaction costs, but would consider transpor-
tation costs.
Transaction costs are the incremental direct costs, that are essential to the transaction, to sell an asset
or transfer a liability and are defined as the costs that would be incurred in the principal (or most advan-
tageous) market and are directly attributable to the sale or transfer. Similar to other requirements, incre-
mental costs are those that would not otherwise have been incurred had the entity not decided to enter
into the transaction to sell or transfer.
Transportation costs are those that would be incurred to move the asset to the principal (or most advan-
tageous) market.
As discussed in section 3.3.2, when determining the most advantageous market (in the absence of a prin-
cipal market), an entity takes into consideration the transaction costs and transportation costs it would
incur to sell the asset or transfer the liability. However, the price in that market that is used to measure the
fair value of an asset or liability is not adjusted for transaction costs. The reason for this is that transaction
costs are not considered to be a characteristic of the asset or liability. Instead they are specific to a trans-
action and will change from transaction to transaction.
An asset may have to be transported from its present location to the principal (or most advantageous)
market. As the location of an asset or a liability is a characteristic of the asset or liability, it will have a
different fair value because of associated transport costs. For example, if an entity located in a capital
city is considering buying a vehicle, then a vehicle located in a country town has a different fair value
compared to one located in the capital city because of the transport costs associated with moving the
vehicle from the country town. A price in the principal (or most advantageous) market is then adjusted
for the transport costs. In contrast, transaction costs, such as registration costs, are not a characteristic of
the asset. Illustrative example 3.1 shows how transport costs and transaction costs are considered in the
measurement of fair value.
52 PART 2 Elements
ILLUSTRATIVE EXAMPLE 3.1 Transaction costs and transport costs
Entity A holds a physical commodity measured at fair value in its warehouse in Europe. For this com-
modity, the London exchange is determined to be the principal market as it represents the market with
the greatest volume and level of activity for the asset that the entity can reasonably access.
The exchange price for the asset is £25. However, the contracts traded on the exchange for this com-
modity require physical delivery to London. Entity A determines that it would cost £5 to transport the phys-
ical commodity to London and the broker’s commission would be £3 to transact on the London exchange.
Since location is a characteristic of the asset and transportation to the principal market is required,
the fair value of the physical commodity would be £20 — the price in the principal market for the asset
£25, less transportation costs of £5. The £3 broker commission represents a transaction cost; therefore,
no adjustment is made to the price in the principal market used to measure fair value.
Source: Adapted from EY, International GAAP 2015, Volume 1, Chapter 14 Fair value measurement, Section 9.2, Example 14.10, p. 973.
LO3 3.3 THE FAIR VALUE FRAMEWORK

In addition to providing a single definition of fair value, IFRS 13 includes a framework for applying this
definition to financial reporting. Many of the key concepts used in the fair value framework are interre-
lated and their interaction needs to be considered in the context of the entire approach.
When measuring fair value, paragraph B2 of IFRS 13 requires an entity to determine all of the following:
• the particular asset or liability that is the subject of the measurement (consistent with its unit of
account) — see section 3.3.1.
• for a non-financial asset, the valuation premise that is appropriate for the measurement (consistent
with its highest and best use) — see section 3.4.
• the principal (or most advantageous) market for the asset or liability — see section 3.3.2.
• the valuation technique(s) appropriate for the measurement, considering the available inputs that
represent market participants assumptions and their categorisation within the fair value hierarchy —
see sections 3.3.3 to 3.3.5.
IFRS 13 provides specific requirements to assist entities in applying its fair value framework to:
(a) non-financial assets;
(b) liabilities and an entity’s own equity instruments; and
(c) financial instruments with offsetting risks.
This application guidance is discussed in sections 3.4 to 3.7.
3.3.1 What is the particular asset or liability that is the subject

of the measurement?
Paragraph 11 of IFRS 13 clarifies that in order to measure fair value for a particular asset or liability, an
entity must take into account those characteristics that exist at the measurement date that a market partici-
pant would consider when pricing the asset or liability. Some of the key questions that need to be asked
when determining the asset or liability to be measured are:
• What is the unit of account? Is the asset a stand-alone asset or is it a group of assets? The unit of account
defines what is to be measured. Other standards specify this — that is, the level at which an asset or
liability is aggregated or disaggregated for financial reporting purposes (Appendix A of IFRS 13). For
example, where a fair value is being calculated for impairment purposes, the assets being valued may
be a single asset or a cash generating unit, as defined in IAS 36. Similarly, if the fair value relates to a
business, the definition of a business in IFRS 3 Business Combinations would need to be considered.
• Are there any restrictions on sale or use of the asset or transfer of the liability? There may be legal limits
on the use of the asset (e.g. patents, licences or expiry dates of related lease contracts). A restriction
that would transfer with the asset in an assumed sale would generally be a characteristic of the
asset that market participants would consider. However, a restriction that is specific to the entity
that holds the asset would not transfer with the asset and, therefore, would not be considered. A
liability or an entity’s own equity instrument may be subject to restrictions that prevent its transfer.
IFRS 13 does not allow an entity to include a separate input (or an adjustment to other inputs) for
such restrictions because the effect will either implicitly or explicitly be included in other inputs.
• What is the condition of the asset? Many of the factors that are considered in depreciating an asset will
be of relevance, such as remaining useful life, physical condition, expected usage, and technical or
commercial obsolescence.

• What is the location of the asset? If the location of a non-financial asset is different from the market in
which it would hypothetically be sold, the asset would need to be transported in order to sell it. In
such cases, location is considered a characteristic of the asset and the costs to transport the asset to
market would be deducted from the price received in order to measure fair value.
A further consideration relates to whether or not the size of an entity’s holding can be considered.
Assume, for example, that an entity holds 100 shares that it needs to measure at fair value. The unit of
account is the individual financial instrument. So, in order to measure fair value, does the entity use the
price to sell a single share or the block of 100 shares? In general, the price per unit would be expected to
fall if a large volume of the units were being sold as a package. This is referred to as a ‘block discount’
arising because the volume is a ‘blockage factor’. Paragraph 69 prohibits the use of a blockage factor,
arguing that a blockage factor is not relevant. As noted in paragraph BC42 of the Basis for Conclusions on
IFRS 13, the transaction being considered between the market participants is a hypothetical transaction,
and as such, the determination of fair value does not consider any entity-specific factors that might influ-
ence the transaction. The size of an entity’s holding is entity-specific. Therefore, fair value must be meas-
ured based on the unit of account of the asset or liability being measured.
In addition to the above, for non-financial assets, an entity must consider the highest and best use of the
asset and the valuation premise. This is discussed further in section 3.4.
3.3.2 What is the principal (or most advantageous) market

for the asset?
When measuring fair value, an entity is required to assume that the hypothetical transaction to sell the
asset or transfer the liability takes place either (paragraph 16):
(a) in the principal market for the asset or liability; or
(b) in the absence of a principal market, in the most advantageous market for the asset or liability.
Appropriately determining the relevant exit market is important because an entity needs to determine the
market participants to whom it would sell the asset or transfer the liability, as is discussed in section 3.3.3.
IFRS 13 is clear that, if there is a principal market for the asset or liability, the fair value measurement
represents the price in that market at the measurement date (regardless of whether that price is directly
observable or estimated using another valuation technique). The price in the principal market must be
used even if the price in a different market is potentially more advantageous (paragraph 18).
Appendix A contains a definition of principal market, as follows:
The market with the greatest volume and level of activity for the asset or liability.
The principal market is, therefore, the deepest and most liquid market for the non-financial asset. How-
ever, an entity need not make an exhaustive search of all markets in order to determine which market is
the principal market. IFRS 13 presumes that the market in which the entity usually enters to sell this type
of asset or liability is the principal market, unless evidence to the contrary exists (paragraph 17).
Where there is no principal market, the entity needs to determine the most advantageous market.
The determination of the most advantageous market is based on a comparison of the amounts that would
be received from transacting for the asset or liability in a number of markets. The most advantageous market
is the one that offers the highest return when selling an asset or requires the lowest payment when transfer-
ring a liability, after taking into consideration transportation and transaction costs. Illustrative example 3.2
provides an example of determining the principal market and the most advantageous market.
ILLUSTRATIVE EXAMPLE 3.2 Principal market and most advantageous market
The following three markets exist for Entity A’s fleet of vehicles. Entity A has the ability to transact in all
three markets. The entity has 100 vehicles (same make, model and mileage) that it needs to measure at
fair value. Volumes and prices in the respective markets are as follows:
The entity’s volume for

the asset in the market Total market-
(based on history and/ based volume for Transportation Transaction
Market Price or intent) the asset costs costs
A £27 000 60% 15% £3 500 £1 100
B £25 000 25% 75% £2 300 £900
C £23 000 15% 10% £900 £800
54 PART 2 Elements
Based on this information, Market B would be the principal market as this is the market in which the
majority of transactions for the asset occur. As such, the fair value of the 100 vehicles as at the measure-
ment date would be £2.27 million (£22 700 = £25 000 per car − transportation costs of £2300). Actual
sales of the assets in either Market A or C would result in a gain or loss to the entity, i.e. when compared
to the fair value of £25 000.
If none of the markets is the principal market for the asset, the fair value of the asset would be meas-
ured using the price in the most advantageous market.
The most advantageous market is the one that maximises the amount that would be received to sell
the asset, after considering transaction costs and transportation costs (i.e. the net amount that would be
received in the respective markets).
In Market A, the net amount received by the entity is £22 400 (= £27 000 − £3500 − £1100).
In Market B, the net amount received by the entity is £21 800 (= £25 000 − £2300 − £900).
In Market C, the net amount received by the entity is £21 300 (= £23 000 − £900 − £800).
Since the net amount that would be received is higher in Market A, that is the most advantageous
market for the entity. Therefore, the fair value of each vehicle is £23 500, being the amount received
net of transportation costs. Please note that although transaction costs are used to determine the most
advantageous market, they are not used in the measurement of fair value.
Source: Adapted from EY, International GAAP 2015, Volume 1, Chapter 14 Fair value measurement, Section 6.1.2, Example 14.16, p. 955.
The principal (or most advantageous) market is considered from the perspective of the reporting entity,
which means that it could be different for different entities. An entity may also be able to access different
markets at different points of time — that is, not all markets are always accessible to the entity. The prin-
cipal (or most advantageous) market must be one that the entity can access at the measurement date
(paragraph 19).
The IASB reasoned that the principal market was the most liquid market and provided the most rep-
resentative input for a fair value measurement (paragraph BC52 of the Basis for Conclusions to IFRS 13).
The IASB also believed that most entities made operational decisions based upon an objective of maxi-
misation of profits; therefore entities would choose the most advantageous market in which to conduct
operations. The most advantageous market would then often be the market that the entity usually enters,
or expects to enter.
In some cases, there may be no observable market in which transactions take place for an asset or lia-
bility — for example, a patent or a trademark. Where this occurs, an entity must assume that a transaction
takes place at the measurement date. The assumed transaction establishes a basis for estimating the price
to sell the asset or transfer the liability.
3.3.3 Who are the market participants?

Market participants are ‘buyers and sellers in the principal (or most advantageous) market for the asset or
liability’ (IFRS 13 Appendix A). IFRS 13 assumes they have all of the following characteristics:
• They are independent of each other, that is, they are not related parties. As a result, the hypothetical
transaction is assumed to take place between market participants at the measurement date, not
between the reporting entity and another market participant. While market participants are not related
parties, the standard does allow the price in a related party transaction to be used as an input in a fair
value measurement provided the entity has evidence the transaction was entered into at market terms.
• They are knowledgeable, having a reasonable understanding about the asset or liability using all available
information. Market participants should have sufficient knowledge before transacting. However, this
knowledge does not necessarily need to come from publicly available information. It could be
obtained in the course of a normal due diligence process.
• They are able and willing to enter into a transaction for the asset or liability. When determining potential
market participants, certain characteristics should be considered, including the legal capability and
the operating or financial capacity of an entity to purchase the asset or assume the liability. As well as
being able to transact, market participants must be willing to do so. That is, they are motivated but
not forced or otherwise compelled to transact.
When measuring fair value, an entity is required to use the assumptions that market participants would
use when pricing the asset or liability. Fair value is not the value specific to the reporting entity and it is
not the specific value to any one market participant that may have a greater incentive to transact than other
market participants. The reporting entity should consider those factors that market participants, in general,
would consider.
There is no need to identify specific market participants. The focus should be on the characteristics
of the participants (paragraph 22). For example, it is not necessary to identify, say, ArcelorMittal S.A.
or Nippon Steel & Sumitomo Metal Corporation as potential market participants; rather, the entity

would identify market participants as large steel producers and consider the characteristics of such
producers.
Determining these characteristics takes into consideration factors that are specific to the asset or liability
(see section 3.3.1); the principal (or most advantageous) market (see section 3.3.2); and the market partici-
pants in that market (paragraph 23).
The proposal that the fair value should not be an entity-specific value was questioned by Nestlé in its
response to the IASB on its exposure draft. Nestlé (2009, p. 3) made the following comment:
Such a market-based measurement method should be driven by the market in which the entity operates. We
consequently believe that the entity being a market participant itself must consider assumptions that other
market participants would use in pricing the asset or liability in addition to its own entity-specific assumptions.
Ernst & Young (2009, pp. 4–5) in its response to the IASB exposure draft noted that it was important to
consider the trade-off between relevance and reliability in assessing the measurement of fair value:
[W]e believe that choosing a measurement basis for any asset or liability includes evaluating the balance
between the relevance of the information provided and its reliability with respect to fair value. Such an assess-
ment includes weighing the relevance of market participant assumptions versus entity-specific assumptions in
predicting expected future cash inflows and outflows associated with an asset or liability. This evaluation also
includes assessing the trade-off between the potential for management bias in entity-specific assumptions versus
the subjectivity of market-based assumptions for assets and liabilities without an active market.
3.3.4 What are the appropriate valuation techniques for

the measurement?
Having determined the nature of the asset being valued (including additional considerations for non-
financial assets, discussed in section 3.4 below) and the principal (or most advantageous) market (the exit
market) in which the asset would be sold or liability transferred, the next step is to determine the appro-
priate valuation technique(s) and inputs (see section 3.3.5) to use to estimate the exit price.
The appropriateness of a valuation technique and inputs may vary depending on the level of activity in
the exit market. However, the objective of a fair value measurement does not change depending on the
level of activity or the valuation technique(s) used (paragraph 62).
The following three possible valuation approaches are noted in paragraph 62. Within the application of
each of these approaches, there may be a number of possible valuation techniques.
• The market approach: based on market transactions involving identical or similar assets or liabilities.
• The income approach: based on future amounts (e.g. cash flows or income and expenses) that are
converted (discounted) to a single present amount. The fair value is based upon market expectations
about future cash flows, or income and expenses associated with that asset. Present value techniques
are an example of techniques used in applying the income approach. The fair value of an asset is then
not based on an observed market price but rather is generated by discounting the expected earnings
from the use of the asset by a market participant. Paragraphs B13–B30 of Appendix B provide details
about present value techniques.
• The cost approach: based on the amount required to replace the service capacity of an asset (often
referred to as current replacement cost). This may involve consideration of the amount to be paid
for a new asset, with this amount then adjusted for both physical deterioration and technological
obsolescence.
IFRS 13 does not propose a hierarchy of valuation techniques (with the exception of the requirement
to measure identical financial instruments that trade in active markets at price multiplied by quantity
(P × Q)). Instead, it prioritises the inputs used in the application of these techniques (see section 3.3.5).
Some valuation techniques are better in some circumstances than in others. Significant judgement is
required in selecting the appropriate valuation technique for the situation. Sufficient knowledge of the
asset or liability and an adequate level of expertise regarding the valuation techniques is also needed.
However, some guidance in the choice of technique is provided in IFRS 13:
• The technique must be appropriate to the circumstances (paragraph 61).
• There must be sufficient data available to apply the technique (paragraph 61).
• The technique must maximise the use of observable inputs and minimise the use of unobservable
inputs (paragraph 61).
• In some cases, multiple techniques may be appropriate. This is likely to result in a range of possible
values. Therefore, an entity must evaluate the reasonableness of the range and select the point within
the range that is most representative of fair value in the circumstances (paragraph 63). This could
include weighting the results. However, evaluating the range does not necessarily require calibration
of the approaches (i.e. the results from different approaches do not have to be equal). Paragraph 40
indicates that a wide range of fair value measurements may indicate that further analysis is needed.
• Valuation techniques used to measure fair value must be consistently applied. Paragraph 65 provides
examples of situations where a change in technique may be appropriate, such as when new markets
develop or new information becomes available.
56 PART 2 Elements
Use of different valuation techniques is shown in illustrative example 3.3.
ILLUSTRATIVE EXAMPLE 3.3 Valuation techniques
MediaCo is a newspaper and magazine publishing company. It previously acquired another publishing
company that had two weekly newspapers and five monthly magazines. As a result of a sustained decline
in circulation for the two newspapers, MediaCo tests the related cash-generating units (including the
newspaper mastheads) for impairment in accordance with IAS 36 and measures the fair value less costs
of disposal.
MediaCo concludes the market and income approaches could be applied as follows:
• The market approach is applied by using prices for comparable business combinations, adjusted for
differences between those business combinations and each cash-generating unit (including location,
circulation) and changes in market conditions since those business combinations took place.
• The income approach is applied using a present value technique. The expected cash flows reflect
market participants’ expectations were a buyer to operate each cash-generating unit, in light of
anticipated market conditions, including expectations about future circulation.
3.3.5 Which inputs should be used when measuring fair

value?
Selecting inputs
According to Appendix A of IFRS 13, inputs are:
The assumptions that market participants would use when pricing the asset or liability, including assumptions
about risk, such as the following:
(a) the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model);
and
(b) the risk inherent in the inputs to the valuation technique.
Inputs may be observable or unobservable.
Observable inputs are defined in Appendix A as:
Inputs that are developed using market data, such as publicly available information about actual events or trans-
actions, and reflect the assumptions that market participants would use when pricing the asset or liability.
Unobservable inputs are defined in Appendix A as:
Inputs for which market data are not available and that are developed using the best information available about
the assumptions that market participants would use when pricing the asset or liability.
Regardless of the selected valuation technique, the inputs an entity uses must be consistent with
the characteristics of the asset or liability that market participants would take into account. In addition,
inputs exclude premiums or discounts that reflect size as a characteristic of the entity’s holding,
as these are not a characteristic of the item being measured (for example, blockage factors, see
section 3.3.1), and any other premiums or discounts that are inconsistent with the unit of account
(paragraph 69).
Regardless of the technique used, an entity must maximise the use of observable inputs and minimise
the use of unobservable inputs. Therefore, for example, an income approach valuation technique that
maximises the use of observable inputs and minimises the use of unobservable inputs may provide a
better measure of fair value than a market valuation technique that requires significant adjustment using
unobservable inputs.
Inputs based on bid and ask prices
Some input measures are based on market prices where there are both bid prices — the price a dealer is
willing to pay — and ask prices — the price a dealer is willing to sell. An example is a foreign exchange
dealer who is willing to exchange one currency for another, such as exchanging Euros for Japanese Yen. In
such cases paragraph 70 of IFRS 13 states that the price within a bid–ask spread that is most representative
of fair value should be used to measure fair value. Paragraph 71 notes that mid-market pricing (that is,
using the mid-point in the bid–ask spread), or another pricing convention that is used by market partici-
pants, may be used as a practical expedient.
Fair value hierarchy — prioritising inputs
To achieve consistency and comparability in the measurement of fair values, IFRS 13 provides a hierarchy
of inputs showing which inputs are considered to be given higher priority in determining a fair value
measurement.

Four important points critical to understanding the uses of these inputs are:
1. The inputs are prioritised into three levels — Level 1, Level 2 and Level 3.
2. The fair value hierarchy gives the highest priority to quoted market prices in active markets for identical
assets and liabilities and the lowest priority to unobservable inputs (paragraph 72).
3. Where observable inputs are used, they must be relevant observable inputs (paragraph 67). As noted in
paragraph BC151 of the Basis for Conclusions, some respondents to the IASB expressed concerns about
being required to use observable inputs during the global financial crisis that started in 2007 when the
available observable inputs were not representative of the asset or liability being measured at fair value.
Observability is, therefore, not the only criterion applied when selecting inputs; the inputs must be rele-
vant as well as observable. Market conditions may require adjustments to be made to current observable
inputs in measuring fair value.
4. The availability of inputs and their relative subjectivity potentially affects the selection of the valuation
technique; however, the fair value hierarchy prioritises the inputs to the valuation techniques, not the
techniques themselves.
IFRS 13 also distinguishes between where an individual input may fall within the fair value hierarchy
and where the entire measurement is categorised for disclosure purposes. The latter is discussed in section
3.8.1.
Level 1 inputs
Level 1 inputs are defined in Appendix A as:
Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the
measurement date.
An active market is defined in Appendix A as follows:
A market in which transactions for the asset or liability take place with sufficient frequency and volume to pro-
vide pricing information on an ongoing basis.
Observable markets in which debt instruments, equity instruments or commodities are regularly traded
on a securities exchange would likely be active markets. However, the above definitions make it clear
that pricing needs to be for identical items. Assets such as vehicles, intangibles and buildings, and many
liabilities may be similar, but will not be identical. Therefore, it is unlikely that Level 1 inputs would be
available for such items.
As noted in paragraph 77, a quoted price in an active market for the identical asset or liability provides
the most reliable evidence of fair value. As a result, IFRS 13 requires this price (without adjustment) to be
used whenever available (also known as price multiplied by quantity, or P × Q). Adjustments to this price
are only permitted in the limited circumstances specified in paragraph 79 of IFRS 13.
A market may no longer be considered active if:
• there has been a significant decrease in the volume and level of activity for the asset or liability when
compared with normal market activity
• there are few recent transactions
• price quotations are not based on current information
• price quotations vary substantially over time or among market-makers.
Level 2 inputs
Level 2 inputs are any inputs, other than Level 1 inputs, that are directly or indirectly observable.
These inputs, like Level 1 inputs, are observable. According to paragraph 82, level 2 inputs include:
• quoted prices for similar assets or liabilities in active markets
• quoted prices for identical or similar assets or liabilities in markets that are not active
• inputs, other than quoted prices, that are observable for the asset or liability, such as interest rates and
yield curves
• inputs that are derived from, or corroborated, by observable market data by correlation or other
means.
It may be necessary to make adjustments to Level 2 inputs. For example, in relation to quoted prices for
similar assets, these may have to be adjusted for the condition of the assets or the location of the assets..
Paragraph B35 in Appendix B contains examples of Level 2 inputs:
• Finished goods inventory at a retail outlet: Level 2 inputs include either a price to customers in a retail
market or a wholesale price to retailers in a wholesale market, adjusted for differences between the
condition and location of the inventory item and the comparable (i.e. similar) inventory items.
• Building held and used: A Level 2 input would be the price per square metre for the building derived
from observable market data, or derived from prices in observed transactions involving comparable
buildings in similar locations.
• Cash-generating unit: A Level 2 input may involve obtaining a multiple of earnings or revenue from
observable market data by observing transactions of similar businesses.
In all cases, the examples refer to market data or to prices being observable either directly (that is, the
price itself is available) or indirectly (that is, price is derived from observable information).
58 PART 2 Elements
Level 3 inputs
Level 3 inputs are those that are unobservable.
While Level 1 and Level 2 inputs are based on observable market data, Level 3 inputs are unobservable.
The data used may be that of the entity itself, which may be adjusted for factors that market participants
would build into the valuation, or to eliminate the effect of variables that are specific to this entity, but not
relevant to other market participants.
Examples of Level 3 inputs include:
• Cash-generating unit: A Level 3 input would include a financial forecast of cash flow or earnings based
on the entity’s own data.
• Trademark: A Level 3 input would be to measure the expected royalty rate that could be obtained by
allowing other entities to use the trademark to produce the products covered by the trademark.
• Accounts receivable: A Level 3 input would be to measure the asset based upon the amount expected to
be recovered based upon the entity’s historical record of recoverability of accounts receivable.
In illustrative example 3.4, an example is given where different valuation techniques could be used to
measure the fair value of an asset, with a consideration of the level of inputs that might be used.
ILLUSTRATIVE EXAMPLE 3.4 Valuation techniques and inputs used
Van Hoff revalues its buildings, which are held and used, in accordance with IAS 16. All three valuation
approaches could be applied to measure fair value. Van Hoff would evaluate the results of using these
valuation techniques. It would consider the relevance, reliability and subjectivity of the information
used in the valuations and the range of values given by the three techniques in order to select the point
within the range that is most representative of fair value in the circumstances.
Market approach
Van Hoff applies the market approach using observable prices for comparable buildings in similar
locations adjusted for differences between the buildings, including its location and condition. The prices
for comparable buildings are Level 2 inputs. Both observable information (e.g. square-metres, age of the
building) and unobservable information was used to determine the adjustments to the prices for com-
parable buildings. As such, the adjustments were generally Level 3 inputs.
Income approach
Van Hoff uses a present value technique using expected cash flows that reflect what market participants
would expect to receive from renting the building to tenants. Van Hoff derives the price per square metre
for the building and expected incentives to entice new tenants from observable market data, which are
Level 2 inputs. Adjustments are made for differences in location and condition of the building. The
expected cash flows also include market participants’ expectations about costs to maintain the building,
which Van Hoff estimates based on its own data, which are Level 3 inputs. The discount rate used is
based on the risk-free rate, which is observable, but is adjusted for the premium a market participant
would require to accept the uncertainty related to purchasing and renting the building. As such, the dis-
count rate is a Level 3 input.
Cost approach
Van Hoff estimates the amount that would currently be required to construct a substitute building.
Adjustments would be necessary for the effects of location and condition of the building. The inputs used
are a mix of Level 2 and Level 3 inputs. Some inputs are based on observable market data; for example,
costs related to materials and labour. Inputs related to estimated physical obsolescence to reflect the cur-
rent condition of the building are derived from Van Hoff’s own data, which is unobservable.
LO4 3.4 APPLICATION TO NON-FINANCIAL ASSETS

In addition to the general fair value framework (discussed in section 3.3), the fair value of a non-financial
asset must take into consideration the highest and best use of the asset from a market participant perspec-
tive. The highest and best use determines the valuation premise. These concepts are discussed in sections 3.4.1
and 3.4.2.
Paragraph BC63 of the Basis for Conclusions to IFRS 13 clarifies that the concepts of highest and best
use and valuation premise in IFRS 13 are only relevant for non-financial assets (and not liabilities or finan-
cial assets). This is because:
• Financial assets have specific contractual terms; they do not have alternative uses. Changing the
characteristics (i.e. contractual terms) of the financial asset causes the item to become a different asset and
the objective of a fair value measurement is to measure the asset as it exists as at the measurement date.

• The different ways by which an entity may relieve itself of a liability (e.g. repayment) are not
alternative uses. In addition, entity-specific advantages (or disadvantages) that enable an entity to
fulfil a liability more or less efficiently than other market participants are not considered in a fair
value measurement.
3.4.1 What is the highest and best use of a non-financial asset?

Unlike liabilities and financial assets, a non-financial asset may have several uses. The way in which the
reporting entity uses a non-financial asset may not be the way market participants would use the asset.
As such, the standard requires that the fair value of a non-financial asset be measured by considering the
highest and best use from a market participant perspective. Highest and best use is defined in Appendix A
of IFRS 13 as:
The use of a non-financial asset by market participants that would maximise the value of the asset or the group
of assets and liabilities (e.g. a business) within which the asset would be used.
Highest and best use is a valuation concept that considers how market participants would use a non-
financial asset in order to maximise its benefit or value. This may come from its use: (a) in combination
with other assets (or with other assets and liabilities); or (b) on a stand-alone basis. This establishes the
valuation premise to be used to measure the fair value of that asset (paragraph 31).
According to paragraph 28 of IFRS 13, the highest and best use must be:
• Physically possible, taking into account the physical characteristics of the asset.
• Legally permissible, considering any legal restrictions (e.g. zoning regulations on the use of property). A
use of a non-financial asset need not be legal (or have legal approval) at the measurement date, but it
must not be legally prohibited in the jurisdiction (paragraph BC69).
• Financially feasible, in that the use of the asset must result in the market participant obtaining an
appropriate return from the asset.
IFRS 13 presumes that an entity’s current use of an asset is its highest and best use, unless market or
other factors suggest that a different use by market participants would maximise the value of that asset
(paragraph 29). On 2 November 2009, at the IASB roundtable held at the FASB offices in Norwalk in the
United States, one participant argued that it is rare that the highest and best use of a commodity would be
something other than its actual current use in its current form, citing that an entity with crude oil should
not have to look to all the different potential uses of that oil such as refined oil, gasoline, and electricity
through oil-burning plants.
Importantly, the highest and best use is determined from a market participant perspective. Therefore,
despite the presumption, the highest and best use may not be the entity’s current use. For example, an entity
may have acquired a trademark that competes with its own trademark and chooses not to use it. If market
participants would use the trademark, the current use may not be the highest and best use. Care is needed
when the highest and best use is in combination with other non-financial assets to ensure that consistent
assumptions are made about the highest and best use (see illustrative example 3.6 in section 3.4.2).
If the highest and best use of the asset is something other than its current use:
• Any costs to transform the non-financial asset (e.g. obtaining a new zoning permit or converting the
asset to the alternative use) and profit expectations from a market participant’s perspective are also
considered in the fair value measurement.
• An entity must disclose that fact and its basis.
3.4.2 What is the valuation premise?

Depending on its highest and best use, the fair value of the non-financial asset will either be measured
assuming market participants would purchase the asset to benefit from the use or sale of the asset on a
stand-alone basis or in combination with other assets (or other assets and liabilities) — that is, the asset’s
valuation premise.
Decisions concerning the highest and best use of an asset and the relevant valuation premise are con-
sidered in illustrative examples 3.5 and 3.6.
Stand-alone valuation premise
As noted in paragraph 31(b) of IFRS 13, under this premise, the fair value of the asset is the price that
would be received in a current transaction to sell the asset to market participants who would use the asset on
a stand-alone basis.
In-combination valuation premise
When a fair value is measured under this premise, the highest and best use of the asset is where the market
participants obtain maximum value through using the asset in combination with other assets and liabilities.
Paragraph 31(a) states that, under this premise, the fair value is measured on the basis of the price that
would be received in a current transaction to sell the asset such that the purchaser could use it with other
60 PART 2 Elements
assets and liabilities as a group and that those assets and liabilities (complementary assets and liabilities)
would be available to market participants. The transaction is for the individual asset, consistent with its
unit of account. The fair value measurement assumes that the complementary assets and liabilities would
be available to market participants. For example, as noted in paragraph B3(c) of Appendix B Application
guidance of IFRS 13, if the asset is work-in-progress that would be converted into finished goods, in deter-
mining the fair value of the work-in-progress, it is assumed that the market participants already have or
would be able to acquire any necessary machinery for that conversion process.
The fair value is what the market participants would pay for the asset being measured knowing that
they can use it with those complementary assets. For some specialised assets, the market price may not
capture the value the asset contributes to the group of complementary assets and liabilities because the
market price would be for an unmodified, stand-alone asset. As noted in paragraph BC79 of the Basis for
Conclusions on IFRS 13, the IASB recognised that in some cases an entity will need to measure fair value
using another valuation technique, such as an income approach, or the cost to replace or recreate the asset.
A further question considered by the IASB was whether the exit price for specialised equipment is equal
to its scrap value (paragraph BC78 of the Basis for Conclusions on IFRS 13). An item of specialised equip-
ment would generally be used in conjunction with other assets; hence the valuation premise would be
in-use rather than in-exchange. The exit price is then based on the sale of the specialised equipment to
market participants who will use the specialised equipment in conjunction with other assets to obtain
a return. The in-use valuation premise assumes there are market participants who will use the asset in
combination with other assets and that those assets are available to them (paragraph 31 of IFRS 13). This
means the answer to the question raised would generally be no.
Under IAS 36 Impairment of Assets, recoverable amount is determined as the higher of value in use and
fair value less costs of disposal. It should be noted that there is a difference between value in use and a fair
value measure determined under the in-use valuation premise as the objective of each of those measures
is different. Value in use measures the expected cash flows an entity expects to receive from using those
assets. This is an entity-specific value. In contrast, fair value measured under the in-use premise is based
on the cash flows that market participants would expect to receive from using the asset. However, the two
measures may often be the same if determined as a market-based value.
ILLUSTRATIVE EXAMPLE 3.5 Determining highest and best use and valuation premise
Addison owns 100 restaurants in a large city. Each restaurant’s land and buildings are accounted for
using the revaluation model in IAS 16. Addison has no intention to sell. However, in the past it has sold
the land and buildings and the buyers have either also used them as restaurants or converted them into
grocery stores.
To measure the fair value, it is necessary to determine the highest and best use of the restaurants, from
a market participant perspective, and the valuation premise. The highest and best use of each parcel of
land and the building thereon may be to:
(a) continue using them (in combination with each other and other assets) as a restaurant. The fair value
would be determined on the basis of the price that Addison would receive to sell the land and build-
ing to market participants, assuming that these market participants would use them in conjunction
with their other assets as a group and that these assets are available to the market participants.
(b) convert the building into a grocery store. The fair value would be determined on the basis of the
price that would be received to sell the land and building to market participants who would convert
the building. This price would take into consideration the conversion costs that market participants
would incur before being able to use the building as a grocery store.
ILLUSTRATIVE EXAMPLE 3.6 Consistent assumptions about highest and best use and valuation premise
in an asset group
A wine producer owns and manages a vineyard and produces its own wine on site. The vines are meas-
ured at fair value less costs to sell in accordance with IAS 41 at the end of each reporting period. The
grapes are measured at the point of harvest at fair value less costs to sell in accordance with IAS 41 (being
its ‘cost’ when transferred to IAS 2). Before harvest, the grapes are considered part of the vines. The wine
producer elects to measure its land using IAS 16’s revaluation model (fair value less any subsequent accu-
mulated depreciation and accumulated impairment). All other non-financial assets are measured at cost.
At the end of the reporting period, the entity assesses the highest and best use of the vines and the
land from the perspective of market participants. The vines and land could continue to be used, in com-
bination with the entity’s other assets and liabilities, to produce and sell its wine (i.e. its current use).
Alternatively, the land could be converted into residential property. Conversion would include removing
the vines and plant and equipment from the land.

Scenario A
The entity determines that the highest and best use of these assets is in combination as a vineyard (that
is, its current use). The entity must make consistent assumptions for assets in the group (for which
highest and best use is relevant, i.e. non-financial assets). Therefore, the highest and best use of all
non-financial assets in the group is to produce and sell wine, even if conversion into residential property
might yield a higher value for the land on its own.
Scenario B
The entity determines that the highest and best use of these assets is to convert the land into residential
property, even if the current use might yield a higher value for the vines on their own. The entity would
need to consider what a market participant would do to convert the land, which could include the cost
of rezoning, selling cuttings from the vines or simply removing the vines, and the sale of the buildings
and equipment either individually or as an asset group.
Since the highest and best use of these assets is not their current use in this scenario, the entity would
disclose that fact, as well as the reason why those assets are being used in a manner that differs from
their highest and best use.
Source: EY, International GAAP 2015, Volume 1, Chapter 14 Fair value measurement, Section 10.2.2, Example 14.13, p. 981.
LO5 3.5 APPLICATION TO LIABILITIES

The objective of a fair value measurement of a liability is to estimate the price that would be paid to
transfer the liability between market participants at the measurement date under current market con-
ditions. In all cases, an entity must maximise the use of relevant observable inputs and minimise the use
of unobservable inputs.
This section applies to both financial and non-financial liabilities.
3.5.1 Settlement versus transfer

Prior to the issuance of IFRS 13, the measurement of a liability was commonly based on the amount required
to settle the present obligation. As per its definition in IFRS 13, fair value is the amount paid to transfer a lia-
bility. The fair value measurement thus assumes that the liability is transferred to another market participant
at the measurement date. According to paragraph 34(a) of IFRS 13, the transfer of a liability assumes:
A liability would remain outstanding and the market participant transferee would be required to fulfil the
obligation. The liability would not be settled with the counterparty or otherwise extinguished on the measure-
ment date.
The liability is assumed to continue (i.e. it is not settled or extinguished), and the market participant to
whom the liability is transferred would be required to fulfil the obligation. The IASB considered the settle-
ment versus transfer in developing IFRS 13. In paragraph BC82 of the Basis for Conclusions on IFRS 13,
the IASB explains that the thought-process to determine a settlement amount is similar to determining an
amount at which to transfer a liability. This is because both settlement and transfer of a liability reflect all
costs incurred, whether direct or indirect, and the entity faces the same risks as a market participant trans-
feree. Despite this, the IASB concluded that the transfer notion was necessary in a fair value measurement.
Importantly, it captures market participants’ expectations (e.g. about the liquidity and uncertainty), which
may not be captured by a settlement notion because it may incorporate entity-specific factors.
The clarification in IFRS 13 that fair value is not based on the price to settle a liability with the existing
counterparty, but rather to transfer it to a market participant of equal credit standing, also affects the
assumptions about the principal (or most advantageous) market and the market participants in the exit
market for the liability.
3.5.2 Non-performance risk

In addition to the fair value framework discussed in section 3.3, when an entity measures the fair value of a lia-
bility it also considers the effect of non-performance risk. Non-performance risk is defined in Appendix A as:
The risk that an entity will not fulfil an obligation. Non-performance risk includes, but may not be limited to,
the entity’s own credit risk.
Non-performance is discussed in paragraphs 42–44 of IFRS 13. When measuring the fair value of a
liability, it is necessary to consider the effect of an entity’s own credit risk and any other risk factors that
may influence the likelihood that the obligation will not be fulfilled (paragraph 43). The requirement
that non-performance risk remains unchanged before and after the transfer implies that the liability is
hypothetically transferred to a market participant of equal credit standing. Illustrative example 3.7 demon-
strates the valuation of liabilities with a consideration of non-performance risk.
62 PART 2 Elements
ILLUSTRATIVE EXAMPLE 3.7 Valuation of liabilities and non-performance risk
Shore Ltd issues a zero coupon loan of €5000 to Cove Bank with a 5-year term. At the time, it has an AA
credit rating and can borrow at 5% p.a. One year later, Shore Ltd issues another zero coupon loan of €5000
to Cove Bank with a 5-year term. Due to a change in credit standing, it must now borrow at 7% p.a.
Shore Ltd measures both liabilities at fair value at initial recognition. The fair value of the first loan is
€3918, being the present value of the payment in 5 years’ time discounted at 5% p.a. A year later Shore
Ltd determines that the fair value of the second loan is €3565, being the present value of the second
loan in 5 years’ time discounted at 7% p.a. As a result, the fair value of each liability reflects the credit
standing of the entity at initial recognition.
Some respondents to the IASB questioned the decision to take non-performance risk into consideration
when valuing a liability (paragraph BC95 of the Basis for Conclusions on IFRS 13). The problem they saw
was that a change in an entity’s credit standing — whether deterioration or improvement — would affect
the fair value of the liability. This would lead to gains and losses being recognised in profit or loss for the
period, potentially affecting the usefulness of the reported numbers. Furthermore, counterintuitively, a
deterioration in the credit standing of the entity could lead to gains being recognised in profit or loss (this
is considered in illustrative example 3.8 in section 3.5.3). However, the IASB noted that this issue was beyond
the scope of the fair value measurement project.
3.5.3 Approaches to measuring the fair value of a liability

Where there is a quoted price for an identical or similar liability, an entity uses that price to measure fair
value. However, in many cases, there will be no quoted prices available for the transfer of an instrument
that is identical or similar to an entity’s liability, particularly as liabilities are generally not transferred. For
example, this might be the case for debt obligations that are legally restricted from being transferred or for
decommissioning liabilities that the entity does not intend to transfer. In such situations, an entity must
determine whether the identical item is held by another party as an asset:
• If the identical item is held by another party as an asset — measure fair value from the perspective of a
market participant that holds the asset
• If the identical item is not held by another party as an asset — measure the fair value using a valuation
technique from the perspective of a market participant that owes the liability.
In most circumstances, a liability will be held as an asset by another entity — for example, a loan is
recognised as a payable by one entity, the recipient of the loan, and a receivable by another entity, the
lender. From the standard setter’s perspective, the fair value of a liability generally equals the fair value of
a properly defined corresponding asset. However, paragraph 39 of IFRS 13 does provide guidance on when
adjustments to that price may be needed.
Paragraph 38 of IFRS 13 states that measurement of the corresponding asset should be in the following
descending order of preference:
• the quoted price of the asset in an active market
• the quoted price for the asset in a market that is not active
• a valuation under a technique such as:
• an income approach: present value techniques could be used based on the expected future cash flows
a market participant would expect to receive from holding the liability as an asset
• a market approach: the measure would be based on quoted prices for similar liabilities held by other
parties as assets.
Illustrative example 3.8 demonstrates a situation where an entity uses a valuation technique under a
market approach to measure the fair value of a liability. Refer to Example 13 of IFRS 13 for an illustration of
an entity using an income approach to measure the fair value of a liability.
ILLUSTRATIVE EXAMPLE 3.8 Liability held as an asset
On 1 January 2016, Urban Ltd issued at par $5 million exchange-traded 4-year fixed rate corporate
bonds with annual coupon payments of 7.5%.
On 30 June 2016, the instrument is trading as an asset in an active market at $1015 per $1000 of par
value after payment of accrued interest. On 31 December 2016, the quoted price is $830 per $1000 of
par value after payment of accrued interest. The decrease in the quoted price is partly caused by con-
cerns about the entity’s ability to pay. Urban Ltd determines there are no factors (e.g. third-party credit
enhancements) that are included in the quoted price for the asset that would not be included in the
price of the liability. Therefore, no adjustments are needed to the quoted price for the asset.

Urban Ltd uses the quoted price for the asset as its initial input into the fair value measurement of
the bond. This results in a fair value of $5 075 000 (= $1015/$1000 = $5 000 000) at 30 June 2016 and
$4 150 000 (= $830/$1000 = $5 000 000) at 31 December 2016. As noted in section 3.5.2, counterintui-
tively a worsening of Urban Ltd’s credit standing leads to a decrease in the fair value of the liability and
a gain recognised in profit or loss.
For some liabilities, the corresponding asset is not held by another entity, such as in the case of an entity
that must decommission an oil platform when drilling ceases. The entity measuring the fair value of a lia-
bility must, therefore, use a valuation technique from the perspective of a market participant that owes the
liability (paragraph 40). In such cases a present value technique could be applied, as is shown in illustra-
tive example 3.9. This illustrative example also highlights the elements that are captured by using a present
value technique (paragraph B13 of IFRS 13), being:
• an estimate of future cash flows
• expectations about variations in the amount and timing of the cash flows representing the uncertainty
inherent in the cash flows
• the time value of money, represented by a risk-free interest rate
• a risk premium, being the price for bearing the uncertainty inherent in the cash flows
• other factors that market participants would take into account
• for a liability, non-performance risk.
ILLUSTRATIVE EXAMPLE 3.9 Present value technique: decommissioning liability
On 1 January 2015, BigOil Ltd assumed a decommissioning liability in a business combination. The
entity is legally required to dismantle and remove an offshore oil platform at the end of its useful life,
which is estimated to be 10 years.
If BigOil Ltd were contractually allowed to transfer its decommissioning liability to a market partici-
pant, market participant would need to take into account the following inputs:
• labour costs — these would be developed on the basis of current market wages, adjusted for
expected wage increases with the final amount to be determined on a probability-weighted basis
allocation of overhead costs
• compensation for undertaking the activity, including a reasonable profit margin and a premium for
undertaking the risks involved effects of inflation time value of money, represented by the risk-free
rate
• non-performance risk relating to the risk that BigOil Ltd will not fulfil the obligation, including
BigOil Ltd’s own credit risk.
The risk-free rate of interest for a 10-year maturity at 1 January 2015 is 5%. BigOil Ltd adjusts that rate
by 3.5% to reflect its risk of non-performance including its credit risk. Hence, the interest rate used in
the present value calculation is 8.5%.
The fair value of the decommissioning liability at 1 January 2015 determined using the present value
technique is $194 879, calculated as follows:
Expected labour costs $131 250
Allocated overhead and equipment costs $105 000
Contractor’s profit margin (20% of total costs of $236 250) $47 250
Expected cash flows before inflation adjustment $283 500
Inflation factor (4% for 10 years) 1.4802
Expected cash flows adjusted for inflation $419 637
Market risk premium (0.05 × $419 637) $20 982
Expected cash flows adjusted for market risk $440 619
Expected present value using a discount rate of 8.5% for 10 years $194 879
Source: Adapted from IASB 2011, IFRS 13 Fair Value Measurement, Illustrative Examples, Example 11 — Decommissioning liability, pp. 17–20.
64 PART 2 Elements
LO6 3.6 APPLICATION TO MEASUREMENT OF AN ENTITY’S
OWN EQUITY
The fair value of an entity’s own equity instruments may need to be measured, for example, when an
entity undertakes a business combination and issues its own equity instruments as part of the consideration
for the exchange. Depending on the facts and circumstances, an instrument may be classified as either a
liability or equity instrument (in accordance with other standards) for accounting purposes. Therefore,
in developing the requirements in IFRS 13 for measuring the fair value of liabilities and an entity’s own
equity, paragraph BC106 in the Basis for Conclusions notes that the Boards concluded the requirements
should generally be consistent with those for liabilities. Therefore, in general, the principles set out
in section 3.5 (in relation to liabilities) also apply to an entity’s own equity instruments, except for the
requirement to consider non-performance risk, which does not apply directly to an entity’s own equity.
A fair value measurement assumes that an entity’s own equity instruments are transferred to a market par-
ticipant at the measurement date. Paragraph 34(b) of IFRS 13 notes that the transfer assumes the following:
An entity’s own equity instrument would remain outstanding and the market participant transferee would take
on the rights and responsibilities associated with the instrument. The instrument would not be cancelled or oth-
erwise extinguished on the measurement date.
In order to exit from its own equity, an entity would need to either cancel the share or repurchase the
share. Since it cannot consider cancelling its own equity, an entity will likely need to measure the fair value
of its own equity instruments from the perspective of a market participant that holds the corresponding
instrument as an asset — for example, shareholders. See section 3.5 for a discussion on measuring the fair
value of a liability by reference to the corresponding asset.
LO7 3.7 APPLICATION TO FINANCIAL INSTRUMENTS WITH

OFFSETTING POSITIONS
Financial instruments consist of both financial assets and financial liabilities. IAS 32 Financial Instruments:
Presentation contains definitions of these terms. An entity may hold both financial assets and financial
liabilities and, as such, be exposed to both market risk (e.g. interest rate risk, currency risk or other price
risk) and to the credit risk of each of its counterparties. Entities may manage some or all of these financial
instruments as a group (or portfolio), having a net exposure to a particular risk(s).
In such a situation, IFRS 13 allows entities to make an accounting policy choice to measure the fair value
of a group of financial assets and liabilities based on the price that would be received to sell a net long
position or transfer a net short position for a particular risk exposure (portfolio approach, paragraph 48).
Paragraph 49 provides conditions under which the portfolio approach may be applied, including that
an entity must manage the group of financial assets and liabilities on a net exposure basis as a part of its
documented risk management strategy. The criteria must be met both initially and on an ongoing basis.
LO8 3.8 DISCLOSURE

3.8.1 Categorisation within the fair value hierarchy for disclosure
purposes
IFRS 13 requires a fair value measurement in its entirety to be categorised within the hierarchy for disclosure
purposes. Inputs used in a valuation technique may be within different levels in the fair value hierarchy
(as discussed in section 3.3.5). Therefore, the observability of a fair value measurement needs to reflect the
observability of the various inputs used. Categorisation within the hierarchy is, therefore, based on the
lowest level input that is significant to the entire measurement (paragraph 73). A valuation technique that
relies solely on a Level 1 input (P × Q) produces a fair value measurement categorised within Level 1.
However, if a measurement uses even a single Level 3 input that is significant to the measurement in its
entirety, the fair value measurement would be categorised within Level 3.
3.8.2 The disclosure requirements

The disclosure requirements in IFRS 13 apply to fair value measurements recognised in the statement of
financial position after initial recognition and disclosures of fair value, with limited exceptions. The standard
establishes a set of broad disclosure objectives and provides the minimum disclosures an entity must make.
The disclosures are designed to provide users of financial statements with additional transparency regarding:
• the extent to which fair value is used to measure assets and liabilities;
• the valuation techniques, inputs and assumptions used in measuring fair value; and
• the effect of Level 3 fair value measurements on profit or loss (or other comprehensive income).

The minimum requirements vary depending on whether the fair value measurements are recurring or
non-recurring and their categorisation within the fair value hierarchy (i.e. Level 1, 2, or 3). More disclosure
is required for fair value measurements categorised in Level 3 of the fair value hierarchy than for those
categorised in Levels 1 or 2.
‘Recurring’ fair value measurements are those that other IFRSs require or permit in the statement of finan-
cial position at the end of the period. ‘Non-recurring’ fair value measurements are those that other IFRSs
require or permit in particular circumstances — for example, under the application of IFRS 5 Non-current
Assets Held for Sale and Discontinued Operations in relation to non-current assets held for sale. Disclosures
must be presented by class of asset or liability. The appropriate classes may depend on the entity’s specific
facts and circumstances and the needs of users of its financial statements.
In order for users of the financial statements to be able to assess the relevance of the fair value infor-
mation provided, IFRS 13 requires the disclosure of information that assists users in understanding:
• An entity’s policies and processes with regard to measuring fair value — for example, its accounting policy
choice with respect to financial instruments with offsetting positions. Another example is the valuation
processes used for fair value measurements categorised within Level 3 of the fair value hierarchy, which
is illustrated in Figure 3.1.
• The specific assets and liabilities for which fair value is being measured — for example, the reason for the
measurement (if non-recurring); and the reason why the current use of a non-financial asset differs
from its highest and best use (if applicable).
• How fair value was measured — for example, the fair value of the asset or liability; valuation
technique(s) used; and the inputs used. For fair value measurements categorised within Level 3, an
entity must disclose quantitative information about the significant unobservable inputs used in the fair
value measurement.
• The likelihood that fair value could change (i.e. the sensitivity) — for example, quantitative and qualitative
information about the sensitivity of the measurement to changes in inputs for any fair value
measurement categorised within Level 3 of the fair value hierarchy.
• The reasons for changes in fair value between periods — examples of such disclosures include a
reconciliation from the opening balances to the closing balances for fair value measurements
categorised within Level 3 of the fair value hierarchy, including what caused any change. In addition,
disclosure is required of changes in valuation techniques used, as well as transfers between levels within
the fair value hierarchy for recurring fair value measurements, along with the reasons for those transfers.
Many of these disclosure requirements apply regardless of whether the fair value measurement is recog-
nised in the financial statements or only disclosed. Figures 3.1 and 3.2 provide illustrations of the type of
information required for fair value measurements categorised within Level 3.
All fair value methods are considered to be able to provide reliable measures of fair value; however, users
need disclosures about the methods, inputs used and the fair value in order to assess the extent of subjectivity
of the techniques used. Irrespective of the frequency at which the measurements are made, the disclosures under
IFRS 13 are intended to provide financial statement users with additional insight into the relative subjectivity
of various fair value measurements and enhance their ability to broadly assess an entity’s quality of earnings.
FIGURE 3.1 Disclosure requirements — valuation processes used for fair value measurements categorised
within Level 3
Note 22 Fair value measurement [extract]

(b) Valuation governance
The Company’s fair value measurement and model governance framework includes numerous controls and
other procedural safeguards that are intended to maximize the quality of fair value measurements reported
in the financial statements. New products and valuation techniques must be reviewed and approved by
key stakeholders from risk and finance control functions. Responsibility for the ongoing measurement of
financial and non-financial instruments at fair value resides with the business divisions, but is validated by
risk and finance control functions, which are independent of the business divisions. In carrying out their
valuation responsibilities, the businesses are required to consider the availability and quality of external
market information and to provide justification and rationale for their fair value estimates.
Independent price verification is performed by the finance function to evaluate the business divisions’
pricing input assumptions and modeling approaches. By benchmarking the business’s fair value estimates
with observable market prices and other independent sources, the degree of valuation uncertainty embedded
in these measurements is assessed and managed as required in the governance framework. Fair value
measurement models are assessed for their ability to value specific products in the principal markets of the
product itself as well as the principal market for the main valuation input parameters to the model.
An independent model review group evaluates the Company’s valuation models on a regular basis, or if
established triggers occur, and approves them for valuing specific products. As a result of the valuation controls
employed, valuation adjustments may be made to the business’s estimate of fair value to align with independent
market information and accounting standards (refer to Note 12d Valuation adjustments for more information).
Source: UBS Ltd, Annual Report and Financial Statements for the year ended 31 December 2013 (Note 22(b), p. 34).
66 PART 2 Elements
FIGURE 3.2 Disclosure requirements — fair value measurements categorised within Level 3
26. Derivative financial instruments [extract]

Level 3 derivatives
The following table shows the changes during the year in the net fair value of derivatives held for trading
purposes within level 3 of the fair value hierarchy.
$ million
Natural
Oil gas Power
price price price Other Total
Net fair value of contracts at 105 304 (43) 71 437

1 January 2013
Gains (losses) recognized (47) 62 81 — 96
in the income statement
Purchases 110 1 — — 111
New contracts — — — 475 475
Settlements (143) (52) 10 (71) (256)
Transfers out of level 3 (43) (1) 36 — (8)
Exchange adjustments — (1) 2 — 1
Net fair value of contracts at (18) 313 86 475 856

31 December 2013
$ million
Natural Power
Oil price gas price price Other Total
Net fair value of contracts at 162 408 13 — 583

1 January 2012
Gains (losses) recognized in the 30 4 (4) — 30
income statement
New contracts — — — 71 71
Settlements (87) (56) — — (143)
Transfers into level 3 — (19) — — (19)
Transfers out of level 3 — (33) (51) — (84)
Exchange adjustments — — (1) — (1)
Net fair value of contracts at 105 304 (43) 71 437
31 December 2012
US natural gas price derivatives are valued using observable market data for maturities up to 60 months in basis
locations that trade at a premium or discount to the NYMEX Henry Hub price, and using internally developed price
curves based on economic forecasts for periods beyond that time. At 31 December 2013, the US natural gas derivatives
in level 3 of the fair value hierarchy had a net fair value of $351 million. Of this amount, $71 million (asset of $598
million and liability of $527 million) depends on level 3 inputs, with the remainder valued using level 2 inputs. The
significant unobservable inputs for fair value measurements categorized within level 3 of the fair value hierarchy for the
year ended 31 December 2013 are presented below.
Weighted average $/
Unobservable inputs Range $/mmBtu mmBtu
Natural gas price contracts Long-dated market 3.15–6.71 4.63

price
If the natural gas prices after 2018 were 10% higher (lower), this would result in a decrease (increase) in
derivative assets of $82 million, and decrease (increase) in derivative liabilities of $78 million, and a net
decrease (increase) in profit before tax of $4 million.
Source: BP plc, Annual Report and Form-20-F (2013, Note 26, pp. 174–175).

SUMMARY
The debate over the best measurement method for assets and liabilities is not a new one. Discussions
of the decision usefulness of various models of current value accounting have occupied many pages
in accounting journals and were the focus of the research of many academics. Historically, accounting
standards have relied primarily on the use of historical cost, but the use of fair values has become
increasingly common, particularly with the focus on financial instruments. The standard setters there-
fore decided that it was time to produce an accounting standard on fair value measurement, with the
focus on how to measure fair value rather than on when to use those fair values. This has resulted in the
issue of IFRS 13 by the IASB.
IFRS 13 contains a definition of fair value that seeks to clarify questions raised in the application of the
definition in previous standards. A key feature of the definition is that fair value is a current exit price,
rather than an entry price.
The fair value framework in IFRS 13 is based on a number of key concepts including unit of
account, exit price, valuation premise, highest and best use, principal market, market participant
assumptions and the fair value hierarchy. The requirements incorporate financial theory and valua-
tion techniques, but are focused solely on how these concepts are to be applied when determining
fair value for financial reporting purposes. Critical to the measurement process are the assumptions
that market participants make when using a valuation technique. The assumptions or inputs are
classified into three levels, the classification being based on the use of observable and unobservable
inputs. In choosing a valuation technique an entity should seek to maximise the number of observ-
able inputs used.
A key element of IFRS 13 is the requirement to disclose sufficient information about the fair value
measures used. Users of financial statements should be able to assess the methods and inputs used to
develop the fair value measurements and the effects on income.
1. Name three current accounting standards that permit or require the use of fair values.
2. What are the main objectives of IFRS 13?
3. What are the key elements of the definition of ‘fair value’?
4. How does the definition of fair value differ from that used in previous accounting standards?
5. How does entry price differ from exit price?
6. Is the reporting entity a market participant?
7. Does the measurement of fair value take into account transport costs and transaction costs? Explain.
8. What are the key steps in measuring fair value?
9. Explain the difference between the current use of an asset and the highest and best use of that
asset.
10. Explain the difference between the in-combination valuation premise and the stand-alone valuation
premise.
11. What is the difference between the principal market for an asset or liability and its most advantageous
market?
12. What valuation techniques are available to measure fair value?
13. Explain the fair value hierarchy.
14. Explain the different levels of fair value inputs.
15. How does the measurement of the fair value of a liability differ from that of an asset?
References
Benston, G. J. 2008, ‘The shortcomings of fair value accounting described in SFAS 157’, Journal of
Accounting and Public Policy, 27(2), March–April, pp. 101–14.
Chasan, E. 2008, ‘Is fair value accounting really fair?’, Reuters, www.reuters.com, 26 February.
Ernst & Young 2009, Invitation to Comment — Fair Value Measurement, www.ifrs.org.
IASB 2009, IASB Fair Value Measurements Roundtable Summary, www.iasplus.com.
Nestlé 2009, Comments on Exposure Draft ED/2009/5/Fair Value Measurement, www.ifrs.org.
Royal Dutch Shell 2009, Exposure Draft 2009/5 Fair Value Measurements, www.ifrs.org.
68 PART 2 Elements
Exercise 3.1 VALUATION PREMISE FOR MEASUREMENT OF FAIR VALUE

★ Heel Ltd conducts a business that makes women’s shoes. It operates a factory in an inner suburb of a large
European city. The factory contains a large amount of equipment that is used in the manufacture of shoes.
Heel Ltd owns both the factory and the land on which the factory stands. The land was acquired in 2005
for €200 000 and the factory was built in that year at a cost of €520 000. Both assets are recorded at cost,
with the factory having a carrying amount at 30 June 2016 of €260 000.
In recent years there has been a property boom in the city with residential house prices doubling such
that the average price of a house is approximately €500 000. A recent valuation of the land on which the
factory stands was performed by a property valuation group and based on recent sales of land in the area.
It valued the land at €1 000 000. The land is now considered prime real estate given its proximity to the
city centre and, with its superb river views, its suitability for building executive apartments. It would cost
€100 000 to demolish the factory to make way for these apartments to be built. It is estimated that to build
a new factory on the current site would cost around €780 000.
The directors of Heel Ltd want to measure both the factory and the land at fair value as at 30 June 2016.
Required
Discuss how you would measure these fair values.
Exercise 3.2 HIGHEST AND BEST USE

★ BGW Ltd is in the business of bottling wine, particularly for small wineries that cannot afford sophisti-
cated technical equipment and want to concentrate on the growing of the grapes themselves. One of the
key features of the bottles that are used by BGW Ltd is that, for the bottles used for white wine and cham-
pagne, they have an built-in insulation device that is successful in keeping the contents of the bottle cold,
with the temperature being unaffected by the bottle being held in the hand.
In January 2014, Solar-Blue, a company experimenting with energy sources useful in combating climate
change, produced a device which, when attached to the outside of a container, could display the actual
temperature of the liquid inside. The temperature was displayed by the highlighting of certain colours on
the device. Exactly how this device could be attached to wine bottles had yet to be specifically determined.
However, BGW Ltd believed that its employees had the skills that would enable the company to determine
the feasibility of such a project. Whether the costs of attaching the device to wine bottles would be prohibi-
tive was also unknown.
As BGW Ltd was concerned that competing wine bottling companies may acquire the device from Solar-
Blue, it paid €7 100 000 for the exclusive rights to use the device with bottles.
The accountant wants to measure the fair value of the asset acquired.
Required
Discuss the process of determining this fair value.
Exercise 3.3 CHARACTERISTICS OF AN ASSET

★ Mr Merman owned a large house on a sizeable piece of land in London. The property had been in his
family since around 1889. Mr Merman was 92 years old and was incapable of taking care of the large
property. He wanted to move into a retirement village and so sold his property to the MedSea Group
which was an association of doctors. The doctors wanted to use the house for their medical practice as
it was centrally situated, had many rooms and had a charming ‘old-world’ atmosphere that would make
patients feel comfortable.
The house was surrounded by a large group of trees that had been planted by the Merman family over
the years. The trees covered a large portion of the land. MedSea did not want to make large alterations to
the house as it was suitable for a doctors’ surgery. Only minor alterations to the inside of the house and
some maintenance to the exterior were required. However, MedSea wanted to divide the land and sell the
portion adjacent to the house; the portion currently being covered in trees. The property sold would be
very suitable for up-market apartment blocks.
One of the conditions of the sale of the property to MedSea was that, while Mr Merman remained alive,
the trees on the property could not be cut down as it would have caused him great distress to see such
alterations to the family home. This clause in the contract would restrict the building of the apartment
blocks. However, this restriction would not be enforceable on subsequent buyers of the property if MedSea
wanted to sell the property in the future. A further issue affecting the building of the apartment blocks was
that across one corner of the block there was a gas pipeline that was a part of the city infrastructure for the
supply of gas facilities to London residents.

Required
Outline any provisions in IFRS 13 that relate to consideration of restrictions on the measurement of fair
values of assets, and how in the situation described above the restrictions would affect the measurement of
the fair value of the property by MedSea.
Exercise 3.4 ASSETS WITHOUT AN ACTIVE MARKET

★ Emily Chasan (2008) reported:
‘It’s ridiculous to apply fair value accounting to assets that have no market,’ said Christopher Whalen, managing
director of risk research firm Institutional Risk Analytics. ‘All this volatility we now have in financial reporting
and disclosure, it’s just absolute madness.’
‘Investors as a group have to get a better understanding of what the volatility means,’ said Ed Nusbaum, chief
executive of accounting firm Grant Thornton. ‘They want to live in a perfect world. They’d like complete trans-
parency and no surprises. But I think it’s unlikely that the big write-downs that we’ve seen will reverse.’
Required
Discuss the issues associated with fair value accounting for assets without an active market.
Exercise 3.5 EXIT PRICES AS FAIR VALUE FOR CLASSES OF ASSETS

★ In its response to the IASB exposure draft, the G100 in Australia stated:
The G100 does not believe that an exit price based measure of fair value is appropriate for all classes of assets.
While such a measure may be appropriate for financial instruments we do not believe that an exit price based
measure provides useful information for certain classes of non-financial assets such as property, plant and equip-
ment where an entity-specific measure may be more appropriate.
Required
Discuss the use of entity-specific information in the generation of fair value numbers under IFRS 13.
Exercise 3.6 MEASUREMENT OF FAIR VALUE

★ The use of fair value to measure assets and liabilities inevitably results in fluctuations in profit or loss,
which can be large. Users of financial statements, therefore, need information that clearly explains the
source of these fluctuations — whether they are realised or unrealised, based on objective or subjective
information, real transactions and market activity or estimates.
Required
Discuss how IFRS 13 attempts to overcome these issues when providing information to users of financial
statements.
Exercise 3.7 MANAGEMENT BIAS ON FAIR VALUE MEASUREMENT

★ One of the concerns associated with fair value measurement is that management bias may affect the relia-
bility of the information. IFRS 13 requires that fair values be based on market-based assumptions rather
than entity-specific assumptions in order to overcome this issue.
Required
Compare the potential for management bias when making market-based or entity-specific assumptions.
70 PART 2 Elements
Fair value measurement has increasingly replaced the historical show that these historical cost measures are incrementally
cost measurement basis in past two decades. One major con- value relevant. They conclude that historical cost measures can
cern for academic research against this background has been still be value relevant when fair value accounting is used.
whether fair value accounting is value relevant and sufficiently IFRS 13, and FAS 157 in the US, set fair value hierarchy
reliable. Historical cost accounting (HCA) is typically verifi- as described in this chapter. Several researchers have con-
able as it is based on past evidence (e.g., an invoice confirming jectured that the value relevance and reliability of fair value
the purchase cost of an asset). In contrast, by construction, decreases from Level 1 to Level 3. However, the evidence
fair value accounting is based on unrealised gains or losses. on this is quite mixed. Song et al. (2010) examine quarterly
Moreover, fair value measurement may be based on unobserv- reports of banks in 2008 and find evidence consistent with
able and subjective inputs, as is the case, for example, with this conjecture. In contrast, Altamuro and Zhang (2013)
Level 3 inputs. Landsman (2007) provides a good discussion examine mortgage services rights that are fair-valued and
on the value relevance and reliability of fair value accounting, find that Level 3 is more value relevant.
although his review of related empirical research precedes The relevance and reliability of Level 2 and Level 3 may
more recent rules and studies. Beatty and Liao’s (2014) review be a function of both noisy inputs, as well as managerial
of accounting in banks is also a very useful source of detailed discretion. Altamuro and Zhang (2013) argue that man-
discussion of issues related to fair value accounting. agers can convey useful information using their discretion in
Since the use of fair value accounting is more pronounced in Level 3 reporting and that this effect may be more pro-
financial firms, such as banks, early research has examined the nounced when the underlying asset is not traded in an active
value relevance of fair value accounting mostly in banks. Barth market. Song et al. (2010) find that the value relevance of
(1994) finds that fair value gains and losses on investment Level 3 fair values increases with the strength of corporate
securities provide incremental explanatory power for stock governance. Taken together, this suggests that opportunism
returns over that of historical cost gains and losses. Nelson plays a role but can be constrained by board monitoring.
(1996) examines fair value disclosures in banks’ financial state- Relying on markets to supply objective inputs into fair value
ments but fails to find evidence that these disclosures are value measurement can introduce noise even absent discretion and
relevant over historical cost measures. In contrast Eccher et al. corporate governance effects. Banks often rely on market-based
(1996) and Barth et al. (1996) find that fair value disclosures indices when valuing mortgage portfolios. Stanton and Wal-
are incorporated into share prices. More recently Livne et al. lace (2011) show that the pricing of a leading default risk index
(2011)examine assets that are recognised and measured at fair used by many banks in marking-to-market loan portfolios was
value. Their evidence suggests that the unrealised component inconsistent with reasonable assumptions about future default
of fair values of investment securities is positively associated rates. They argue that, consequently, certain banks that relied
with stock returns, but the historical cost component is not. on this index wrote off billions of dollars’ worth of assets
This result is intriguing because the unrealised component during the financial crisis, potentially unnecessarily.
is precisely the part in the fair value measure that may be sus- The above-mentioned research is mostly focused on fair
ceptible to managerial discretion and manipulation. Evans value accounting for financial assets and liabilities. However,
et al. (2014) provide evidence that the unrealised component fair value accounting is also employed in non-financial assets
in fair value measurement has predictive ability with respect (see also the Academic Perspective to chapter 11). Aboody et
to future income and cash flows. This may explain the associ- al. (1999) examine revaluations of property plant and equip-
ation of unrealised gains and losses with returns in that inves- ment under UK GAAP (prior to IFRS adoption in 2005). They
tors use this information to value shares. Consistent with the provide evidence that the revalued balances of these assets are
evidence in Livne et al. (2011), Evans et al. (2014) also show positively associated with share prices and that changes in reval-
that unrealised gains and losses are associated with market uation amounts are positively associated with stock returns.
value of equity. Beaver and Venkatachalam (2003) find that They also provide evidence suggesting that revaluations pre-
whether the discretionary component in fair value measure- dict future performance. Liang and Riedl (2014) examine the
ment (i.e., the unrealised gain or loss) is value relevant is value relevance of unrealised gains and losses recorded when
dependent on managers’ reporting incentives. They provide investment properties are measured at fair value. They find that
some evidence suggesting that when the discretionary com- analyst forecasts of EPS are less accurate when investment prop-
ponent is measured in opportunistic fashion, investors find erties are measured at fair value than when they are measured
it less relevant than when opportunism does not play a role. at historical cost. However, analysts are better able to forecast
Does this evidence then suggest that historical cost the balance sheet for firms employing the fair value model.
accounting is not useful? An answer for this can be found by
taking advantage of the accounting rules for available-for-sale
(AFS) securities. These require that gains and losses arising
References
upon the disposal of AFS assets are recorded on historical cost Aboody, D., Barth., M., and Kasznik, R., 1999. Revaluations
basis. But, at the same time AFS securities are measured on of fixed assets and future firm performance: Evidence from
the balance sheet at fair value. If historical cost accounting is the UK. Journal of Accounting and Economics, 26, 149–178.
superfluous when fair value accounting is used, then it is not Altamuro, A., and Zhang, H., 2013. The financial reporting
expected that historical cost measures of realised gains and of fair value based on managerial inputs versus market
losses would be value relevant incrementally over fair value inputs: Evidence from mortgage servicing rights. Review of
measures of the underlying assets. Dong et al. (2014), however, Accounting Studies,18, 833–858.

Barth, M., 1994. Fair Value accounting: Evidence from performance of commercial banks and the relation of
investment securities and the market valuation of banks. predictive ability to banks’ share prices. Contemporary
The Accounting Review, 69, 1–25. Accounting Research, 31, 13–44.
Barth, M., Beaver, W., and Landsman, W., 1996. Value- Landsman, W., 2007. Is fair value accounting information
relevance of banks’ fair value disclosures under SFAS No. relevant and reliable? Evidence from capital market
107. The Accounting Review, 71, 513–537. research. Accounting and Business Research, 37, 19–30.
Beatty, A., and Liao, S., 2014. Financial accounting in the Liang., L., and Riedl, E., 2014. The effect of fair value
banking industry: A review of the empirical literature. versus historical cost reporting model on analyst forecast
Journal of Accounting and Economics, 58, 339–383. accuracy. The Accounting Review, 89, 1151–1177.
Beaver, W., and Venkatachalam, M., 2003. Differential Livne, G., Markarian, G., and Milne, A., 2011. Bankers’
pricing of components of bank loan fair values. Journal of compensation and fair value accounting. Journal of
Accounting, Auditing and Finance, 18, 41–67. Corporate Finance, 17, 1096–1115.
Dong, M., Ryan, S., and Zhang, X.-J., 2014. Preserving Nelson, K.K., 1996. Fair value accounting for commercial
amortized costs within a fair-value-accounting framework: banks: An empirical analysis of SFAS No. 107. The
Reclassification of gains and losses on available-for-sale Accounting Review, 161–182.
securities upon realization. Review of Accounting Studies, Song, C., Thomas, W., and Yi, H., 2010. Value relevance of
19, 242–280. FAS 157 fair value hierarchy information and the impact
Eccher, E., Ramesh, K., and Thiagarajan, S., 1996. Fair of corporate governance mechanisms. The Accounting
value disclosures by bank holding companies. Journal of Review, 85, 1375–1410.
Accounting and Economics, 22, 79–117. Stanton, R., and Wallace, N., 2011. The Bear’s Lair: Index
Evans, M.E., Hodder, L., and Hopkins, P.E., 2014. The credit defaults waps and the subprime mortgage crisis.
predictive ability of fair values for future financial Review of Financial Studies, 24, 3250–3280.
72 PART 2 Elements
4 Revenue from contracts
with customers
ACCOUNTING IFRS 15 Revenue from Contracts with Customers

STANDARDS
IN FOCUS

OBJECTIVES
1 discuss the background behind the issuance of IFRS 15
2 identify the types of contracts that are within the scope of IFRS 15
3 apply the five-step model for measuring and recognising revenue under IFRS 15
4 understand how to account for contract related costs
5 identify other significant application issues associated with IFRS 15
6 explain the presentation and disclosure requirements of IFRS 15.
CHAPTER 4 Revenue from contracts with customers 73

The International Accounting Standards Board (IASB®) issued IFRS 15 Revenue from Contracts with Cus-
tomers (‘IFRS 15’ or ‘the standard’) in May 2014. The standard was developed jointly with the US FASB
(collectively, ‘the Boards’). The US FASB issued its new revenue standard at the same time that the IASB
issued IFRS 15. The new revenue standards issued by the Boards are largely converged and will supersede
virtually all revenue recognition requirements currently in IFRS® Standards and US GAAP.
Noting several concerns with existing requirements for revenue recognition under both IFRS Standards
and US GAAP, the Boards jointly developed a revenue standard that would:
• remove inconsistencies and weaknesses in the current revenue recognition literature;
• provide a more robust framework for addressing revenue recognition issues;
• improve comparability of revenue recognition practices across the various industries, entities,
jurisdictions and capital markets;
• provide a single reference point in order to reduce the volume of the relevant standards and
interpretations that entities will need to refer to; and
• provide more useful information to users through enhanced disclosure requirements.
IFRS 15 outlines the accounting treatment for all revenue arising from contracts with customers and
provides a model for the measurement and recognition of gains and losses on the sale of certain non-fi-
nancial assets, such as intangible assets, property, plant or equipment or investment properties. IFRS 15
replaces all of the existing revenue standards and interpretations in IFRS Standards, including IAS 11 Con-
struction Contracts, IAS 18 Revenue, IFRS Interpretations Committee (IFRIC®) Interpretation 13 Customer
Loyalty Programmes, IFRIC Interpretation 15 Agreements for the Construction of Real Estate, IFRIC Interpreta-
tion 18 Transfers of Assets from Customers and Standing Interpretations Committee (SIC®) Interpretation 31
Revenue–Barter Transactions Involving Advertising Services.
The core principle of IFRS 15 is that an entity will recognise revenue at an amount that reflects the
consideration to which the entity expects to be entitled in exchange for transferring goods or services to a
customer, which requires entities to apply a five-step model as follows:
1. Identify the contract(s) with a customer (discussed in section 4.3).
2. Identify the performance obligations in the contract (discussed in section 4.4).
3. Determine the transaction price (discussed in section 4.5).
4. Allocate the transaction price to the performance obligations in the contract (discussed in section 4.6).
5. Recognise revenue when (or as) the entity satisfies a performance obligation (discussed in section 4.7).
For the purposes of first-time adoption of IFRS 15, entities can choose to apply either a fully retrospec-
tive approach for all periods presented in the period of adoption (with some limited relief provided) or a
modified retrospective approach. At the time of writing this chapter, IFRS 15 is mandatorily effective for
annual periods beginning on or after 1 January 20171 with early adoption permitted.
LO2 4.2 SCOPE

All contracts with customers to provide goods or services in the ordinary course of business are included
within the scope of IFRS 15, except for the following contracts and arrangements:
• lease contracts accounted for under IAS 17 Leases;
• insurance contracts accounted for under IFRS 4 Insurance Contracts;
• financial instruments and other contractual rights or obligations accounted for under IFRS 9 Financial
Instruments or IAS 39 Financial Instruments: Recognition and Measurement, IFRS 10 Consolidated Financial
Statements, IFRS 11 Joint Arrangements, IAS 27 Separate Financial Statements and IAS 28 Investments in
Associates and Joint Ventures; and
• non-monetary exchanges between entities in the same line of business to facilitate sales to customers
or potential customers.
Entities will have to evaluate their relationship with the counterparty to the contract in order to determine
whether a vendor–customer relationship exists, which may be particularly judgemental for certain arrange-
ments. For example, some collaboration arrangements are more akin to a partnership, while others represent
a vendor–customer relationship. Only transactions that are with a customer are within the scope of IFRS 15.
Entities may enter into transactions that are partially within the scope of IFRS 15 and partially within
the scope of other standards. In these situations, the standard requires that an entity apply the require-
ments in the other standard(s) first, to separate and measure the different parts in the contract, before
applying the requirements in IFRS 15.
1 In
September 2015, the IASB issued Effective Date of IFRS 15, which amends IFRS 15 to defer the effective date of the
standard by one year (i.e. for annual periods beginning on or after 1 January 2018).
74 PART 2 Elements
LO3 4.3 IDENTIFY THE CONTRACT WITH THE CUSTOMER
An entity must identify the contract, or contracts, to provide goods and services to customers as the first step
in the model in IFRS 15. Any contracts that create enforceable rights and obligations fall within the scope of
the standard. Such contracts may be written, oral or implied through an entity’s customary business practice
and this may impact an entity’s determination of when an arrangement meets the definition of a contract
with a customer. Since enforceability is driven by the laws within the jurisdiction, the assessment of whether
there are legally enforceable rights and obligations will depend on the facts and circumstances.
Take, for example, an entity that has an established business practice of starting performance based on
oral agreements with its customers. The entity may assess that such oral agreements result in a contract as
defined in IFRS 15 and therefore account for a contract as soon as performance begins, instead of delaying
until there is a signed agreement. Certain arrangements may require a written agreement to comply with
jurisdictional law or trade regulation. In those cases, the assessment may differ and a contract may exist
only when there is a written document.
4.3.1 Arrangements that meet the definition of a contract

To help entities determine whether (and when) their arrangements with customers are contracts within
the scope of the standard, the Boards provided five criteria that must be met at the commencement of the
arrangement. Once the criteria are met, an entity would apply the five-step model in IFRS 15 to account
for the contract and it is not required to reassess these criteria unless there is a significant change in facts
and circumstances.
Paragraph 9 of IFRS 15 provides five criteria, as summarised below:
(a) the contract is approved by all parties, whether in writing, orally or in accordance with other customary
business practices, and the parties are committed to carrying out their respective obligations;
(b) the entity can identify the rights of each party with regard to the goods or services that are to be trans-
ferred under the contract;
(c) the entity can identify the payment terms for the goods or services to be transferred;
(d) the contract has commercial substance; and
(e) collectability of the amount of consideration that an entity will be entitled to in exchange for the
goods and services that will be transferred to the customer is probable.
The purpose of these criteria is to help an entity assess whether a contract with its customer is genuine
and entered into for a valid business purpose. If the criteria are not met, then the arrangement is not con-
sidered a revenue contract under IFRS 15. Instead, the requirements discussed in section 4.3.2 must be applied.
Entities are required to continue assessing the criteria throughout the term of the arrangement to deter-
mine if they are subsequently met.
4.3.2 Arrangements that do not meet the definition of a contract

Paragraph 15 of IFRS 15 indicates that when a contract with a customer does not meet the criteria for a
revenue contract (i.e. the criteria discussed in section 4.3.1) and an entity receives consideration from the
customer, the entity can only recognise the consideration received as revenue when such amounts are
non-refundable and either of the following events has occurred:
(a) the entity has completed performing all of its obligations under the contract and has received all, or
substantially all, of the consideration promised by the customer; or
(b) the contract has been terminated.
The standard goes on to specify that an entity must recognise any consideration received from a cus-
tomer as a liability until one of the events described above occurs or until the contract meets the criteria to
be accounted for within the revenue model.
4.3.3 Contracts that are combined

In some cases, entities have to combine individual contracts entered into at, or near, the same time with
the same customer if they meet one or more of the following criteria in paragraph 17 of IFRS 15:
(a) the contracts are negotiated as a package with the intent of meeting a singular business purpose (e.g.
where a contract would be loss-making without taking into account the consideration received under
another contract);
(b) the amount of consideration that a customer has to pay in one contract is impacted by the price or
performance of the other contract (e.g. where failure to perform under one contract affects the amount
paid under another contract); or
(c) some or all of the goods or services promised in the individual contracts form a single performance
obligation (e.g. a contract for the sale of specialised equipment and a second contract entered into at
the same time with the same customer for significant customisation and modification of that special-
ised equipment may give rise to a single performance obligation).

Note that only contracts entered into at or near the same time are assessed under the contract combi-
nation requirements. Arrangements entered into at a much later date that were not anticipated at the start
of the contract or implied based on the entity’s customary business practices may be accounted for as
contract modifications, which are discussed in section 4.9.1.
LO3 4.4 IDENTIFY THE PERFORMANCE OBLIGATIONS

Once an entity has identified the contract with the customer, the second step in the model requires an
entity to identify the promised goods and services in the contract. This assessment is performed at the
commencement of the contract.
The entity has to determine which of the promised goods or services (individually or as a bundle of
promised goods or services) will be treated as separate performance obligations. Under IFRS 15, a prom-
ised good or service that is not distinct on its own must be combined with other goods or services until a
distinct bundle of goods or services is formed. Each separate performance obligation is an individual unit
of account for purposes of applying the standard. These concepts are discussed further below.
4.4.1 Separate performance obligations

Paragraph 26 of IFRS 15 provides a non-exhaustive list of examples of promised goods or services that
may be identified in a contract. Such promised goods or services are accounted for as separate performance
obligations if they are distinct (either by themselves or as part of a bundle of goods and services) or they
are part of a series of distinct goods and services that are substantially the same and have the same pattern
of transfer to the customer (see section 4.4.2).
In assessing whether a promised good or service (or a bundle of goods and services) is distinct, an entity
has to meet both of the criteria below:
• the goods or services are capable of being distinct; and
• the goods or services are distinct when considered in the context of the entire contract.
Capable of being distinct

A good or service is capable of being distinct if the customer can benefit from it (i.e. it could be used, con-
sumed, sold for an amount greater than scrap value or otherwise held in a way that generates economic
benefits). In assessing this, an entity considers the individual characteristics of the good or service, rather
than how a customer may use the good or service.
A customer may be able to benefit from some goods or services on their own or in conjunction with
other readily available resources. Readily available resources are goods and services that may be sold sepa-
rately by the entity (or another entity) or that the customer has already obtained from the entity (including
goods or services that have already been transferred to the customer under the contract) or from other
transactions or events. Separately selling a good or service on a regular basis indicates that a customer can
benefit from that good or service on its own or with readily available resources.
Distinct within the context of the contract

The second criterion requires that the entity considers whether the good or service is separable from other
promises in the contract. The standard provides a non-exhaustive list of indicators that an entity’s promise
to transfer a good or service to a customer is separately identifiable. The indicators are summarised as
follows:
(a) The entity is not using the good or service as an input into a single process or project that is the output
of the contract. That is, the entity is not providing a significant integration service.
(b) The good or service does not significantly modify or customise other promised goods and services in
the contract.
(c) The good or service is not highly dependent on, or highly interrelated with, other promised goods or
services in the contract. For example, if a customer could decide not to purchase a particular good or
service and it would not significantly impact the customer’s decision to purchase the other promised
goods or services in the contract, this might indicate that the good or service is not highly dependent
on or highly interrelated with those other promised goods or services.
If a promised good or service is not distinct, an entity is required to combine that good or service
with other promised goods or services until it identifies a bundle of goods or services that is distinct. As
a consequence, an entity may end up accounting for all the goods or services promised in a contract as
a single performance obligation if the bundle of promised goods and services is the only distinct item
identified.
Illustrative example 4.1 demonstrates how an entity might apply the two-step process for determining
whether promised goods or services in a contract are distinct and how an entity might bundle inseparable
goods and services.
76 PART 2 Elements
ILLUSTRATIVE EXAMPLE 4.1 Determining whether goods or services are distinct
Entity Z is a software development company that provides hosting services to a variety of consumer
products entities. Entity Z offers a hosted inventory management software product that requires the
customer to purchase hardware from Entity Z. In addition, customers may purchase professional ser-
vices from Entity Z to migrate historical data and create interfaces with existing back office accounting
systems. Entity Z always delivers the hardware first, followed by professional services and finally, the
ongoing hosting services.
Scenario A – All goods and services sold separately
Entity Z determines that all of the individual goods and services in the contract are capable of being
distinct because the entity regularly sells each element of the contract separately. Entity Z also deter-
mines that the goods and services are separable from other promises in the contract (i.e. distinct within
the context of the contract), because it is not providing a significant service of integrating the goods
and services and the level of customisation is not significant. Furthermore, because the customer could
purchase (or not purchase) each good and service without significantly affecting the other goods and
services purchased, the goods and services are not highly dependent on, or highly interrelated with, each
other. Accordingly, the hardware, professional services and hosting services are each accounted for as
separate performance obligations.
Scenario B – Hardware not sold separately
Entity Z determines that the professional services are distinct because it frequently sells those services on
a stand-alone basis (e.g. Entity Z also performs professional services related to hardware and software
it does not sell). Furthermore, the entity determines that the hosting services are distinct because it also
sells those services on a stand-alone basis. For example, customers that have completed their initial
contractual term and elect each month to continue purchasing the hosting services are purchasing those
services on a stand-alone basis. The hardware, however, is always sold in a package with the professional
and hosting services and the customer cannot use the hardware on its own or with resources that are
readily available to it. Therefore, Entity Z determines the hardware is not distinct.
Entity Z must determine which promised goods and services in the contract to bundle with the hard-
ware. Entity Z likely would conclude that because the hardware is integral to the delivery of the hosted
software, the hardware and hosting services should be accounted for as one performance obligation, and
the professional services, which are distinct, would be a separate performance obligation.
Source: Ernst & Young (2015, p. 1959).
4.4.2 Series of distinct goods and services that are substantially

the same and have the same pattern of transfer
Even if a good or service is determined to be distinct, if it is part of a series of goods or services that are
substantially the same and have the same pattern of transfer, that series of goods or services must be
treated as a single performance obligation when both of the following criteria are met:
• each distinct good or service in the series is a performance obligation that would be satisfied over time
(see section 4.7.1) if it were accounted for separately; and
• the measure used to assess the entity’s progress toward satisfaction of the performance obligation is the
same for each distinct good or service in the series (see section 4.7.2).
4.4.3 Customer options for additional goods or services

Some entities frequently give customers the option to purchase additional goods or services (‘cus-
tomer options’). These additional goods or services may be priced at a discount or may even be free of
charge. Customer options also come in many forms, including sales incentives, customer award credits
(e.g. frequent flyer programmes offered by airlines), contract renewal options (e.g. waiver of certain fees,
reduced future rates) or other discounts on future goods or services.
IFRS 15 indicates that a customer option is a separate performance obligation only if it provides the cus-
tomer with a material right that the customer would not have received without entering into the contract
(e.g. a discount that exceeds the range of discounts typically given for those goods or services to that class
of customer in that geographical area or market). The purpose of this requirement is for entities to identify
and account for options that customers are essentially paying for as part of the current transaction.
If the discounted price of the customer option reflects the stand-alone selling price (see section 4.6.1),
separate from any existing relationship or contract, the entity is deemed to have made a marketing offer
rather than having granted a material right. This is the case even if the customer option can only be exer-
cised because the customer entered into the earlier transaction.

LO3 4.5 DETERMINE THE TRANSACTION PRICE
The third step in the model requires an entity to determine the transaction price. This is the amount of
consideration to which an entity expects to be entitled in exchange for transferring promised goods or
services to a customer, which excludes amounts collected on behalf of third parties (e.g. some sales taxes).
In determining the transaction price, the entity has to consider the contractual terms and its customary
business practices.
In many cases, the transaction price can be readily determined because the entity receives a fixed payment
when it transfers promised goods or services to the customer (e.g. the sale of goods in a retail store). Deter-
mining the transaction price can be more challenging in other situations, such as:
• when the transaction price is variable
• when a customer pays for the goods or services before or after the entity’s performance
• when a customer pays in a form other than cash, or
• when the entity pays consideration to the customer.
The effects of these items on the determination of the transaction price are discussed in sections 4.5.1 to 4.5.4.
Determining the transaction price is an important step in the model because this amount is subse-
quently allocated to the identified performance obligations in the fourth step of the model. It is also the
amount that will be recognised as revenue as those performance obligations are satisfied.
4.5.1 Variable consideration

Paragraph 50 of IFRS 15 requires that if the consideration promised in a contract includes a variable
amount, the entity must estimate the amount of consideration to which it will be entitled and include that
amount in the transaction price, subject to a constraint (which is discussed further below).
Variable consideration may include discounts, rebates, refunds, credits, price concessions, incentives,
performance bonuses, penalties or other similar items. If an entity’s entitlement to the consideration is
contingent on the occurrence or non-occurrence of a future event, the transaction price is considered to
be variable. An example of this is when a portion of the transaction price depends on an entity meeting
specified performance conditions and there is uncertainty about the outcome and therefore whether the
entity will receive that amount of consideration.
Estimating variable consideration

An entity is required to estimate the variable consideration using either an ‘expected value’ or a ‘most
likely amount’ approach. An entity has to decide which approach better predicts the amount of consider-
ation to which it expects it will be entitled and apply that approach. That is, an entity will need to select
the method not based on a ‘free choice’ but rather on what is most suitable given the specific facts and
circumstances. In some cases, an entity may have to use different approaches (i.e. expected value or most
likely amount) for estimating different types of variable consideration within a single contract.
The selected method(s) must be applied consistently throughout the contract and an entity will have
to update the estimated transaction price at the end of each reporting period. Furthermore, an entity is
required to apply the selected approach consistently to similar types of contracts.
The expected value approach is based on probability weighting the possible outcomes of a contract. As
a result, it may better predict the expected consideration when an entity has a large number of contracts
with similar characteristics. Using the most likely amount approach, an entity will select the amount that
is most likely to be received considering the range of possible amounts. The most likely amount approach
may be the better method to use when there are a limited number of possible amounts expected (e.g. a
contract in which an entity is entitled to receive all or none of a specified commission payment, but not a
portion of that commission).
When applying either of these approaches, all information (historical, current and forecast) that is rea-
sonably available to the entity must be considered.
Constraining the cumulative amount of revenue recognised

As mentioned earlier, after estimating the amount of variable consideration, an entity must apply the
‘constraint’ to the estimated amount. The constraint is aimed at preventing revenue from being overstated.
To include variable consideration in the estimated transaction price, the entity has to conclude that it is
‘highly probable’ that a significant revenue reversal will not occur in future periods when the uncertain-
ties related to the variability are subsequently resolved. This conclusion involves considering both the
likelihood and magnitude of a potential revenue reversal. In assessing the magnitude, an entity needs to
consider if the potential revenue reversal is ‘significant’ relative to total contract revenue, rather than just
the variable consideration. The estimate of the variable consideration (which is subject to the effect of the
constraint) included in the transaction price is updated throughout the contractual period to reflect the
conditions that exist at the end of each reporting period.
Illustrative example 4.2 provides an example of estimating the variable consideration using the ‘expected
value’ and the ‘most likely amount’ approaches, and the effect of the constraint on both approaches.
78 PART 2 Elements
ILLUSTRATIVE EXAMPLE 4.2 Estimating variable consideration
Scenario A
Entity A provides transportation to theme park customers to and from accommodation in the area
under a 1 year agreement. It is required to provide scheduled transportation throughout the year for a
fixed fee of $400 000 annually. Entity A also is entitled to performance bonuses for on-time performance
and average customer wait times. Its performance may yield a bonus from $0 to $600 000 under the
contract. Based on its history with the theme park, customer travel patterns and its current expectations,
Entity A estimates the probabilities for different amounts of bonus within the range as follows:
Bonus amount Probability of outcome
$0 30%
$200 000 30%
$400 000 35%
$600 000 5%
Analysis
Expected value
Because Entity A believes that there is no one amount within the range that is most likely to be received, Entity
A determines that the expected value approach is most appropriate to use. As a result, Entity A estimates
variable consideration to be $230 000 (($200 000 × 30%) + ($400 000 × 35%) + ($600 000 × 5%))
before considering the effect of the constraint.
Assume that Entity A is a calendar year-end entity and it entered into the contract with the theme park
during its second quarter. Customer wait times were slightly above average during the second quarter.
Based on this experience, Entity A determines that it is highly probable that a significant revenue reversal
for $200 000 of variable consideration will not occur. Therefore, after applying the constraint, Entity
A only includes $200 000 in its estimated transaction price. At the end of its third quarter, Entity A
updates its analysis and expected value calculation. The updated analysis again results in estimated var-
iable consideration of $230 000, with a probability outcome of 75%. Based on analysis of the factors
in paragraph 57 of IFRS 15 and in light of slightly better-than-expected average customer wait times
during the third quarter, Entity A determines that it is probable that a significant revenue reversal for the
entire $230 000 estimated transaction price would not be subject to a significant revenue reversal. Entity
A updates its estimate to include the entire $230 000 in the transaction price. Entity A will continue to
update its estimate of the transaction price at each subsequent reporting period.
Scenario B
Assume the same facts as in Scenario A, except that the potential bonus will be one of four stated
amounts: $0, $200 000, $400 000 or $600 000. Based on its history with the theme park and customer
travel patterns, Entity A estimates the probabilities for each bonus amount as follows:
Bonus amount Probability of outcome
$0 30%
$200 000 30%
$400 000 35%
$600 000 5%
Analysis
Expected value
Entity A determined that the expected value approach was the most appropriate to use when estimating
its variable consideration. Under that approach, it estimates the variable consideration is $230 000.
Entity A must then consider the effect of the constraint on the amount of variable consideration included
in the transaction price. Entity A notes that, because there are only four potential outcomes under the
contract, the constraint essentially limits the amount of revenue Entity A can recognise to one of the
stated bonus amounts. In this example, Entity A would be limited to including $200 000 in the esti-
mated transaction price until it became highly probable that the next bonus level (i.e. $400 000) would

be achieved. This is because any amount over $200 000 would be subject to subsequent reversal, unless
$400 000 was received.
Most likely amount
As there are only a limited number of outcomes for the amount of bonus that can be received, Entity A
is concerned that a probability-weighted estimate may result in an amount that is not a potential out-
come. Therefore, Entity A determines that estimating the transaction price by identifying the most likely
outcome would be the best predictor.
The standard is not clear about how an entity would determine the most likely amount when there
are more than two potential outcomes and none of the potential outcomes is significantly more likely
than the others. A literal reading of the standard might suggest that, in this example, Entity A would
select $400 000 because that is the amount with the highest estimated probability. However, Entity A
must then apply a constraint on the amount of variable consideration included in the transaction price.
To include $400 000 in the estimated transaction price, Entity A has to believe it is highly probable
that the bonus amount will be at least $400 000. Based on the listed probabilities above, however, Entity
A believes it is only 40% likely to receive a bonus of at least $400 000 (i.e. 35% + 5%) and 70% likely
it will receive a bonus of at least $200 000 (i.e. 30% + 35% + 5%). As a result, Entity A would include
only $200 000 in its estimate of the transaction price.
Source: Ernst & Young (2015, pp. 1973–1974).
4.5.2 Significant financing component

For some transactions, customers may pay in advance or in arrears of the goods or services being trans-
ferred to them. When the customer pays before (or after) the goods or services are provided, the entity
is effectively receiving financing from (or providing financing to) the customer. Paragraph 60 of IFRS 15
requires that the entity adjusts the transaction price for the effects of the time value of money if either the
customer or the entity is provided with a significant financing benefit due to the timing of payments.
As a practical expedient, an entity is only required to assess whether the arrangement contains a sig-
nificant financing component when the period between the customer’s payment and the entity’s transfer
of the goods or services is greater than 1 year. This assessment, performed at the commencement of the
contract, will likely require entities to exercise significant judgement. Furthermore, a financing component
only affects the transaction price when it is considered significant to the contract.
For contracts with a significant financing component, the transaction price is calculated by discounting
the amount of promised consideration, using the same discount rate that an entity would use if it were
to enter into a separate financing transaction with the customer. Using a risk-free rate or a rate that is
explicitly specified in the contract that does not reflect the borrower’s credit characteristics would not be
acceptable. An entity does not need to update the discount rate for changes in circumstances or interest
rates after the commencement of the contract.
4.5.3 Non-cash consideration

A customer might pay in cash or in forms other than cash (e.g. goods, services, equity shares). Paragraph 66
of IFRS 15 requires an entity to include the fair value of any non-cash consideration it receives (or expects
to receive) in the transaction price. An entity applies the requirements of IFRS 13 Fair Value Measurement
when measuring the fair value of any non-cash consideration. If an entity cannot reasonably estimate the
fair value of non-cash consideration, it measures the non-cash consideration indirectly by reference to the
estimated stand-alone selling price of the promised goods or services.
The fair value of non-cash consideration may change because of the occurrence (or non-occurrence)
of a future event (e.g. performance considerations that affect the amount of consideration) or because
of the form of consideration (e.g. shares in which the share price may change). Under IFRS 15, an
entity has to consider constraining the non-cash consideration using the requirements for constraining
variable consideration (as discussed in section 4.5.1), if the amount may vary for reasons other than
the form of consideration (i.e. there is uncertainty as to whether the entity will receive the non-cash
consideration).
4.5.4 Consideration paid or payable to a customer

It is common for entities to make payments to their customers or, in some cases, to other parties that
purchase the entity’s goods or services from the customer (e.g. customers of a reseller or distributor). Such
payments might be explicitly stated in the contract or implied by the entity’s customary business practice.
In addition, the term ‘payments’ does not only refer to cash payments. Paragraph 70 of IFRS 15 provides
that consideration paid or payable can also be in the form of non-cash items (e.g. discounts, coupons,
vouchers) that a customer can apply against amounts owed to the entity.
80 PART 2 Elements
To determine the appropriate accounting treatment, an entity would need to assess the purpose of the
payments. That is, an entity must first determine whether the consideration paid or payable to a customer is:
• a payment for a distinct good or service (see discussion in section 4.4.1); or
• to reduce the transaction price; or
• a combination of both.
If the consideration paid or payable to a customer is a payment for a distinct good or service from the
customer, an entity accounts for the purchase of the good or service like any other purchase from a sup-
plier. Otherwise, such payments are accounted for as a reduction to the transaction price and recognised at
the later of when the entity:
• transfers the promised goods or services to the customer; or
• pays or promises to pay the consideration.
In some cases, the payments could be for both a distinct good or service and to reduce the transaction
price. If the payments to the customer exceed the fair value of the distinct good or service received from the
customer, the excess is accounted for as a reduction of the transaction price. If the fair value of the good or
service received from the customer cannot be reasonably estimated, the entire payment to the customer is
accounted for as a reduction of the transaction price.
Furthermore, the consideration paid or payable to a customer may be fixed or variable in amount (e.g.
in the form of a discount or refund for goods or services provided). If the discount or refund is subject
to variability, an entity would estimate it using either of the two approaches discussed in section 4.5.1 and
apply the constraint to the estimate to determine the effect of the discount or refund on the transaction
price or related revenues.
LO3 4.6 ALLOCATE THE TRANSACTION PRICE

In the fourth step of the model, IFRS 15 requires an entity to allocate the transaction price to each per-
formance obligation that has been identified. In this step, an entity allocates the transaction price to each
identified performance obligation based on the proportion of the stand-alone selling price of that perfor-
mance obligation to the sum of the total stand-alone selling prices of all performance obligations. This
is known as the relative stand-alone selling price method. Under this method, any discount within the
contract will be allocated proportionally to all of the separate performance obligations in the contract.
There are two exceptions to using the relative stand-alone selling price method:
• An entity will allocate variable consideration to one or more (but not all) performance obligations, or
one or more (but not all) distinct goods or services promised in a series of distinct goods or services
that forms part of a single performance obligation (as discussed in section 4.4.2), in a contract in some
situations.
• An entity will allocate a discount in an arrangement to one or more (but not all) performance
obligations in a contract, if specified criteria are met.
4.6.1 Stand-alone selling prices

In applying the relative stand-alone selling price method, an entity must first determine the stand-alone
selling price for each identified performance obligation. The stand-alone selling price is the price at which
a good or service is, or would be, sold separately by the entity. This price is determined by the entity at
the commencement of the contract and is not typically updated subsequently. However, if the contract is
modified and that modification is not treated as a separate contract, the entity would update its estimate
of the stand-alone selling price at the time of the modification (see section 4.9.1).
Under IFRS 15, an entity should use the observable price of a good or service sold separately, when it
is readily available. In situations in which there is no observable stand-alone selling price, the entity must
estimate the stand-alone selling price. Paragraph 79 of IFRS 15 highlights the following methods, which
may be, but are not required to be, used:
• Adjusted market assessment approach — this approach considers the amount that the market is willing
to pay for a good or service and focuses primarily on external factors rather than entity-specific factors.
• Expected cost plus margin approach — this approach is based primarily on internal factors (e.g.
incurred costs). However, it factors in a margin that the entity believes the market would be willing to
pay, not the margin that an entity would like to get.
• Residual approach — this approach allows an entity that can estimate the stand-alone selling prices for
one or more, but not all, promised goods or service to allocate the remaining transaction price to the
goods or services for which it could not reasonably make an estimate, provided certain criteria are met.
However, the use of this approach may be limited because it requires that the selling price of the goods
or services be either highly variable or uncertain because the goods or services have not yet been sold.
An entity is required to consider all reasonably available information (including market conditions,
entity-specific factors and information about the customer or class of customer) when determining the
estimated stand-alone selling price. The standard requires an entity to make as much use of observable

inputs as reasonably possible and to apply estimation methods consistently to similar circumstances. This
will require an entity to consider a variety of data sources.
4.6.2 Application of the relative stand-alone selling price method

Under the relative stand-alone selling price method, once the stand-alone selling price of each perfor-
mance obligation is determined, the entity will then allocate the transaction price to each performance
obligation based on the proportion of the stand-alone selling price of each performance obligation to
the sum of the stand-alone selling prices of all the performance obligations in the contract. Illustrative
example 4.3 shows a relative stand-alone selling price allocation.
ILLUSTRATIVE EXAMPLE 4.3 Relative stand-alone selling price allocation
Manufacturing Co. entered into a contract with a customer to sell a machine for £100 000. The total
contract price included installation of the machine and a 2 year extended warranty. Assume that Man-
ufacturing Co. determined there were three performance obligations and the stand-alone selling prices
of those performance obligations were as follows: machine — £75 000, installation services — £14 000
and extended warranty — £20 000.
The aggregate of the stand-alone selling prices (£109 000) exceeds the total transaction price of
£100 000, indicating there is a discount inherent in the contract. That discount must be allocated to
each of the individual performance obligations based on the relative stand-alone selling price of each
performance obligation. Therefore, the amount of the £100 000 transaction price is allocated to each
performance obligation as follows:
Machine — £68 807 (£75 000 × (£100 000/£109 000))
Installation — £12 844 (£14 000 × (£100 000/£109 000))
Warranty — £18 349 (£20 000 × (£100 000/£109 000))
The entity would recognise as revenue the amount allocated to each performance obligation when (or as)
each performance obligation is satisfied.
LO3 4.7 SATISFACTION OF PERFORMANCE OBLIGATIONS

Under IFRS 15, revenue can only be recognised when an entity satisfies an identified performance obliga-
tion by transferring a promised good or service to a customer. A good or service is considered transferred
when the customer obtains control over the promised good or service (i.e. the customer can direct the use
of, and receive benefits from, the good or service, or prevent others from doing the same).
For each performance obligation identified in the contract, an entity must determine at the commence-
ment of the contract, whether the performance obligation will be satisfied over time or at a point in time.
If a performance obligation does not meet the criteria to be satisfied over time, it is presumed to be satis-
fied at a point in time. These concepts are explored further in the following sections.
4.7.1 Performance obligations satisfied over time

Paragraph 35 of IFRS 15 provides the criteria to help an entity determine if a performance obligation is sat-
isfied over time. An entity has to meet one of the following criteria in order to recognise revenue over time:
(a) the benefits provided by the entity’s performance are simultaneously received and consumed by the
customer;
(b) the customer controls an asset that is being created or enhanced by the entity’s performance; or
(c) the asset created has no alternative use to the entity and there is an enforceable right to payment for
the work performed to date.
Illustrative example 4.4 demonstrates the application of each of the above criteria:
ILLUSTRATIVE EXAMPLE 4.4 Application of the criteria for recognition over time
Scenario A — Customer simultaneously receives and consumes the benefits

Sparkle and Co. enters into a contract to provide weekly cleaning services to a customer for 2 years.
The promised cleaning services are accounted for as a single performance obligation as discussed in
section 4.4.2. The performance obligation is satisfied over time because the customer simultaneously
receives and consumes the benefits of Sparkle and Co.’s cleaning services as and when Sparkle and Co.
performs. The fact that another entity would not need to re-perform the cleaning services that Sparkle
82 PART 2 Elements
and Co. has provided to date also demonstrates that the customer simultaneously receives and con-
sumes the benefits of Sparkle and Co.’s performance as Sparkle and Co. performs. As such, Sparkle and
Co. recognises revenue over time by measuring its progress towards satisfaction of that performance
obligation as discussed in section 4.7.2.
Scenario B — Customer controls asset as it is created or enhanced
Sakalian enters into an agreement to build an integrated IT system that interfaces sales, procurement
and accounting functions. Sakalian is expected to take 1 year to complete the work.
During the development of the integrated system, Sakalian works extensively with the customer to
design and configure the system as well as to run tests to check its operability. All work is being per-
formed at the customer’s site so that throughout the different stages of development, the customer takes
ownership and physical possession of the integrated system as it is being built.
Because the customer controls the integrated IT system as it is built, Sakalian determines that the per-
formance obligation is satisfied over time (i.e. the control over the asset is transferred over time), rather
than at a point in time.
Scenario C — Asset with no alternative use and right to payment
Novak Ltd enters into a contract to construct a highly customised piece of equipment subject to specifi-
cations provided by the customer. If the customer were to terminate the contract for reasons other than
Novak Ltd’s failure to perform as promised, the contract requires the customer to compensate Novak Ltd
for its costs incurred plus a 10% margin. The 10% margin approximates the profit margin that Novak
Ltd earns from similar contracts.
In the event of contract cancellation, the contract also contains an enforceable restriction on Novak
Ltd’s ability to direct the equipment (regardless of the extent of completion) for another use, such as
selling the equipment to another customer. As a result, the equipment does not have an alternative use
to Novak Ltd.
Furthermore, Novak Ltd has an enforceable right to payment for its performance completed to date
for its costs plus a reasonable margin, which approximates the profit margin in other contracts.
As a result, Novak Ltd recognises revenue over time by measuring the progress towards satisfaction of
the performance obligation as discussed in section 4.7.2.
If a performance obligation is satisfied over time, an entity would recognise revenue over time by using a
method that best reflects its progress in satisfying that performance obligation (see section 4.7.2).
4.7.2 Measure of progress

When an entity has determined that a performance obligation is satisfied over time, paragraph 40 of
IFRS 15 requires an entity to select a single revenue recognition method to measure the entity’s progress
in transferring the promised goods or services over time. In selecting the method that best reflects the
transfer of the promised goods or services, the entity considers both the nature of the goods or services
and the work to be performed by the entity. The selected method must be applied consistently to sim-
ilar performance obligations and in similar circumstances, and the standard does not allow a change in
methods. That is, a performance obligation is accounted for under the method the entity selects until it
has been fully satisfied. However, the standard does require an entity to update its estimates related to
the measure of progress selected at each reporting date. The effect of changes in the measure of progress
is accounted for as a change in estimate under IAS 8 Accounting Policies, Changes in Accounting Estimates
and Errors.
There are two methods for recognising revenue on arrangements involving the transfer of goods and
services over time:
• Output methods — measure the value of goods or services transferred to date relative to the
remaining goods or services promised under the agreement (e.g. surveys of performance completed
to date, appraisals of results achieved, milestones reached, time elapsed and units produced or units
delivered).
• Input methods — measure the inputs/efforts put in by the entity relative to the total expected inputs
needed to transfer the promised goods or services to the customer (e.g. resources consumed, labour
hours expended, costs incurred, time elapsed or machine hours used). Using a straight-line basis to
recognise revenue is appropriate only if the entity’s efforts or inputs are expended evenly throughout
the period that an entity performs.
If an entity does not have a reasonable basis to measure its progress, revenue is not recognised until
the entity is able to measure its progress. However, in cases in which the entity is not able to reasonably
estimate the amount of profit but is able to determine that a loss will not be incurred, the entity will recog-
nise revenue but only up to the amount of the costs incurred, until the outcome/profit can be reasonably
estimated.

4.7.3 Performance obligation satisfied at a point in time
For performance obligations in which control is not transferred over time, control is transferred at a point
in time. In many situations, the determination of the point at which control is transferred is relatively
straightforward. However, there are instances when this determination could be more complicated. To
help entities determine the point in time when a customer obtains control of a particular good or service,
the standard provides a non-exhaustive list of indicators of the transfer of control, as follows:
(a) The entity has a present right to payment for the asset.
(b) The asset’s legal title is held by the customer.
(c) Physical possession of the asset has been transferred by the entity.
(d) The significant risks and rewards of ownership of the asset reside with the customer.
(e) There is customer acceptance of the asset.
These indicators are not individually determinative and no one indicator is more important than the
others. Rather, an entity must consider all relevant facts and circumstances to determine when control
has been transferred. Furthermore, this list of indicators is not intended to be a ‘checklist’. That is, an
entity does not need to meet all of these indicators to determine that the customer has gained control.
Rather, they are just some common factors that are often present when a customer has obtained control
of an asset.
LO4 4.8 CONTRACT COSTS

IFRS 15 requires an entity to capitalise, as an asset, two types of costs relating to a contract with a customer:
• any incremental costs to obtain the contract that would otherwise not have been incurred, if the entity
expects to recover them;
• costs incurred to fulfil a contract with the customer, if certain criteria are met.
We will discuss these two types of costs further in section 4.8.1.
Any capitalised contract costs are then amortised on a systematic basis that reflects the pattern of transfer
of the related promised goods or services to the customer. Entities will also have to assess any capitalised
contract costs for impairment at the end of each reporting period. See further discussion in section 4.8.2.
4.8.1 Contract costs to be capitalised

Incremental costs to obtain a contract
Under IFRS 15, the costs that an entity incurs in order to obtain a contract are capitalised only if they are
incremental and expected to be recoverable. This means that the costs need to be either explicitly reim-
bursable under the contract or implicitly recoverable through the margin inherent in the contract. Costs
that would have been incurred regardless of whether the contract is obtained or those costs that are not
directly related to obtaining a contract would not be capitalisable.
To illustrate this distinction, consider the following examples:
• Sales commissions paid to an employee if a contract with a customer is successfully won would likely
meet the requirements for capitalisation.
• Bonuses paid to an employee based on quantitative or qualitative metrics that are unrelated to winning
a contract (e.g. profitability, earnings per share, performance evaluations) would likely not meet the
criteria for capitalisation.
If the amortisation period of the incremental costs would be 1 year or less, an entity can choose to
expense these costs immediately, as a practical expedient, instead of capitalising such costs.
Costs to fulfil a contract
Entities may incur some costs as they fulfil a contract. An entity will first have to determine if such contract
fulfilment costs are within the scope of other standards (e.g. IAS 2 Inventories, IAS 16 Property, Plant and
Equipment, IAS 38 Intangible Assets). The requirements of IFRS 15 will apply only if such costs do not fall
within the scope of other standards.
Under IFRS 15, the costs incurred to fulfil a contract are capitalised only if all the following conditions
are met:
(a) they are directly related to a specific contract or to a specific anticipated contract (e.g. direct labour,
direct materials);
(b) they generate or enhance resources of the entity that will be used in satisfying (or in continuing to
satisfy) performance obligations in the future; and
(c) they are expected to be recovered (see discussion on incremental costs to obtain a contract).
If the above criteria are not met, an entity will expense the contract fulfilment costs as they are incurred.
In assessing the above criteria, an entity must consider its specific facts and circumstances.
Criterion (a) above indicates that such costs may be incurred even before the related contract is final-
ised. However, such costs need to be associated with a specifically identifiable anticipated contract in order
to be capitalisable.
84 PART 2 Elements
4.8.2 Amortisation and impairment of contract costs
An entity has to amortise any capitalised contract costs and recognise the expense in the statement of
profit or loss. As discussed earlier in the introduction to section 4.8, an entity amortises the capitalised contract
costs on a systematic basis that reflects the pattern of transfer of the related promised goods or services to
the customer.
In some cases, the capitalised costs may relate to multiple goods and services that are transferred under
multiple contracts. Entities will need to consider this aspect when determining the amortisation period
to apply. Entities are also required to update the amortisation period to reflect a significant change in
the expected timing of transfer to the customer of the goods or services to which the asset relates. Such a
change would need to be treated as a change in accounting estimate under IAS 8.
Capitalised contract costs must continue to be recoverable throughout the arrangement. As such, any
contract costs asset recognised under IFRS 15 is subject to an impairment assessment at the end of each
reporting period. An impairment loss is recognised in the statement of profit or loss for the difference
between:
• the carrying amount of the capitalised contract costs; and
• the remaining amount of consideration that an entity expects to receive in exchange for providing the
associated goods and services, less the remaining costs that relate directly to providing those good and
services.
LO5 4.9 OTHER APPLICATION ISSUES

4.9.1 Contract modifications
Paragraph 18 of IFRS 15 states that:
A contract modification is a change in the scope or price (or both) of a contract that is approved by the
parties to the contract. In some industries and jurisdictions, a contract modification may be described as a
change order, a variation or an amendment. A contract modification exists when the parties to a contract
approve a modification that either creates new or changes existing enforceable rights and obligations of the
parties to the contract. A contract modification could be approved in writing, by oral agreement or implied
by customary business practices. If the parties to the contract have not approved a contract modification,
an entity shall continue to apply this Standard to the existing contract until the contract modification is
approved.
As evident in the definition, an approved contract modification can be explicit or implicit; however,
as long as it results in enforceable changes to the rights and obligations of the parties involved in the
contract, it would need to be accounted for.
Once an entity has determined that a contract has been modified, the entity has to determine the
appropriate accounting treatment under IFRS 15. Certain modifications are treated as separate, stand-alone
contracts, while others are combined with the existing contract and accounted for together. Two criteria
must be met for a modification to be treated as a separate contract:
(a) The scope of the contract increases because of the promise of additional goods or services that are
distinct from those already promised in the original contract.
This assessment is done in accordance with IFRS 15’s requirements for determining whether promised
goods and services are distinct as discussed in section 4.4.1. Although a contract modification may add a
new good or service that would be distinct in a stand-alone transaction, the new good or service may
not be distinct when it is considered within the context of a contract modification. Furthermore, only
modifications that add distinct goods or services to the arrangement can be treated as separate contracts.
Arrangements that reduce the amount of promised goods or services or change the scope of the original
promised goods or services cannot, by their very nature, be considered separate contracts. Instead, they
would be considered modifications of the original contract.
(b) The expected amount of consideration for the additional promised goods or services reflects the enti-
ty’s stand-alone selling price(s) of those goods or services.
However, when determining the stand-alone selling price, entities have some flexibility to adjust that
price, depending on the facts and circumstances. For example, a discount may be given to a customer
who decides to purchase additional goods and the discount relates to selling-related costs that are only
incurred for new customers. In this example, the entity may determine that the adjusted selling price
meets the stand-alone selling price requirement, even though the discounted price is less than the
stand-alone selling price of that good or service for a new customer.
If the two criteria are not met, the contract modification would be accounted for as a change to the
original contract (i.e. not accounted for as a separate contract). Such types of contract modifications
(which may include changes that modify or remove previously agreed-upon goods and services) may be
accounted for in any of the following three ways depending on the specific facts and circumstances:
1. Termination of the old contract and the creation of a new contract.

This accounting treatment applies if the remaining goods or services after the contract modification are
distinct from the goods or services transferred on or before the contract modification. Under this approach,
an entity does not adjust the revenue previously recognised. Instead, the remaining portion of the original
contract and the modification are accounted for, together, on a prospective basis by allocating the total
remaining consideration to the remaining performance obligations.
2. Continuation of the original contract.
This accounting treatment applies if the remaining goods and services to be provided after the contract
modification are not distinct from those already provided. That is, the remaining goods or services con-
stitute part of a single performance obligation that is partially satisfied at the date of modification. Under
this approach, the entity adjusts the revenue previously recognised, either up or down, for any changes to
the transaction price and the measure of progress as a result of the contract modification, on a cumulative
catch-up basis.
3. Modification of the existing contract and the creation of a new contract.
This accounting treatment is a combination of the two above treatments. In this case, an entity does not
adjust the revenue previously recognised for the goods or services already transferred that are distinct from
the modified goods or services.
However, for the transferred goods or services that are not distinct from the modified goods or services,
the entity would have to adjust the revenue previously recognised, either up or down, for any changes to
the estimated transaction price and the measure of progress as a result of the contract modification, on a
cumulative catch-up basis.
4.9.2 Licences of intellectual property

The standard provides separate application guidance specific to licences of intellectual property (‘licences’)
that will apply to licences for any of the following: software and technology, media and entertainment
(e.g. motion pictures and music), franchises, patents, trademarks and copyrights.
Determining whether a licence is distinct
The application guidance on licences applies to distinct licences regardless of whether they are promised
explicitly or implicitly in the contract. In many transactions, licences may be sold together with other
goods or services. In these circumstances, the entity needs to assess whether the licence is a separate perfor-
mance obligation (i.e. whether the benefit derived from the licence can only be obtained when it is used
together with another good or service or whether it can be of use to the customer on its own) as discussed
in section 4.4.1.
If the licence is distinct, the entity then has to determine the nature of its promise to the customer
(discussed further below) to determine if the licence revenue is recognised over time or at a point in time.
If the licence is not distinct, then an entity would look to the other requirements in IFRS 15 to account
for the combined performance obligation that includes the licence. However, in some cases, it could be
necessary for an entity to consider the nature of the entity’s promise in granting a licence (discussed further
below) even when the licence is not distinct (e.g. when the licence is the primary or dominant component
of a combined performance obligation) in order to appropriately determine whether the performance obli-
gation is satisfied over time or at a point in time and/or to determine the appropriate measure of progress.
Determining the nature of the entity’s promise
For distinct licences (and in some cases, combined performance obligations for which the licence is the
primary or dominant component), an entity must determine whether the licence is a ‘right to access’ or a
‘right to use’.
If the entity has promised a customer a right to access the intellectual property (including any updates)
throughout the licence period, revenue is recognised over time. In making this assessment as to whether
the nature of the promise is a right to access, all of the following criteria must be met:
(a) the entity is required to (or the customer reasonably expects that the entity will) perform activities that
significantly affect the intellectual property to which the licence relates;
(b) the customer is directly exposed to any affects (both positive and negative) of those activities in (a) as
a result of the rights granted under the licence; and
(c) the activities in (a) do not transfer any goods or services to the customer.
If the licensed intellectual property does not have the above characteristics, the nature of the entity’s
promise will be a right to use (i.e. the customer is granted the use of the intellectual property as it exists at
the point in time in which the licence is granted). Therefore the revenue for a right to use licence is recog-
nised at a point in time.
It is critical for an entity to assess the above criteria and judgement will be required to assess whether a
customer has a reasonable expectation that the entity will perform the relevant activities. For example, the
existence of a shared economic interest between the parties (e.g. sales or usage-based royalties which are
discussed further below) may be an indicator that the customer has a reasonable expectation for the entity
to perform such activities. These activities need not be specifically linked to the contract but they can be
part of an entity’s ongoing business activities and customary business practices.
86 PART 2 Elements
Sales or usage-based royalties on licences of intellectual property
IFRS 15 includes an exception in which sales-based or usage-based royalties on licences of intellectual
property are excluded from the estimate of variable consideration. Under the standard, these amounts are
recognised only at the later of:
• when the subsequent sale or usage occurs; or
• the performance obligation to which some or all of the sales-based or usage-based royalty has been
allocated is wholly or partially satisfied.
This exception is applicable to all licences of intellectual property, regardless of whether they have been
determined to be distinct. However, the exception is not applicable to all arrangements involving sales or
usage-based royalties. It only applies to sales- or usage-based royalties related to licences of intellectual
property.
4.9.3 Principal versus agent considerations

In arrangements that have three or more parties, an entity will have to determine whether it is acting as
a principal or an agent in order to determine the amount of revenue to which it is entitled. To make this
determination, the entity must conclude whether the nature of its promise to the customer is to provide
the specified goods and services itself (i.e. it is a principal) or if its promise is to arrange for another to
provide those goods or services (i.e. it is an agent).
When the entity is the principal in the arrangement, the revenue recognised is the gross amount to
which the entity expects to be entitled. When the entity is the agent, the revenue recognised is the net
amount that the entity is entitled to retain in return for its services as the agent (e.g. its commission).
Given that the identification of the principal and agent in a contract is not always straightforward, IFRS
15 provides the following indicators to help entities assess if there is an agency relationship:
(a) the entity does not have the primary responsibility of fulfilling the contract
(b) the entity has no inventory risk over the goods transferred (or to be transferred)
(c) the entity does not have discretion in establishing prices for the other party’s goods or services
(d) the entity’s consideration is in the form of a commission
(e) the entity is not exposed to customer credit risk for the amount due in exchange for the other party’s
goods or services.
After an entity identifies its promise and determines whether it is the principal or the agent, the entity
recognises the revenue to which it is entitled when it satisfies that performance obligation (see section 4.7).
LO6 4.10 PRESENTATION AND DISCLOSURES

4.10.1 Presentation of contract assets, contract liabilities
and revenue
Under the standard, when either party to a contract performs, a contract asset or contract liability must be
recognised in the statement of financial position.
A contract liability arises if the customer performs first (e.g. by prepaying the promised consideration
before the promised goods or services are transferred). Conversely, a contract asset represents an entity’s
conditional right to consideration from the customer when it satisfies a performance obligation under the
contract. This conditional right may be because the entity must first satisfy another performance obliga-
tion in the contract before it is entitled to invoice the customer. When the entity’s right to collect the con-
sideration becomes unconditional (i.e. there is nothing other than the passage of time before the customer
pays the entity), a receivable is recognised in place of the contract asset.
The standard does not require entities to specifically use the terms ‘contract assets’ or ‘contract liabilities’.
However, the standard does require that the unconditional rights to consideration (i.e. receivables) be
clearly distinguished from the conditional rights to receive consideration (i.e. contract assets). After initial
recognition, receivables and contract assets are subject to an impairment assessment in accordance with
IFRS 9 or IAS 39.
Other assets, such as capitalised contract costs (see section 4.8), are required to be presented separately
from contract assets and contract liabilities in the statement of financial position, if they are material. In
addition, revenue from contracts with customers is required to be separately presented or disclosed from
other sources of revenue.
4.10.2 Disclosure objective and general requirements

The overall disclosure objective is set out in paragraph 110 of IFRS 15:
The objective of the disclosure requirements is for an entity to disclose sufficient information to enable users of
financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising
from contracts with customers.

As a result, qualitative and quantitative information about the following must be disclosed:
(a) contracts with customers (see section 4.10.3);
(b) the significant judgements, and changes in the judgements, made in applying the standard (see section
4.10.4); and
(c) any assets recognised from the costs to obtain or fulfil a contract with a customer (see section 4.10.5).
Entities are required to ensure that useful information is not obscured by either the inclusion of a large
amount of insignificant detail or the aggregation of items that have substantially different characteristics.
The disclosures are required for (and as at) each annual period for which a statement of comprehensive
income and a statement of financial position are presented. The standard also requires information on
disaggregated revenue in both an entity’s annual and interim financial statements (see section 4.10.3).
4.10.3 Disclosures on contracts with customers

These disclosures comprise information on disaggregation of revenue, contract asset and liability balances
and an entity’s performance obligations.
The main purpose of the disaggregated revenue disclosures is to illustrate how the nature, amount,
timing and uncertainty about revenue and cash flows are affected by economic factors. Entities would have
to determine how they should present the disaggregated revenue information according to their facts and
circumstances because the standard does not specify how revenue should be disaggregated. However, the
application guidance suggests categories, including: by major product line, by country or region, by type of
customer, by type of contract or by contract duration.
Furthermore, an entity is required to disclose:
• the opening and closing balances of receivables, contract assets and contract liabilities from contracts
with customers, if not otherwise separately presented or disclosed;
• revenue recognised in the reporting period that was included in the contract liability balance at the
beginning of the period; and
• revenue recognised in the reporting period from performance obligations satisfied (or partially
satisfied) in previous periods (e.g. changes in transaction price).
In addition, an entity is required to explain the interaction between the revenue recognised and signifi-
cant movements in the contract asset and the contract liability balances during the reporting period. This
requires both qualitative and quantitative information to be disclosed, such as how the timing of satis-
faction of the entity’s performance obligations relates to the typical timing of payment and the effect that
those factors have on the contract asset and the contract liability balances.
Illustrative example 4.5 shows how an entity may fulfil these requirements:
ILLUSTRATIVE EXAMPLE 4.5 Disclosure of contract balances
Cheng Ltd discloses trade receivables separately in the statement of financial position. In order to comply
with the remainder of the required disclosures pertaining to contract assets and liabilities, Cheng Ltd
includes the following information in the notes to the financial statements:
2019 2018 2017
Contract asset € 1 500 € 2 250 € 1 800

Contract liability € (200) € (850) € (500)
2019 2018 2017

Revenue recognised in the period from:
Amounts included in contract liability
at the beginning of the period € 650 € 200 € 100
Performance obligations satisfied in
previous periods € 200 € 125 € 200
We receive payments from customers based on a billing schedule, as established in our contracts. The contract
asset relates to costs incurred to perform in advance of scheduled billing. The contract liability relates to pay-
ments received in advance of performance under the contract. Changes in the contract asset and liability are
due to our performance under the contract. In addition, a contract asset decreased in 2018 due to a contract
asset impairment of €400 relating to an early cancellation of a contract with a customer.
Note that IFRS 15 requires the disclosure of opening and closing balances for contract assets and lia-
bilities and, as such, the balances presented for 2017 reflect the opening balances for 2018. There may be
alternative approaches to presenting such information.
Source: Adapted from Ernst & Young (2015, p. 2048).
88 PART 2 Elements
Separate disclosure of an entity’s remaining performance obligations is also required, as well as the
amount of the transaction price allocated to the remaining performance obligations and an explanation of
the expected timing of recognition for those amount(s). This disclosure can be provided on either a quan-
titative basis (e.g. amounts to be recognised in given time bands, such as between 1 and 2 years or between
2 and 3 years) or by disclosing a mix of quantitative and qualitative information.
Note that there is a practical expedient exempting an entity from making these particular disclosures if
the remaining performance obligation is for contracts with an original expected duration of less than 1
year or the entity is recognising revenue based on invoiced amounts.
4.10.4 Significant judgements

IFRS 15 requires an entity to disclose the significant accounting estimates and judgements made in
applying Steps 3 to 5 of the model in IFRS 15 (see section 4.1). These requirements are in addition to the
requirements in IAS 1 Presentation of Financial Statements.
Entities will need to exercise significant judgement when applying the model in IFRS 15, such as when
estimating the variable consideration included in the transaction price and application of the constraint
(Step 3), when estimating the stand-alone selling prices used to allocate the transaction price (Step 4) and
when measuring obligations for returns, refunds and other similar obligations. Paragraph 126 of IFRS 15
requires entities to disclose qualitative information about the methods, inputs and assumptions used in all
of the above judgements in their annual financial statements.
IFRS 15 also requires entities to provide disclosures about the significant judgements made in deter-
mining when performance obligations are satisfied. For performance obligations that are satisfied over
time, entities must disclose the output or input method used to recognise revenue and how the selected
method reflects the pattern of goods or services that are transferred.
For performance obligations satisfied at a point in time, entities must disclose the significant judge-
ments made in determining the point at which the entity transfers control of the promised goods or ser-
vices to the customer.
4.10.5 Assets recognised from the costs to obtain

or fulfil a contract
IFRS 15 requires entities to disclose information on contract costs that are capitalised to help users under-
stand the amounts and types of costs that have been capitalised, the amortisation methods applied or any
impairment losses that have been recognised. The information includes an explanation of any judgements
made in applying the requirements under IFRS 15.
4.10.6 Practical expedients

In addition, IFRS 15 has several practical expedients that entities can elect to use. If either or both of the
practical expedients relating to a significant financing component (see section 4.5.2) or incremental costs of
obtaining a contract (see section 4.8.1) are applied, the entity must disclose this fact.
SUMMARY
IFRS 15 is a new standard specifying the accounting treatment for all revenue arising from contracts with
customers and, at the time of writing this chapter, is effective for annual reporting periods beginning on
or after 1 January 2018. It applies to all entities that enter into contracts to provide goods or services to
their customers, unless the contracts are within the scope of other IFRS Standards. The standard outlines
the principles an entity must apply to measure and recognise revenue and the related cash flows. Under
the standard, an entity applies the five-step model outlined in sections 4.3 to 4.7 to recognise revenue at an
amount that reflects the consideration to which the entity expects to be entitled in exchange for transfer-
ring goods or services to a customer.
At the time of writing, entities had not yet adopted this standard and therefore there were no examples
of its use in practice. As a result, additional implementation issues are likely to arise as entities begin to
apply the standard and practice may evolve during that process.
1. What are the main accounting issues associated with the recognition of revenue and how does IFRS 15
address those?
2. Why might it be necessary to combine individual contracts? Give two examples of these and discuss
how IFRS 15 applies to such transactions.

3. Compare and contrast the revenue recognition criteria for the sale of goods with those for the rendering
of services.
4. Explain the disclosure objectives and general requirements of IFRS 15.
References
Ernst & Young 2015, International GAAP 2015, Volume 2, Chapter 29: Revenue from contracts with
customers (IFRS 15). Chichester: John Wiley & Sons.
Exercise 4.1 DEFINITIONS, SCOPE

State whether each of the following is true or false:
1. ‘Income’ means the same as ‘revenue’.
2. ‘Gains’ are always recognised net under IFRSs.
3. ‘Revenue’ must always be in respect of an entity’s ordinary operations.
4. ‘Gains’ must always be outside of an entity’s ordinary operations.
5. ‘Deferred revenue’ meets the definition of a liability under the Conceptual Framework.
6. Services provided under a construction contract are accounted for under IFRS 15.
Exercise 4.2 MEASUREMENT
State whether each of the following is true or false:
1. Revenue is measured at the fair value of the consideration given by the seller.
2. Revenue is measured at 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.
3. If payment for the goods or services is deferred, the fair value of the consideration will be less than the
nominal amount of the cash receivable.
4. A swap or exchange for goods or services of a similar nature and value generates revenue.
5. Collectability of amounts due from customers is a measurement issue, not a recognition issue.
Exercise 4.3 REVENUE RECOGNITION — SALE OF GOODS
In each of the following situations, state at which date, if any, revenue will be recognised:
1. A contract for the sale of goods is entered into on 1 May 2016. The goods are delivered on 15 May 2016.
The buyer pays for the goods on 30 May 2016. The contract contains a clause that entitles the buyer to
rescind the purchase at any time. This is in addition to normal warranty conditions.
The buyer pays for the goods on 30 May 2016. The contract contains a clause that entitles the buyer to
return the goods up until 30 June 2016 if the goods do not perform according to their specification.
The contract contains a clause that states that the buyer shall only pay for those goods that it sells to a
third party for the period ended 31 August 2016. Any goods not sold to a third party by that date will be
returned to the seller.
4. Retail goods are sold with normal provisions allowing the customer to return the goods if the goods do
not perform satisfactorily. The goods are invoiced on 1 May 2016 and the customer pays cash for them
on that date.
Exercise 4.4 MULTIPLE-ELEMENT ARRANGEMENT
Company A provides a bundled service offering to Customer B. It charges Customer B $35 000 for initial
connection to its network and two ongoing services — access to the network for 1 year and ‘on-call trou-
ble-shooting’ advice for that year.
Customer B pays the $35 000 upfront, on 1 July 2015. Company A determines that, if it were to charge a
separate fee for each service if sold separately, the fee would be:
Connection fee $ 5 000

Access fee $ 12 000
Troubleshooting $ 23 000
The end of Company A’s reporting period is 30 June.

Required
Prepare the journal entries to record this transaction in accordance with IFRS 15 for the year ended 30
June 2016, assuming Company A applies the relative fair value approach. Show all workings.
90 PART 2 Elements
Exercise 4.5 REVENUE RECOGNITION — RENDERING OF SERVICES
In each of the following situations, state at which date(s), if any, revenue will be recognised:
1. A contract for the rendering of services is entered into on 1 May 2016. The services are delivered on 15
May 2016. The buyer pays for the services on 30 May 2016.
2. A contract for the rendering of services is entered into on 1 May 2016. The services are delivered contin-
uously over a 1-year period commencing on 15 May 2016. The buyer pays for all the services on 30 May
2016.
3. A contract for the rendering of services is entered into on 1 May 2016. The services are delivered contin-
uously over a 1-year period commencing on 15 May 2016. The buyer pays for the services on a monthly
basis, commencing on 15 May 2016.
4. Company A is an insurance agent and provides insurance advisory services to Customer B. Company
A receives a commission from Insurance Company I when Company A places Customer B’s insurance
policy with Insurance Company I, on 1 April 2016. Company A has no further obligation to provide
services to Customer B.
5. Company A is an insurance agent and provides insurance advisory services to Customer B. Company
A receives a commission from Insurance Company I when Company A places Customer B’s insurance
policy with Insurance Company I, on 1 April 2016. Company A is required to provide ongoing services
to Customer B until 1 April 2017. Additional amounts are charged for these services. All amounts are at
market rates.
6. Company A receives a non-refundable upfront fee from Customer B for investment advice, on 1 March
2016. Under the agreement with Customer B, Company A must provide ongoing management services
until 1 March 2017. An additional amount is charged for these services. The upfront fee is higher than
the market rate for equivalent initial investment advice services.

Perhaps no other line-item in the income statement invites of increasing conservatism. In addition Dichev and Tang
as much scrutiny as the top line of sales (or, revenues). (2008) find that earnings persistence declined in the latter
Wagenhofer (2014)1 states that ‘Revenue is one of the most period relative to the earlier period.
important measures of companies’ financial performance’. While Dichev and Tang’s (2008) paper is consistent with
He bases this assertion, in part, on reference to analysts’ the notion of poorer matching in recent years, a limitation
view of revenues as hard to manipulate, persistent and more of their study is the way they define expenses. Specifically,
responsive to underlying changes in the business environ- expenses are captured as the difference between revenues
ment than expenses. and profits. Hence, their study is silent on which expense
If revenues possess these properties, we would expect line-item contributes the most to the documented decline
them to be more value relevant than other numbers in the in matching. Donelson et al. (2011) take up this task by
financial statements. Ertimur et al. (2003) analyse market looking at cost of goods sold; selling, general, and adminis-
reaction to earnings surprises. They claim that expenses trative expense; depreciation; taxes; other income/expenses
reported in the income statement aggregate variety of and special items. Their evidence suggests that the decline
expense types, which makes this information harder to in the association between revenues and expenses is mostly
analyse than revenues. Consistent with this argument attributable to special items. Special items include a variety
they find that surprises in revenues are incorporated into of ‘one-off’ events, such as impairments and restructuring
prices with a larger magnitude than surprises in expenses. charges. Once these one-off items are excluded, Donelson
Jegadeesh and Livnat (2006) extend this line of research. et al. (2011) find no evidence of poorer matching in recent
They examine the relation between both earnings sur- years.
prises and revenue surprises on one hand and current and Contrary to what some may believe, revenues may be
future stock return on the other hand. They are motivated susceptible to earnings manipulations. In particular, the US
by the question of whether any reaction to earnings sur- Securities and Exchange Commission (SEC) raised the con-
prises is driven by news about revenue growth or contrac- cern that firms advance recognition of revenues. As a result,
tion of costs (or vice versa). They show that both earnings the SEC issued in 1999 Staff Accounting Bulletin (SAB) No.
surprises and revenue surprises are associated with cur- 101. The essence of this pronouncement is the tightening
rent and future stock returns. However, the association of revenue recognition criteria to reduce the incidence of
with current returns is considerably weaker for revenue premature revenue recognition. To the extent that the new
surprises. At the same time, future stock returns are more regulation was effective, it is expected that firms that had
closely associated with current revenue surprises than cur- to adopt SAB 101 would exhibit evidence of greater earn-
rent earnings surprises. This suggests that market partici- ings management before adoption than after it. Altamuro
pants may under-react to the information content in the et al. (2005) investigate this hypothesis. They find evidence
revenue surprises. suggesting that firms that adopted SAB 101 managed earn-
A fundamental property of accrual accounting is the ings more prior to adoption and less subsequently. This is
matching between revenues and expenses and costs. The supportive for the motivation behind the SEC’s decision to
Conceptual Framework (IASB, 2010, section 4.50) describes pass SAB 101. This also speaks to the success of this prom-
the process of matching as follows: ‘Expenses are recognised ulgation. To provide further support for this result and
in the income statement on the basis of a direct associa- remove suspicion it only captures time effect, Altamuro
tion between the costs incurred and the earning of specific et al. (2005) compare earnings management in firms that
items of income’. This implies that expenses follow reve- were unaffected by SAB 101 around adoption time. Unlike
nues. Accounting researchers have been therefore interested firms subject to SAB 101, unaffected firms do not exhibit a
in understanding this process and whether the quality of decline in earnings management following the enactment
matching has improved over time. This question is of high of SAB 101.
relevance given the force with which standard setters have
embarked on improving existing standards and issuing new
ones over time. Dichev and Tang (2008) argue that more
recent standards deviate from the tradition of matching as
References
income is progressively based on changes in the balance Altamuro, J., Beatty, A.L., and Weber, J., 2005. The effects of
sheet. Dichev and Tang (2008) develop a simple model accelerated revenue recognition on earnings management
for matching. Based on this model they posit that poor and earnings informativeness: Evidence from SEC Staff
matching is manifested in lower correlation between reve- Accounting Bulletin No. 101. The Accounting Review, 80,
nues and expenses, higher variability of earnings and lower 373–401.
persistence. They then examine a long period (1967–2003) Dichev, I.D., and Tang, V.W., 2008. Matching and the
and find lower association between current expenses and changing properties of accounting earnings over the last 40
current revenues for the sub-period of 1986–2003 than years. The Accounting Review, 83, 1425–1460.
the earlier period of 1967–1985. Moreover, consistent with Donelson, D.C., Jennings, R., and McInnis, J., 2011. Changes
Givoly and Hayn (2000), they find evidence of early recogni- over time in the revenue–expense relation: Accounting or
tion of expenses in the latter sub-period, which is indicative economics? The Accounting Review, 86, 945–974.
1 This paper provides a more extensive review of the literature and is recommended for the interested reader.
92 PART 2 Elements
Ertimur, Y., Livnat, J., and Martikainen, M., 2003. Differential Jegadeesh, N., and Livnat, J., 2006. Revenue surprises and
market reactions to revenue and expense surprises. Review stock returns. Journal of Accounting and Economics, 41,
of Accounting Studies, 8, 185–211. 147–171.
Givoly, D., and Hayn, C., 2000. The changing time-series Securities and Exchange Commission (SEC), 1999. Revenue
properties of earnings, cash flows and accruals: Has recognition. Staff Accounting Bulletin No. 101. Washington
financial reporting become more conservative? Journal of DC: Government Printing Office.
Accounting and Economics, 29, 287–320. Wagenhofer A., 2014. The role of revenue recognition in
IASB, 2010. The Conceptual Framework for Financial Reporting. performance reporting. Accounting and Business Research, 44,
London: IASB. 349–379.

5 Provisions, contingent
liabilities and contingent
assets
ACCOUNTING IAS 37 Provisions, Contingent Liabilities and Contingent Assets
STANDARDS
IN FOCUS

OBJECTIVES
1 describe the background to IAS 37
2 identify which items are included within the scope of the standard
3 outline the concept of a provision
4 discuss how to distinguish provisions from other liabilities
5 outline the concept of a contingent liability
6 describe how to distinguish a provision from a contingent liability
7 explain when a provision should be recognised
8 explain how a provision, once recognised, should be measured
9 apply the definitions, recognition and measurement criteria for provisions and contingent
liabilities to practical situations
10 outline the concept of a contingent asset
11 describe the disclosure requirements for provisions, contingent liabilities and contingent assets
12 compare the requirements of IFRS 3 regarding contingent liabilities with those of IAS 37
13 explain the expected future developments for IAS 37.
CHAPTER 5 Provisions, contingent liabilities and contingent assets 95

LO1 5.1 INTRODUCTION TO IAS 37
IAS 37 deals with the recognition, measurement and presentation of provisions, contingent liabilities
and contingent assets. In 2005, the International Accounting Standards Board (IASB®) added a project on
amending IAS 37 to its agenda and subsequently issued an exposure draft in June 2005. After obtaining and
considering feedback from constituents, the IASB issued a second exposure draft in January 2010. However,
the project was suspended, pending the outcome of the Board’s 2011 consultation on its future agenda.
The IASB decided in May 2012 to initiate a research programme which includes the topic of non-
financial liabilities. At the time of writing, the IASB has issued an exposure draft proposing the revision
of its Conceptual Framework. One of the proposed changes is the revised definition of a liability (see
chapter 1).
Therefore, IAS 37 remains largely unchanged since its original issue date of 1998 by the IASC. This
chapter addresses the standard and its related interpretations in effect at 1 January 2015.
The standard:
• defines provisions and specifies recognition criteria and measurement requirements for the recognition
of provisions in financial statements
• defines contingent liabilities and contingent assets and prohibits their recognition in the financial
statements but requires their disclosure when certain conditions are met
• requires that where provisions are measured using estimated cash flows the cash flows be discounted to
their present value at the reporting date and specifies the discount rate to be used for this purpose
• prohibits providing for future operating losses
• defines onerous contracts and requires the estimated net loss under onerous contracts to be provided
for
• specifies recognition criteria for restructuring provisions and identifies the types of costs that may be
included in restructuring provisions
• requires extensive disclosures relating to provisions, recoveries, contingent liabilities and contingent
assets.
LO2 5.2 SCOPE

IAS 37 prescribes the accounting and disclosure for all provisions, contingent liabilities and contingent
assets except:
(a) those resulting from financial instruments (see chapter 7) and those arising in insurance entities from
contracts with policy holders
(b) those resulting from executory contracts, except where the contract is onerous (Executory contracts are
contracts under which neither party has performed any of its obligations or both parties have partially
performed their obligations to an equal extent.)
(c) those specifically covered by another IAS®/IFRS® Standard. For example, certain types of provisions are
also addressed in standards on:
• income taxes (see IAS 12 Income Taxes, covered in chapter 6)
• leases (see IAS 17 Leases, covered in chapter 12. However, as IAS 17 contains no specific requirements
to deal with operating leases that have become onerous, IAS 37 applies to such cases.)
• employee benefits (see IAS 19 Employee Benefits)
• insurance contracts (see IFRS 4 Insurance Contracts).
Some amounts sometimes described as provisions may relate to the recognition of revenue; for example,
where an entity gives guarantees in exchange for a fee. This may also be described as ‘deferred revenue’. IAS
37 does not address the recognition of revenue. IFRS 15 Revenue from Contracts with Customers identifies
the circumstances in which revenue is recognised and provides practical guidance on the application of the
recognition criteria (see chapter 4).
Sometimes the term ‘provision’ is also used in the context of items such as depreciation, impairment of
assets and doubtful debts. These are adjustments to the carrying amounts of assets and are not addressed
in IAS 37. Refer to IAS 36 Impairment of Assets, which is covered in chapter 15.
Other standards specify whether expenditures are treated as assets or as expenses. These issues are not
addressed in IAS 37. However, this issue has been discussed by the IFRS Interpretations Committee in the
context of levies imposed by governments. The Committee spent considerable time debating this issue and
eventually decided not to address this in IFRIC 21 Levies, which is covered in section 5.9.5. Accordingly, IAS
37 neither prohibits nor requires capitalisation of the costs recognised when a provision is made. Refer to
IAS 38 Intangible Assets, which deals partly with this issue, and is covered in chapter 13.
IAS 37 applies to provisions for restructuring (including discontinued operations). Where a restruc-
turing meets the definition of a discontinued operation, additional disclosures may be required by IFRS
5 Non-current Assets Held for Sale and Discontinued Operations. IFRS 3 Business Combinations deals with
accounting for restructuring provisions arising in business combinations. This chapter covers the relevant
requirements of IFRS 3 in section 5.12.
96 PART 2 Elements
LO3 5.3 DEFINITION OF A PROVISION
Paragraph 4.4 of the current Conceptual Framework for Financial Reporting (Conceptual Framework) defines a
liability as:
a present obligation of the entity arising from past events, the settlement of which is expected to result in an
outflow from the entity of resources embodying economic benefits.
This definition is repeated in paragraph 10 of IAS 37.
A provision is a subset of liabilities (i.e. it is a type of liability) which is of uncertain timing or amount
in accordance with paragraph 10 of IAS 37.
It is this uncertainty that distinguishes provisions from other liabilities.
The current Conceptual Framework states that an essential characteristic of a liability is that the entity has
a present obligation. An obligation is a duty or responsibility to act or perform in a certain way. Obliga-
tions may be legally enforceable as a consequence of a binding contract, for example. This is normally
the case with amounts payable for goods or services received, which are described as ‘payables’ or ‘trade
creditors’. However, legal enforceability is not a necessary requirement to demonstrate the existence of a
liability. An entity may have a constructive obligation, arising from normal business practice or custom,
to act in an equitable manner. Determining whether a constructive obligation exists is often more difficult
than identifying a legal obligation. A constructive obligation is defined as an obligation that derives from
an entity’s actions where an established pattern of past practice (including published or sufficiently specific
current statements) indicates to other parties that the entity will accept certain responsibilities, conse-
quently creating a reasonable expectation from those parties that the entity will discharge those responsi-
bilities (IAS 37 paragraph 10).
A present obligation exists only where the entity has no realistic alternative but to settle the obligation
(Conceptual Framework paragraph 4.16).
For example, assume that an entity makes a public announcement that it will match the financial
assistance provided by other entities to victims of a natural disaster and, because of past practice and
moral considerations, has no realistic alternative but to provide the assistance. In this case the events
have already taken place — the natural disaster — and the public announcement is the obligating
event.
Importantly, a decision by the entity’s management or governing body does not, in itself, create
a constructive obligation. This is because the management or governing body retains the ability to
reverse that decision. A present obligation would come into existence when the decision was com-
municated publicly to those affected by it. This would result in the valid expectation that the entity
would fulfil the obligation, thus leaving the entity with little or no discretion to avoid the outflow of
economic benefits.
LO4 5.4 DISTINGUISHING PROVISIONS FROM

OTHER LIABILITIES
A provision may arise from either a legal or constructive obligation. As stated previously, the key distin-
guishing factor is the uncertainty relating to either the timing of settlement or the amount to be settled.
Paragraph 11 of IAS 37 illustrates the distinction between liabilities and provisions. The first example
used for the illustration is trade payables to suppliers, which are certain in both timing and amount. The
second example used is accruals, such as accrued vacation pay, which may not be as certain in terms of
timing and amount, but the uncertainty is generally much less than for provisions. Accruals are generally
reported as part of trade and other payables, whereas provisions are reported separately.
Note, however, that employee benefits are addressed specifically by IAS 19 Employee Benefits, and are not
included in the scope of IAS 37, as mentioned in section 5.2.
Some examples of typical provisions include provisions for warranty, restructuring provisions and provi-
sions for onerous contracts. These are discussed in more detail later in this chapter.
LO5 5.5 DEFINITION OF A CONTINGENT LIABILITY

A contingent liability is defined in the standard as:
(a) a possible obligation that arises from past events and whose existence will be confirmed only by the occur-
rence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle
the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
The definition of a contingent liability is interesting because it encompasses two distinctly different con-
cepts. The first, part (a) of the definition, is the concept of a possible obligation. This seemingly fails one
of the essential characteristics of a liability — the requirement for the existence of a present obligation. If

there is no present obligation, only a possible one, there is no liability. Hence, part (a) of the definition
does not meet the definition of a liability which may lead one to argue that the term ‘contingent liability’
is misleading, because items falling into category (a) are not liabilities by definition.
Part (b) of the definition, on the other hand, deals with liabilities that fail the recognition criteria.
They are present obligations, so they meet the essential requirements of the definition of liabilities, but
they do not meet the recognition criteria (probability of outflow of economic benefits and reliability of
measurement).
However, the definition needs to be considered together with the criteria for recognising a provision in
the standard. A possible obligation whose existence is yet to be confirmed does not meet the definition of
a liability; and a present obligation in respect of which an outflow of resources is not probable, or which
cannot be measured reliably, does not qualify for recognition. On that basis a contingent liability under
IAS 37 means one of the following:
• an obligation that is estimated to have less than a 50% likelihood of existing (i.e. it does not meet the
definition of a liability). Where it is more likely than not that a present obligation exists at the end of
the reporting period, a provision is recognised (see IAS 37 paragraph 16(a)). Where it is more likely
than not that no present obligation exists, a contingent liability is disclosed (unless the possibility is
remote); or
• a present obligation that has less than a 50% likelihood of requiring an outflow of economic benefits
(i.e. it meets the definition of a liability but does not meet the recognition criteria). Where it is not
probable that there will be an outflow of resources, an entity discloses a contingent liability (unless the
possibility is remote); or
• a present obligation for which a sufficiently reliable estimate cannot be made (i.e. it meets the
definition of a liability but does not meet the recognition criteria). In these rare circumstances, a
liability cannot be recognised and it is disclosed as a contingent liability (see IAS 37 paragraph 26).
LO6 5.6 DISTINGUISHING A CONTINGENT LIABILITY FROM

A PROVISION
As mentioned previously, contingent liabilities are not recognised in the financial statements but must be
disclosed in the financial statements unless the possibility of an outflow in settlement is remote. All pro-
visions can be seen as being ‘contingent’, however, as they are uncertain in timing or amount. However,
in the context of this standard, the term ‘contingent’ specifically refers to liabilities and assets that are not
recognised because their existence can only be confirmed by the occurrence or non-occurrence of one or
more uncertain future events that are not wholly within the control of the entity. A contingent liability in
IAS 37 also refers to a liability that does not meet the recognition criteria.
Illustrative example 5.1 illustrates the difference between a contingent liability and a provision.
ILLUSTRATIVE EXAMPLE 5.1 Example of the difference between a provision and a contingent liability
Legal proceedings against Lemon Pharma Co. started after several people became ill, possibly as a result
of taking the health supplements manufactured and sold by Lemon. Lemon disputes any liability and, up
to the authorised date of issue of its financial statements for 31 December 2015, its lawyers have advised
that it is probable that Lemon will not be found liable. However, when Lemon prepares its financial state-
ments for 31 December 2016, its lawyers advise that, owing to the developments in the case, it is probable
that Lemon will be found liable and a reliable estimate of the amount of damages can be made.
For 31 December 2015, no provision is recognised and the matter is disclosed as a contingent liability
unless the probability of any outflow is regarded as remote. On the basis of the evidence available when
the financial statements were approved, there is no obligation as a result of a past event.
For 31 December 2016, a provision is recognised for the best estimate of the amount required to
settle the obligation. The fact that an outflow of economic benefits is now believed to be probable and a
reliable estimate can be made means that this is no longer a contingent liability, but a provision.
LO7 5.7 THE RECOGNITION CRITERIA FOR PROVISIONS

The recognition criteria for provisions are the same as those for liabilities as set out in the Conceptual
Framework. IAS 37 also includes part of the definition of a liability in its recognition criteria for provisions
(part (a) of the recognition criteria below).
98 PART 2 Elements
Paragraph 14 of IAS 37 requires a provision to be recognised when:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the
obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
If these conditions are not met, no provision shall be recognised.
The concept of probability is discussed in the Conceptual Framework and deals essentially with
the likelihood of something eventuating. If it is more likely than not to eventuate, IAS 37 regards
the outflow as probable. Probability is assessed for each obligation separately, unless the obligations
form a group of similar obligations (such as product warranties) in which case the probability that
an outflow will be required in settlement is determined by assessing the class of obligations as
a whole.
In instances of rare cases where it is unclear whether a present obligation exists, a past event is
deemed to give rise to a present obligation if, taking account of all available evidence, it is more
likely than not that a present obligation exists at the end of the reporting period, For example in
a law suit, it may be disputed either whether certain events have occurred or whether those events
result in a present obligation. In such a circumstance, an entity determines whether a present obliga-
tion exists at the end of the reporting period by taking all available evidence into account, including,
for example, the opinion of experts. The evidence considered includes any additional evidence pro-
vided by events after the end of the reporting period. On the basis of such evidence, where it is more
likely than not that a present obligation exists at the end of the reporting period, a provision is rec-
ognised, provided the recognition criteria are met. Alternatively, if it is more likely that no present
obligation exists at the end of the reporting period, the entity discloses a contingent liability, unless
the possibility of an outflow of resources embodying economic benefits is remote, in which case no
disclosure is made.
A past event that leads to a present obligation is called an obligating event. As discussed in the
section on constructive obligations, for an event to be an obligating event the entity must have no real-
istic alternative to settling the obligation created by the event. In the case of a legal obligation this
is because the settlement of the obligation can be enforced by law. In the case of a constructive obli-
gation the event needs to create a valid expectation in other parties that the entity will discharge the
obligation.
Reliable estimation is the final criterion for recognition of a provision. Although the use of estimates is
a necessary part of the preparation of financial statements, in the case of provisions the uncertainty asso-
ciated with reliable measurement is greater than for other liabilities. Accordingly, IAS 37 goes on to give
more detailed guidance on measurement of provisions, which we will discuss later in the chapter. However,
it is expected that except in very rare cases an entity will be able to determine a reliable estimate of the
obligation.
Note the use of the concept of ‘probability’ in the recognition criteria for liabilities, including provi-
sions, contrasted with the use of the concept of ‘possibility’ in determining whether or not a contingent
liability should be disclosed. Paragraph 86 of IAS 37 requires contingent liabilities to be disclosed in
the financial statements ‘unless the possibility of an outflow in settlement is remote’. IAS 37 interprets
‘probable’ as meaning more likely than not to occur (IAS 37 paragraph 23). IAS 37 does not, however,
provide any further guidance on what it means by ‘possibility’. In plain English terms, ‘probability’
addresses the likelihood of whether or not something will happen, whereas ‘possibility’ has a broader
meaning — virtually anything is possible, but how probable is it? Given this distinction, we should
assume that the intention of IAS 37 is that most contingent liabilities should be disclosed and that only
in very rare circumstances is no disclosure appropriate.
Contingent liabilities need to be continually assessed to determine whether or not they have become
actual liabilities. This is done by considering whether the recognition criteria for liabilities have been met.
If it becomes probable that an outflow of economic benefits will be required for an item previously dealt
with as a contingent liability, a provision is recognised in the financial statements in the period in which
the change in probability occurs (IAS 37 paragraph 30).
5.7.1 Putting it all together — a useful decision tree

In sections 5.3 to 5.7 we discussed the definitions of provisions and contingent liabilities, the recognition
criteria for provisions and when a contingent liability must be disclosed. The decision tree (figure 5.1)
summarises this discussion. The decision tree is based on Appendix B of IAS 37 but has been modified to
aid understanding.

Start
DEFINITION
Present obligation arises

as a result of a past
event?
YES UNCLEAR NO
Is the outflow NO Liability fails recognition Possible liability exists, Neither a provision
of economic benefits
RECOGNITION
criteria, classified as a classified as a nor a contingent

probable? contingent liability contingent liability liability exists
YES
NO Liability fails recognition Is the possibility NO

Reliable estimate? criteria, classified as a of outflow higher
contingent liability than remote?
YES YES
Recognition Disclose contingent liability Do nothing
FIGURE 5.1 Decision tree
LO8 5.8 MEASUREMENT OF PROVISIONS

5.8.1 Best estimate
When measuring a provision, the amount recognised should be the best estimate of the consideration
required to settle the present obligation at the end of the reporting period (IAS 37 paragraph 36). This
amount is often expressed as the amount which represents, as closely as possible, what the entity would
rationally pay to settle the present obligation at the end of the reporting period or to provide considera-
tion to a third party to assume it. The fact that it is difficult to measure the provision and that estimates
have to be used does not mean that the provision is not reliably measurable.
The standard provides guidance on estimation of a provision which involves a large population of
items. In such circumstances, the obligation is estimated using the expected value method, i.e. weighting
all possible outcomes by their associated probabilities. For example, in January 20X1 Taiwan Imports sells
10 000 units of good Y with a 1-year warranty which covers manufacturing defects that become apparent
within the first 12 months after purchase. If minor defects are detected, repair costs of $200 per unit of
good Y would result. If major defects are detected, repair costs of $1000 per unit of good Y would result.
Taiwan Import’s past experience and future expectations indicate that, for the coming year, 85% of the
goods sold will have no defects, 10% of the goods sold will have minor defects and 5% of the goods sold
will have major defects. Therefore Taiwan Imports assesses the probability of an outflow for the warranty
obligations as a whole. The expected value of the cost of repairs will be (85% of nil) + (10% of ($200 ×
10 000)) + (5% of ($1000 × 10 000)) = $700 000.
In situations where there is only one single obligation to measure, the individual most likely outcome
may be the best estimate of the liability. However, the entity has to consider other possible outcomes
as well. Where other possible outcomes are either mostly higher or mostly lower than the most likely
100 PART 2 Elements

outcome, the best estimate will be a higher or lower amount. For example, if an entity has to rectify a
serious fault in a major plant that it has constructed for a customer, the individual most likely outcome
may be for the repair to succeed at the first attempt at a cost of €100 000, but a provision for a larger
amount is made if there is a significant chance that further attempts might be necessary.
The provision is measured before tax. Any tax consequences are accounted for in accordance with IAS
12 Income Taxes.
The need to use judgement in determining the best estimate is clearly evident. Judgement is used in
assessing, inter alia:
• what the likely consideration required to settle the obligation will be
• when the consideration is likely to be settled
• whether there are various scenarios that are likely to arise
• what the probability of those various scenarios arising will be.
The distinguishing characteristic of provisions — the uncertainty relating to either the timing of settle-
ment or the amount to be settled — is clearly illustrated in the above discussion. Because of the extent of
judgement required in measuring provisions, auditors focus more on auditing provisions than on other
normal liabilities such as trade creditors and accruals. This is particularly the case if a change in one of
the assumptions, such as the probability of a particular scenario eventuating or the likely consideration
required to settle the obligation, could have a significant impact on the amount recognised as a provision
and thus on the financial statements.
5.8.2 Risks and uncertainties

IAS 37 paragraph 42 requires that the risks and uncertainties surrounding the events and circumstances
should be taken into account in reaching the best estimate of a provision. The standard also requires a
risk adjustment to be made when measuring liabilities. However, uncertainty is not a justifiable reason for
making excessive provisions or deliberately overstating liabilities.
Furthermore, disclosure of the uncertainties surrounding the amount or timing of expected outflows is
required by paragraph 85(b) of the standard.
5.8.3 Present value

Provisions are required to be discounted to present value where the effect of discounting is material (IAS 37
paragraph 45). IAS 37 (paragraph 47) requires that the discount rate used must be a pre-tax rate that reflects
current market assessments of the time value of money and the risks specific to the liability. Where future cash
flow estimates have been adjusted for risk, the discount rate should not reflect this risk — otherwise the
effect of risk would be double-counted.
In practical terms it is often difficult to determine reliably a liability-specific discount rate. Usually enti-
ties use a rate available for a liability with similar terms and conditions or, if a similar liability is not avail-
able, a risk-free rate for a liability with the same term (e.g. a government bond1 with a 5-year term may be
used as the basis for a company’s specific liability with a 5-year term) and this rate is then adjusted for the
risks pertaining to the liability in question.
The mechanism for risk-adjusting a discount rate may seem counterintuitive at first as a risk-adjusted
rate for a liability would be a lower rate than the risk-free rate. This is demonstrated and further explained
in illustrative example 5.2.
ILLUSTRATIVE EXAMPLE 5.2 Calculation of a risk-adjusted rate
A company has a provision for which the expected value of the cash outflow in 3 years’ time is £150 and
the risk-free rate is 5%. However, the possible outcomes from which the expected value has been deter-
mined lie within a range between £100 and £200. The company is risk-averse and would settle instead for
a certain payment of, say, £160 in 3 years’ time rather than be exposed to the risk of the actual outcome
being as high as £200. The effect of risk in calculating present value can be expressed as either:
(a) discounting the risk-adjusted cash flow of £160 at the risk-free (unadjusted) rate of 5%, giving a
present value of £138; or
(b) discounting the expected cash flow (which is unadjusted for risk) of £150 at a risk-adjusted rate that
will give the present value of £138, i.e. a rate of 2.8%.
As can be seen from this example, the risk-adjusted discount rate is a lower rate than the unadjusted
(risk-free) discount rate. This may seem counterintuitive initially, because the experience of most borrowers
is that lenders will charge a higher rate of interest on loans that are assessed to be higher risk to the lender.
However, in the case of a provision a risk premium is being suffered to eliminate the possibility of the
1 Assumed
to be risk-free although this may not always be the case.

actual cost being higher (thereby capping a liability), whereas in the case of a loan receivable a premium is
required to compensate the lender for taking on the risk of not recovering its full value (setting a floor for
the value of the lender’s financial asset). In both cases the actual cash flows incurred by the paying entity
are higher to reflect a premium for risk. In other words, the discount rate for an asset is increased to reflect
the risk of recovering less and the discount rate for a liability is reduced to reflect the risk of paying more.
Perhaps an easier way to factor in risk is to use it in assessing the probability of outcomes (as discussed in
section 5.8.1) and then use a risk-free rate in discounting the cash flows. Paragraph 83 of IAS 19 Employee
Benefits requires the discount rate for long-term employee benefit obligations to be determined by refer-
ence to market yields at the end of the reporting period on high-quality corporate bonds or, where there
is no deep market in such bonds, the market yield on government bonds. The currency and term of
the corporate bonds or government bonds should be consistent with the currency and estimated term of
the employee benefit obligations. Although there may be some debate about how to determine the risk-free
rate, market yields on high-quality corporate bonds or government bonds could serve as a reasonable basis
for assessing the risk-free rate.
Illustrative example 5.3 shows the way a provision should be measured, taking into account risks and
the time value of money.
ILLUSTRATIVE EXAMPLE 5.3 Measuring a provision
Iconic plc estimates that the expected cash outflows to settle its warranty obligations at the end of the
reporting period are as follows. (Note that the probability of cash outflows has already been adjusted for
risk and, accordingly, no further adjustment for risk is made to the discount rate.) Iconic plc has used
a discount rate based on government bonds with the same term and currency as the expected cash out-
flows as a proxy for the risk-free rate.
Expected cash outflow Timing Discount rate Present value of cash outflow
£400 000 In 1 year 6.0% £377 358
100 000 In 2 years 6.5% 88 166
20 000 In 3 years 6.9% 16 371
Present value 481 895
5.8.4 Future events

Anticipated future events expected to affect the amount required to settle the entity’s present obligation
must be reflected in the amount provided, when there is reliable evidence that they will occur. For example,
an entity may believe that the cost of cleaning up a site at the end of its life will be reduced by future
changes in technology. The amount recognised reflects a reasonable expectation of technically qualified,
objective observers, taking account of all available evidence as to the technology that will be available at
the time of the clean-up. Therefore, it is appropriate to include, for example, expected cost reductions asso-
ciated with increased experience in applying existing technology or the expected cost of applying existing
technology to a larger or more complex clean-up operation than has previously been carried out.
5.8.5 Expected disposal of assets

Gains from the expected disposal of assets must not be taken into account when measuring the amount
of a provision (IAS 37 paragraph 51), even if the expected disposal is closely linked to the event giving
rise to the provision. Rather, when the gain on disposal is made, it should be recognised at that time, in
accordance with the relevant IFRS. Therefore, it is clear that only expected cash outflows must be taken into
account in measuring the provision. Any cash inflows are treated separately from the measurement of the
provision.
5.8.6 Reimbursements
When some of the amount required to settle a provision is expected to be recovered from a third party,
IAS 37 requires that the recovery be recognised as an asset, but only when it is virtually certain that the
102 PART 2 Elements

reimbursement will be received if the entity settles the obligation (paragraph 53). This differs from the
normal asset recognition criteria, which require that the inflow of future economic benefits be probable.
Presumably, the standard setters were concerned with recognition of an uncertain asset related to a liability
of uncertain timing and amount, and therefore decided to make the recognition criteria stricter for these
types of assets to avoid variability in the balance sheet. When such an asset is recognised, the amount
should not exceed the amount of the provision. No ‘netting off’ is allowed in the statement of financial
position, with any asset classified separately from any provision in accordance with paragraph 53 of IAS
37. However, IAS 37 allows the income from the asset to be set off against the expense relating to the pro-
vision in the income statement.
5.8.7 Changes in provisions and use of provisions

IAS 37 requires provisions to be reviewed at the end of each reporting period and adjusted to reflect the
current best estimate. If it is no longer probable that an outflow of resources embodying economic benefits
will be required to settle the obligation, the provision should be reversed (IAS 37 paragraph 59).
Where discounting is used, the carrying amount of a provision increases in each period to reflect the
passage of time. This increase is recognised as borrowing cost. This is similar to the way finance lease lia-
bilities are accounted for under IAS 17 Leases, as shown in chapter 12.
A provision should be used only for expenditures for which the provision was originally recognised.
Illustrative example 5.4 shows how a provision is accounted for where discounting is applied and where
the provision is adjusted to reflect the current best estimate.
ILLUSTRATIVE EXAMPLE 5.4 Accounting for a provision
Weber AG estimates that it will be required to pay €100 000 in 3 years’ time to settle a warranty obliga-
tion. The risk-free discount rate applied is 5.5%. The probability of cash outflows has been assessed (i.e.
adjusted for risk) in determining the €100 000.
The following table shows how the provision is accreted over the 3 years:
B. C. E.
A. Present value at the Interest expense at D. Present value at the end
Year beginning of the year 5.5% (B × 5.5%) Cash flows of the year (B + C − D)
1 85 161 4 683 — 89 844

2 89 844 4 942 — 94 786
3 94 786 5 214 (100 000) —
Journal entries are as follows:
On initial recognition in year 1:

Warranty Expense Dr 85 161
Warranty Provision Cr 85 161
On recognition of interest in year 1:

Interest Expense Dr 4 683


On settlement of provision, end of year 3:

Warranty Provision Dr 100 000
Cash Cr 100 000
Now assume the same facts as above except that, at the end of year 2, Weber AG re-estimates the
amount to be paid to settle the obligation at the end of year 3 to be €90 000. The appropriate discount
rate remains at 5.5%.

The present value of €90 000 at the end of year 2 is €85 306. Company A thus adjusts the provision by
€9480 (€94 786 − €85 306) to reflect the revised estimated cash flows.
Journal entries are as follows:
Revision of estimate at end of year 2:

Warranty Expense (statement of
comprehensive income) Cr 9 480

Interest Expense (€85 306 × 5.5% rounded) Dr 4 694
On settlement of provision, end of year 3:

Cash Cr 90 000
The re-estimated cash flows are adjusted against the warranty expense recorded in the statement
of comprehensive income, while the unwinding of the discount continues to be recorded as interest
expense (IAS 37 paragraph 60). Any change in the discount rate used would also be adjusted against
interest expense.
LO9 5.9 APPLICATION OF THE DEFINITIONS,

RECOGNITION AND MEASUREMENT RULES
5.9.1 Future operating losses
IAS 37 disallows recognition of provisions for future operating losses (paragraph 63). Even if a
sacrifice of future economic benefits is expected, a provision for future operating losses is not recog-
nised because a past event creating a present obligation has not occurred. This is because the enti-
ty’s management will generally have the ability to avoid incurring future operating losses by either
disposing of or restructuring the operation in question. An expectation of future operating losses may,
however, be an indicator that an asset is impaired and the requirements of IAS 36 Impairment of Assets
should be applied.
5.9.2 Onerous contracts

IAS 37 defines an onerous contract as a contract in which the unavoidable costs of meeting the obligations
under the contract exceed the economic benefits expected to be received under it.
If an entity is a party to an onerous contract, a provision for the present obligation under the
contract must be recognised (IAS 37 paragraph 66). The reason these losses should be provided for is
that the entity is contracted to fulfil the contract. Therefore an onerous contract gives rise to a present
obligation.
Examples of onerous contracts include:
• where an electricity supplier has entered into a contract to supply electricity at a price lower than the
price at which it is contracted to receive
• where a manufacturer has entered into a supply contract to provide goods to a customer at a price
below its costs of production.
IAS 37 does not go into a lot of detail regarding onerous contracts. Judgement has to be applied on
a case-by-case basis to assess whether or not individual contracts qualify as onerous contracts under the
standard.
For the purpose of raising a provision in respect of an onerous contract, the amount to be recognised is
the least net cost of exiting the contract; that is, the lesser of:
• the cost of fulfilling the contract, and
• any compensation or penalties arising from failure to fulfil the contract.
IAS 37 also requires that before a separate provision is made for an onerous contract, an entity must
first recognise any impairment loss that has occurred on assets dedicated to that contract. This is shown in
illustrative example 5.5.
104 PART 2 Elements

ILLUSTRATIVE EXAMPLE 5.5 Accounting for an onerous contract
Alpha Ltd enters into a supply agreement with Beta Ltd on 1 January 2015. The agreement states that
Alpha Ltd must supply Beta Ltd with 100 chairs at a price of $150 per chair. The agreement also states
that if Alpha Ltd cannot deliver the chairs on time and under the terms of the contract it must pay Beta
Ltd a penalty of $12 000. The delivery date is 31 March 2015. Alpha Ltd commences manufacturing the
chairs on 1 March and experiences a series of production problems that result in the cost to produce
each chair totalling $200 as at 31 March 2015. As at 31 March, Alpha Ltd identifies an onerous contract
in accordance with IAS 37 because the costs of fulfilling the contract (100 × $200 = $20 000) exceed
the agreed amount to be received (100 × $150 = $15 000). The cost of the chairs is recognised as inven-
tory as at 31 March 2015. Assuming the end of Alpha Ltd’s reporting period is 31 March, it must first
recognise an impairment loss on the inventory. This would be calculated and recorded as $5000 (lower
of cost and net realisable value (ignoring costs to sell) under IAS 2 Inventories — see chapter 9). Once
this impairment loss has been recognised, there is no amount to be recorded as a provision under the
onerous contract. However, if Alpha Ltd had not yet recorded any costs as inventory it would need to
determine what amount to recognise as a provision for the onerous contract. This would be the lesser
of the penalty required to be paid to Beta Ltd ($12 000) and the cost of fulfilling the contract ($5000,
which is only to the extent that costs are not covered by related revenues). Thus, Alpha Ltd would record
a provision of $5000.
5.9.3 Restructuring provisions

Perhaps one of the more controversial aspect of IAS 37 is the recognition criteria for restructuring pro-
visions. IFRS 3 Business Combinations addresses restructuring provisions arising as part of a business
combination, whereas IAS 37 addresses restructuring provisions arising other than as part of a business
combination. Although the fundamental criteria are consistent, i.e. only liabilities for restructuring or exit
activities that meet the definition of a liability at acquisition date are recognised as liabilities, see IFRS 3
Basis for Conclusions BC132, IFRS 3 has more prescriptive requirements than IAS 37. For ease of discussion,
both types of restructuring provision are discussed here.
During the 1990s, standard setters in various jurisdictions set tougher rules on when a restructuring
provision could be recognised, particularly when the provision related to the acquisition of a business. The
reason for stricter requirements was the tendency for companies to create restructuring provisions deliber-
ately to avoid the recognition of an expense in future periods. Illustrative example 5.6 demonstrates this
point.
ILLUSTRATIVE EXAMPLE 5.6 Restructuring provisions
Assume Presto SpA acquires Costa SpA on 1 February 2013. The identifiable net assets and liabilities
of Costa SpA are €400 million and Presto SpA pays €500 million cash as purchase consideration. The
goodwill arising on acquisition is thus €100 million. Presto SpA then decides to create a restructuring
provision of €60 million for future possible restructuring activities related to Costa SpA. Presto SpA
records the following additional entry as part of its acquisition accounting entries:
Goodwill Dr 60 m
Restructuring Provision Cr 60 m
Why does Presto SpA have an incentive to record this entry? The entry increases the amount recorded
as goodwill, and in the 1990s goodwill was required to be amortised in most jurisdictions. Why would
Presto SpA want to expose itself to future goodwill amortisation? The answer is that because the restruc-
turing provision was recorded directly against goodwill, an expense for the restructuring will never be
recorded. When Presto SpA incurs the expenditure in the future, the outflows will be recorded against
the provision. Presto SpA would likely have been able to highlight goodwill amortisation as a separate
item either in its statement of comprehensive income or the attached notes, and thus would have been
satisfied that the amortisation expense was effectively quarantined from the rest of its reported profit.
The benefit for Presto SpA was that the restructuring expense never affected its profit, and thus the crea-
tion of the restructuring provision as part of the acquisition entries protected Presto SpA’s future profits.

Examples of restructurings include:
(a) sale or termination of a line of business;
(b) the closure of business locations in a country or region or the relocation of business activities from one
country or region to another;
(c) changes in management structure, for example, eliminating a layer of management; and
(d) fundamental reorganisations that have a material effect on the nature and focus of the entity’s operations.
In broad terms, to be able to raise a restructuring provision, three conditions need to be met. First, the
entity must have a present obligation (either legal or constructive) to restructure such that it cannot realistically
avoid going ahead with the restructuring and thus incurring the costs involved. Second, only costs that are
directly and necessarily caused by the restructuring and not associated with the ongoing activities of the entity
may be included in a restructuring provision. Third, if the restructuring involves the sale of an operation,
no obligation is deemed to arise for the sale of an operation until the entity is committed to the sale by a
binding sale agreement.
Each of these requirements is considered in more detail below.
Present obligation
Usually management initiates a restructuring and thus it is uncommon that a legal obligation will exist
for a restructuring. IAS 37 therefore focuses on the conditions that need to be met for a constructive obli-
gation to exist.
In respect of restructuring provisions, a constructive obligation to restructure arises only when an entity:
(a) has a detailed formal plan for the restructuring identifying at least:
(i) the business or part of a business concerned;
(ii) the principal locations affected;
(iii) the location, function, and approximate number of employees who will be compensated for termi-
nating their services;
(iv) the expenditures that will be undertaken; and
(v) when the plan will be implemented; and
(b) has raised a valid expectation in those affected that it will carry out the restructuring by starting to imple-
ment that plan or announcing its main features to those affected by it (see IAS 37 paragraph 72).
Therefore, we see that the entity needs to have a detailed formal plan and must have raised a valid expec-
tation in those affected.
Recording restructuring provisions
Where a provision for restructuring costs arises on the acquisition of an entity, judgement is required as
to whether the restructuring activities form part of the liabilities assumed in accounting for the business
combination. Illustrative example 5.7 demonstrates this issue further.
ILLUSTRATIVE EXAMPLE 5.7 Recognition or otherwise of a restructuring liability as part of a business combination
The acquirer and the acquiree (or the vendors of the acquiree) enter into an arrangement before the
acquisition that requires the acquiree to restructure its workforce or activities. They intend to develop
the main features of a plan that involve terminating or reducing its activities and to announce the plan’s
main features to those affected by it so as to raise a valid expectation that the plan will be implemented.
The combination is contingent on the plan being implemented.
Does such a restructuring plan that the acquiree puts in place simultaneously with the business com-
bination, i.e. the plan is effective upon the change in control, but was implemented by or at the request
of the acquirer, qualify for inclusion as part of the liabilities assumed in accounting for the business
combination?
The facts to be analysed are:
(a) the reason: a restructuring plan implemented at the request of the acquirer is presumably arranged
primarily for the benefit of the acquirer or the combined entity because of the possible redundancy
expected to arise from the combination of activities of the acquirer with activities of the acquiree, e.g.
capacity redundancy leading to closure of the acquiree’s facilities;
(b) who initiated: if such a plan is the result of a request of the acquirer, it means that the acquirer is
expecting future economic benefits from the arrangement and the decision to restructure;
(c) the timing: the restructuring plan is usually discussed during the negotiations; therefore, it is contem-
plated in the perspective of the future combined entity.
Accordingly, a restructuring plan that is implemented as a result of an arrangement between the
acquirer and the acquiree is not a liability of the acquiree as at the date of acquisition and cannot be
part of the accounting for the business combination under the acquisition method.
Does the answer differ if the combination is not contingent on the plan being implemented?
The answer applies regardless of whether the combination is contingent on the plan being imple-
mented or not. A plan initiated by the acquirer will most likely not make commercial sense from the
acquiree’s perspective absent the business combination. For example, there are retrenchments of staff
106 PART 2 Elements

whose position will only truly become redundant once the entities are combined. In that case, this is an
arrangement to be accounted for separately rather than as part of the business combination exchange.
This arrangement may also indicate that control of the acquiree has already passed to the acquirer as
otherwise there would be little reason for the acquiree to enter into an arrangement that makes little or
no commercial sense to it.
Source: Ernst & Young (2015).
Looking at the discussion in IAS 37 in more detail, in order to satisfy the ‘valid expectation’ test in IAS
37, an entity needs to have started to implement the detailed formal plan or announced the main features
to those affected by it. An entity can do this in the following ways:
• By the entity having already entered into firm contracts to carry out parts of the restructuring. These
contracts would be of such a nature that they effectively force the entity to carry out the restructuring.
This would be the case if they contained severe penalty provisions or the costs of not fulfilling the
contract were so high that it would effectively leave the entity with no alternative but to proceed.
• By starting to implement the detailed restructuring. This could include, for example, selling assets,
notifying customers that supplies will be discontinued, notifying suppliers that orders will be ceasing,
dismantling plant and equipment, and terminating employees’ service.
• By announcing the main features of the plan to those affected by it (or their representatives). There
may be a number of ways in which such an announcement could be made. It could be through written
communication, meetings or discussions with the affected parties.
It is important that the communication is made in such a way that it raises a valid expectation in the
affected parties such that they can be expected to act as a result of the communication, and by them
doing so the entity would be left with no realistic alternative but to go ahead with the restructuring. For
example, affected employees would start looking for other employment and customers would seek alter-
native sources of supply.
Qualifying restructuring costs
The second requirement for recognition of a restructuring provision is that the provision can include only
costs that are directly and necessarily caused by the restructuring and not associated with the ongoing
activities of the entity (IAS 37 paragraph 80).
Examples of the types of costs that would be included in a restructuring provision include the costs of
terminating leases and other contracts as a direct result of the restructuring; costs of operations conducted
in effecting the restructuring, such as employee remuneration while they are engaged in such tasks as
dismantling plant, disposing of surplus stocks and fulfilling contractual obligations; and costs of making
employees redundant.
Paragraph 81 of IAS 37 specifically indicates that the types of costs excluded from provisions for restruc-
turing would be the costs of retraining or relocating the continuing staff, marketing costs and costs related
to investment in new systems and distribution networks. These types of costs relate to the future conduct
of the entity and do not relate to present obligations.
These requirements relating to the types of costs that qualify as restructuring costs apply equally to
internal restructurings as well as to restructurings occurring as part of an acquisition.
It is important to note that, although certain costs have occurred only because of restructuring (i.e. they
would not have had to be incurred had the restructuring not taken place), this fact alone does not qualify
them for recognition as restructuring costs. They also have to be costs that are not associated with the
ongoing activities of the entity.
Binding sale agreement
The final requirement for recognition of a restructuring provision is that if the restructuring involves the
sale of an operation, no obligation is deemed to arise for the sale until the entity is committed to the sale
by a binding sale agreement (IAS 37 paragraph 78). It is because, before there is a binding sale agreement,
an entity could change its mind or take another course of action if a purchaser cannot be found on accept-
able terms. For the treatment of non-current assets held for sale and discontinued operations, refer to IFRS 5
Non-current Assets Held for Sale and Discontinued Operations for further guidance.
5.9.4 Decommissioning provisions

When an entity is required to remove an asset at the end of its useful life and to restore the site where
it was located, these decommissioning costs are required to be provided for (see IAS 37 IE Example 3).
A provision is required to be recognised at the time the asset is being constructed as the environmental
damage requiring restoration in the future presumably starts at that point in time.
Using IE Example 3 from IAS 37, recognition of the provision starts at construction of the oil rig, to
reflect the need to reverse the damage caused. The total decommissioning cost as well as its timing is

estimated and subsequently discounted to its present value. This initial estimate of the costs to remove the
asset is added to the cost of the asset. Thereafter, the asset is depreciated over its useful life, while interest
is accrued on the provision, with the accrual shown as a finance cost.
For changes in estimates of the decommissioning provision, IAS 37 lacks relevant guidance, therefore
IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities was issued in May 2004 to
rectify this.
IFRIC 1 addresses:
(a) a change in the estimated outflow of resources embodying economic benefits (e.g. cash flows) required
to settle the obligation;
(b) change in the current market-based discount rate (including changes in time value of money and risks
specific to the liability); and
(c) an increase that reflects the passage of time (i.e. the unwinding of the discount).
For a change caused by (a) or (b), the adjustment is first taken to the carrying amount of the asset to
which it relates. If the adjustment gives rise to an addition to cost, the entity should test the new carrying
amount for impairment. Reductions that are over and above the remaining carrying amount of the asset
are recognised immediately in the income statement. The adjusted depreciable amount of the asset is then
depreciated prospectively over its remaining useful life (see IFRIC 1 paragraphs IE1–4).
A change caused by (c) above, the periodic unwinding of the discount, is recognised in profit or loss as
a finance cost as it occurs.
5.9.5 Levies
As a result of economic events in recent years, levies (e.g. bank levies) have become more common as gov-
ernments try to generate income from other sources. Issues have arisen regarding timing of when such lia-
bilities should be recognised, in which the obligation to pay depended upon participation in a particular
market on a specified date. IFRIC 21 Levies was issued in May 2013 to address these concerns.
The types and mechanisms of levies can be complex. The concerns regarding timing of recognition of
levies mainly surfaced as a result of how bank levies across various jurisdictions were calculated and meas-
ured. Typically, a bank levy is calculated based on the closing balances of the respective figures as stipu-
lated by legislation, at the last day of the annual reporting period. The question is whether the bank would
be able to estimate and accrue for the levy as it operates throughout the year.
IFRIC 21 clarifies that although an entity (such as the bank) could be economically compelled to con-
tinue operations, that does not mean the bank would have a constructive obligation to pay the levy, before
the obligating event to pay the levy occurs. Coming back to the bank levy example, assuming that in
accordance with legislation, the levy is only payable if the bank is operating as a bank at the last day of the
reporting period, the activity that triggers payment of the levy does not occur till that last day. Therefore no
provision is recognised till that point in time.
In circumstances where a levy is payable progressively, for example as a company generates revenue, the
company would be able to recognise liability over a period of time on that basis. This is because the obli-
gating event is the activity that generates revenue. If an obligation to pay a levy is triggered in full as soon
as a minimum threshold is reached, such as when the entity commences generating sales or achieves a cer-
tain level of revenue, the liability is recognised in full on the first day that the entity reaches that threshold.
Table 5.1 summarises the illustrative examples that accompany IFRIC 21.
TABLE 5.1 IFRIC 21 examples
Illustrative examples Obligating event Recognition of liability
Levy triggered Generation of revenue in Recognise progressively.

progressively as revenue the specified period. A liability must be recognised
is generated in a specified progressively because, at any point in
period. time during the specified period, the
entity has a present obligation to pay a
levy on revenues generated to date.
Levy triggered in full First generation of revenue Full recognition at that point in time.
as soon as revenue is in subsequent period. Where an entity generates revenue in
generated in one period, one period, which serves as the basis for
based on revenues from a measuring the amount of the levy, the
previous period. entity does not become liable for the levy,
and therefore cannot recognise a liability,
until it first starts generating revenue in
the subsequent period.
108 PART 2 Elements

TABLE 5.1 (continued)
Illustrative examples Obligating event Recognition of liability
Levy triggered in full if the Operating as a bank at Full recognition at the end of the annual
entity operates as a bank the end of the reporting reporting period.
at the end of the annual period. Before the end of the annual reporting
reporting period. period, the entity has no present
obligation to pay a levy, even if it is
economically compelled to continue
operating as a bank in the future. The
liability is recognised only at the end of
the annual reporting period.
Levy triggered if revenues Reaching the specified Recognise an amount consistent with the
are above a minimum minimum threshold. obligation at that point of time.
specified threshold (e.g. A liability is recognised only at the point
when a certain level that the specified minimum threshold is
of revenue has been reached. For example, a levy is triggered
achieved). when an entity generates revenues above
specified thresholds: 0% for the first $50
million and 2% above $50 million.
In this example, no liability is accrued
until the entity’s revenues reach the
revenue threshold of $50 million.
Source: Ernst & Young (2015).
5.9.6 Other applications

Illustrative examples 5.8 to 5.15, sourced from IAS 37 and modified to aid understanding, illustrate the
applications of the recognition requirements of IAS 37.
ILLUSTRATIVE EXAMPLE 5.8 Warranties
Eastern Systems gives warranties at the time of sale to purchasers of its product. Under the terms of the
contract for sale Eastern Systems undertakes to make good, by repair or replacement, manufacturing
defects that become apparent within 3 years from the date of sale. On past experience, it is probable
(that is, more likely than not) that there will be some claims under the warranties.
In these circumstances the obligating event is the sale of the product with a warranty, which gives
rise to a legal obligation. Because it is more likely than not that there will be an outflow of resources
for some claims under the warranties as a whole, a provision is recognised for the best estimate of
the costs of making good under the warranty for those products sold before the end of the reporting
period.
ILLUSTRATIVE EXAMPLE 5.9 Legal obligation
Hadafa Petrochemical in the oil industry causes contamination but cleans up only when required to do
so under the laws of the particular country in which it operates. One country in which it operates has
had no legislation requiring cleaning up, and the entity has been contaminating land in that country
for several years. At 31 December 2015, it is virtually certain that a draft law requiring a clean-up of land
already contaminated will be enacted shortly after the year end.
In these circumstances, the virtual certainty of new legislation being enacted means that Hadafa has
a present legal obligation as a result of the past event (contamination of the land), requiring a provision
to be recognised.

ILLUSTRATIVE EXAMPLE 5.10 Present constructive obligation
Conch in the oil industry causes contamination and operates in a country where there is no environ-
mental legislation. However, Conch has a widely published environmental policy in which it undertakes
to clean up all contamination that it causes. Conch has a record of honouring this published policy.
In these circumstances a provision is still required because Conch has created a valid expectation
that it will clean up the land, meaning that Conch has a present constructive obligation as a result of
past contamination. It is therefore clear that where an entity causes environmental damage and has a
present legal or constructive obligation to make it good, it is probable that an outflow of resources will
be required to settle the obligation, and a reliable estimate can be made of the amount, a provision will
be required.
ILLUSTRATIVE EXAMPLE 5.11 Obligating event
Pearl operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the
end of production and restore the seabed. Of the eventual costs, 90% relate to the removal of the oil
rig and restoration of damage caused by building it, and 10% arise through the extraction of oil. At
the end of the reporting period, the rig has been constructed but no oil has been extracted.
A provision is recognised at the time of constructing the oil rig (obligating event) in relation to the
eventual costs that relate to its removal and the restoration of damage caused by building it. Additional
provisions are recognised over the life of the oil field to reflect the need to reverse damage caused during
the extraction of oil. A provision is recognised for the best estimate of 90% of the eventual costs that
relate to the removal of the oil rig and restoration of damage caused by building it. These costs are
included as part of the cost of the oil rig. The 10% of costs that arise through the extraction of oil are
recognised as a liability when the oil is extracted.
ILLUSTRATIVE EXAMPLE 5.12 Recognition of provision
Under new legislation, Karachi Ltd is required to fit smoke filters to its factories by 30 June 20X3. Karachi
Ltd has not fitted the smoke filters.
(a) At the end of the reporting period, 31 December 20X2:
No event has taken place to create an obligation. Only once the smoke filters are fitted or the legislation
takes effect will there be a present obligation as a result of a past event, either for the cost of fitting
smoke filters or for fines under the legislation.
(b) At the end of the reporting period, 31 December 20X3:
There is still no obligating event to justify provision for the cost of fitting the smoke filters required
under the legislation because the filters have not been fitted. However, an obligation may exist as at
the reporting date to pay fines or penalties under the legislation because Karachi Ltd is operating its
factory in a non-compliant way. However, a provision would only be recognised for the best estimate
of any fines and penalties if, as at 31 December 20X3, it is determined to be more likely than not
that such fines and penalties will be imposed.
ILLUSTRATIVE EXAMPLE 5.13 Obligating event
Indonesian Clothing Inc. operates profitably from a factory that it has leased under an operating lease.
During December 20X3 Indonesian Clothing Inc. relocates its operations to a new factory. The lease on
the old factory continues for the next 4 years, it cannot be cancelled and the factory cannot be re-let to
another user.
In these circumstances, the obligating event is the signing of the lease contract (a legal obligation) and
when the lease becomes onerous, an outflow of resources embodying economic benefits is probable.
Accordingly, a provision is recognised for the best estimate of the unavoidable lease payments.
110 PART 2 Elements

ILLUSTRATIVE EXAMPLE 5.14 Provision not recognised
Some assets require, in addition to routine maintenance, substantial expenditure every few years for
major refits or refurbishment and the replacement of major components. IAS 16 Property, Plant and
Equipment gives guidance on allocating expenditure on an asset to its component parts where these com-
ponents have different useful lives or provide benefits in a different pattern.
An aircraft has an air-conditioning and pressurisation system that needs to be replaced every 5 years
for technical reasons. At the end of the reporting period, the system has been in use for 3 years.
In these circumstances, a provision for the cost of replacing the system is not recognised because,
at the end of the reporting period, no obligation to replace the system exists independently of the
entity’s future actions. Even the intention to incur the expenditure depends upon the entity deciding
to continue operating the system or to replace the system. Instead of a provision being recognised,
the initial cost of the system is treated as a significant part of the aircraft and depreciated over a
period of 5 years. The replacement costs are then capitalised when incurred and depreciated over the
next 5 years.
ILLUSTRATIVE EXAMPLE 5.15 Cost identifi ed as separate
Sunshine Air is required by law to overhaul its aircraft once every 3 years.
Even with the legal requirement to perform the overhaul, there is no obligating event until the 3-year
period has elapsed. As with the previous example, no obligation exists independently of Sunshine Air’s
future actions. Sunshine Air could avoid the cost of the overhaul by selling the aircraft before the 3-year
period has elapsed. Instead of a provision being recognised, the overhaul cost is identified as a separate
part of the aircraft asset under IAS 16 and is depreciated over 3 years.
LO10 5.10 CONTINGENT ASSETS

A contingent asset is a possible asset that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the
control of the entity (IAS 37 paragraph 10). IAS 37 does not allow the recognition of a contingent asset
and disclosures are required when an inflow of benefits is probable.
An example of a contingent asset would be the possible receipt of damages arising from a court case,
which has been decided in favour of the entity as at the end of the reporting period. The hearing to
determine damages, however, will be held after the end of the reporting period. The outcome of the
hearing is outside the control of the entity, but the receipt of damages is probable because the case has
been decided in the entity’s favour. The asset meets the definition of a contingent asset because it is
possible that the entity will receive the damages and the hearing is outside its control. In addition, the
contingent asset is disclosed because it is probable that the damages (the inflow of economic benefits)
will flow to the entity.
LO11 5.11 DISCLOSURE

The disclosure requirements of IAS 37 are self-explanatory and are described in paragraphs 84 to 92 of
the standard.
Note that the disclosures required for contingent liabilities and assets would involve judgement and
estimation. Many analysts consider the contingent liabilities note to be one of the most important notes
provided by a company because it helps the analyst in making decisions about the likely consequences for
the company and is useful in providing an overall view of the company’s exposures. Therefore, the use of
the exemption for non-disclosure of information, which would prejudice an entity’s position in a dispute
with other parties as permitted in paragraph 92, should be treated with caution because it could be inter-
preted as a deliberate concealing of the company’s exposures.
An example of extensive disclosures of provisions, related assumptions and contingent liabilities is
included in the annual report of Bayer AG, a global enterprise based in Germany, reporting under IFRS
Standards (see note 4). Figure 5.2 is an extract from the contingencies note (note 31) and the first part
of the note on legal risks (note 32). Students should refer to the annual report at www.bayer.com for the
full note 32.

FIGURE 5.2 Example of disclosures of contingencies
31. Contingencies and other financial commitments

The following warranty contracts, guarantees and other contingent liabilities existed at the end of the
reporting period:
Contingent Liabilities
31 Dec. 2013 31 Dec. 2014
€ million € million
Warranties 107 95
Guarantees 140 144
Other contingent liabilities 467 339
Total 714 578
The guarantees mainly comprise a declaration issued by Bayer AG to the trustees of the UK pension plans
guaranteeing the pension obligations of Bayer Public Limited Company and Bayer CropScience Limited.
Under the declaration, Bayer AG — in addition to the two companies — undertakes to make further
payments into the plans upon receipt of a payment request from the trustees. The net liability with respect
to these defined benefit plans as of 31 December 2014 amounted to €144 million (2013: €100 million).
The potential payment claims related to the partial exemption from the surcharge levied under the
German Renewable Energy Act that were included in other contingent liabilities in 2013 no longer
exist following the conclusion of the EU state-aid proceedings in 2014 (2013: €172 million).
Other financial commitments
The other financial commitments were as follows:
Other financial commitments
31 Dec. 2013 31 Dec. 2014

Operating leases 596 671

Orders already placed under purchase agreements 365 476
Unpaid portion of the effective initial fund 1 005 1 005
Potential payment obligations under R&D collaboration 2 106 2 427
agreements
Revenue-based milestone payment commitments 2 191 2 169
Total 6 263 6 748
The non-discounted future minimum lease payments relating to operating leases totalled €671
million (2013: €596 million). The maturities of the respective payment obligations were as follows:
Operating Leases
Maturing in 31 Dec. 2013 Maturing in 31 Dec. 2014
2014 174 2015 174

2015 144 2016 125
2016 81 2017 98
2017 66 2018 70
2018 42 2019 59
2019 or later 89 2020 or later 145
Total 596 Total 671
112 PART 2 Elements

Financial commitments resulting from orders already placed under purchase agreements related to
planned or ongoing capital expenditure projects totalled €476 million (2013: €365 million).
The Bayer Group has entered into cooperation agreements with third parties under which it has
agreed to fund various research and development projects or has assumed other payment obligations
based on the achievement of certain milestones or other specific conditions. If all of these payments
have to be made, their maturity distribution as of 31 December 2014 was expected to be as set forth
in the following table. The amounts shown represent the maximum payments to be made, and it
is unlikely that they will all fall due. Since the achievement of the conditions for payment is highly
uncertain, both the amounts and the dates of the actual payments may vary considerably from those
stated in the table.
Potential payment
obligations under
R&D collaboration
agreements
Maturing in 31 Dec. 2013 Maturing in 31 Dec. 2014
2014 155 2015 155
2015 181 2016 198
2016 144 2017 164
2017 113 2018 130
2018 95 2019 203
2019 or later 1 418 2020 or later 1 577
Total 2 106 Total 2 427
In addition to the above commitments, there were also revenue-based milestone payment commitments
totalling €2169 million (2013: €2191 million), of which €2157 million (2013: €2090 million) were not
expected to fall due until 2020 (2013: 2019) or later. These commitments are also highly uncertain.
Should the achievement of the milestones or specific conditions become sufficiently probable, a
provision or other liability is recognised in the statement of financial position, and this may also lead
to the recognition of an intangible asset in the same amount. The above table includes neither current
revenue-based royalty payments nor future payments that are probable and therefore already reflected
in the statement of financial position.
32. Legal risks

As a global company with a diverse business portfolio, the Bayer Group is exposed to numerous legal
risks, particularly in the areas of product liability, competition and antitrust law, patent disputes, tax
assessments and environmental matters. The outcome of any current or future proceedings cannot
normally be predicted. It is therefore possible that legal or regulatory judgments or future settlements
could give rise to expenses that are not covered, or not fully covered, by insurers’ compensation
payments and could significantly affect our revenues and earnings.
Source: Bayer AG (Annual Report 2014, pp. 320–326).
The legal proceedings (which includes product-related proceedings, competition law, patent disputes
and tax proceedings) were also listed in Bayer AG’s note 32.
LO12 5.12 COMPARISON BETWEEN IFRS 3 AND IAS 37

IN RESPECT OF CONTINGENT LIABILITIES
IFRS 3 Business Combinations, as revised in 2008, contains a number of requirements that are inconsistent
with IAS 37. However, as discussed in section 5.9.3, the requirements in respect of restructuring provisions
are consistent with IAS 37. The two areas of difference are in respect of contingent liabilities acquired in a
business combination and contingent consideration.

5.12.1 Contingent liabilities acquired in a business combination
As discussed in section 5.6, IAS 37 does not allow contingent liabilities to be recognised in the statement of
financial position. Instead, they are disclosed if certain conditions are met. However, IFRS 3 (paragraph
23) states that the requirements of IAS 37 do not apply in determining which contingent liabilities to
recognise at the acquisition date. Instead, the acquirer must recognise contingent liabilities assumed in a
business combination — just as it must recognise all other liabilities assumed in a business combination.
The only conditions for recognising the contingent liability are:
(a) it must be a present obligation arising from past events
(b) its fair value can be measured reliably.
Condition (a) means that contingent liabilities falling within part (a) of the contingent liability
definition (i.e. a possible obligation — see section 5.5) are not recognised in a business combination —
only those that fall within part (b) of the definition are eligible for recognition (i.e. there is a present
obligation) provided their value can be reliably measured (see chapter 3 Fair Value Measurement which covers
the requirements with respect to measuring fair value for liabilities). This means that an acquirer must identify
which contingent liabilities of the acquiree are present obligations that failed the recognition criteria from
the perspective of the acquiree but which can be assigned a fair value by the acquirer. This is shown in
ILLUSTRATIVE EXAMPLE 5.16 Contingent liabilities in a business combination
Assume that an acquiree had identified damages payable in a lawsuit as a present obligation because it
had lost the case, but it did not record the contingent liability as a liability because it could not reliably
measure the amount payable. In this case, the acquirer would need to estimate the fair value of the
amount payable and recognise it as one of the liabilities assumed in the business combination.
5.12.2 Contingent consideration in a business combination

Sometimes an acquirer may enter into an agreement with the vendor of the acquiree that entitles the
vendor to additional consideration if certain conditions are met in the future. This is referred to as
contingent consideration. IFRS 3 paragraph 39 requires the acquirer to include the acquisition-date
fair value of that contingent consideration as part of the consideration transferred in exchange for the
acquiree. This means that the acquirer must make an estimate, if necessary, to determine the fair value and
would record a liability for the amount of the contingency. This is demonstrated in illustrative example
5.17. The classification of a contingent consideration obligation that meets the definition of a finan-
cial instrument as either a financial liability or equity is based on the definitions in IAS 32 Financial
Instruments: Presentation.
ILLUSTRATIVE EXAMPLE 5.17 Accounting for contingent consideration in a business combination
Sporty Co. acquires 100% of Pluto Co. from Venus Co. The purchase consideration is comprised of cash
of $1 500 000 plus an agreement to pay a further $200 000 in cash to Venus Co. if Pluto Co. achieves
certain profit targets within 3 years of the acquisition date. The fair value of the identifiable assets and
liabilities of Pluto Co. acquired is $1 200 000. Sporty Co. estimates the acquisition-date fair value of the
contingent consideration to be $140 000 based on its expectations of Pluto Co.’s future performance and
the time value of money. Sporty Co. thus records the following journal entry at the date of acquisition
(see chapter 14 for more details on how to account for a business combination):
Net Assets of Pluto Co. Dr 1 200 000

Goodwill Dr 440 000
Cash Cr 1 500 000
Liability to Pay Venus Co. Cr 140 000
Note that if the contingent consideration was not recorded (i.e. if the requirements of IAS 37 were
followed) goodwill would be lower. Companies wishing to minimise the amount of goodwill arising on
acquisition would thus want to record a lower amount for contingent consideration.
114 PART 2 Elements

Table 5.2 summarises the similarities and differences between IFRS 3 and IAS 37.
TABLE 5.2 Similarities and differences between IFRS 3 and IAS 37
IAS 37 IFRS 3 Same/Different
Contingent liabilities — Possible liabilities are not Possible liabilities are not Same
part (a) of the definition recognised by the entity recognised by the acquirer
of a contingent liability
Contingent liabilities — A present obligation A present obligation Different

part (b) of the definition that fails either of the whose fair value can be
of a contingent liability recognition criteria must not reliably measured must be
be recognised by the entity recognised by the acquirer
Contingent consideration Contingent consideration is Contingent consideration Different

not specifically addressed, must be recognised by the
but applying the definition acquirer at its acquisition-
of a contingent liability date fair value
would likely result in no
amount being recognised by
the entity
Restructuring provisions A restructuring provision A restructuring provision Same

is recognised by the entity is recognised by the
only if the criteria in IAS 37 acquiree only if the
are met criteria in IAS 37 are met
LO13 5.13 EXPECTED FUTURE DEVELOPMENTS

In June 2005, the IASB issued an exposure draft proposing significant changes to IAS 37 as part of
its programme to amend IFRS 3 (see chapter 14). The exposure draft proposed amendments to the title
of IAS 37 (to ‘Non-financial Liabilities’), new definitions of contingencies, and new recognition and
measurement criteria. The proposed changes are so far-reaching that they attracted widespread concern
by respondents to the exposure draft. In 2012, the project on non-financial liabilities was paused and
removed from the Board’s active agenda. However, it has since been added back onto the work plan as a
short- and medium-term research project. At the time of writing, the IASB has indicated that progress of
this project is dependent on the developments of the Conceptual Framework. Therefore it is not yet clear
what the direction and scope of the project will be.
SUMMARY
IAS 37 deals with the recognition, measurement and presentation of provisions and contingent assets and
contingent liabilities. The standard contains specific requirements regarding the recognition of restruc-
turing provisions and onerous contracts.
The standard:
• defines provisions and specifies recognition criteria and measurement requirements for the recognition
of provisions in financial statements
• defines contingent liabilities and contingent assets and prohibits their recognition in the financial
statements but requires their disclosure when certain conditions are met
• requires that where provisions are measured using estimated cash flows, that the cash flows be
discounted to their present value at the reporting date and specifies the discount rate to be used for
this purpose
• prohibits providing for future operating losses
• defines onerous contracts and requires the estimated net loss under onerous contracts to be provided for
• specifies recognition criteria for restructuring provisions and identifies the types of costs that may be
included in restructuring provisions
• requires extensive disclosures relating to provisions, recoveries, contingent liabilities and contingent
assets.
The standard differs from IFRS 3 Business Combinations in respect of the recognition of contingent lia-
bilities and contingent consideration. However, it is consistent with IFRS 3 in respect of restructuring
provisions.

1. How is present value related to the concept of a liability?
2. Define (a) a contingency and (b) a contingent liability.
3. What are the characteristics of a provision?
4. Define a constructive obligation.
5. What is the key characteristic of a present obligation?
6. What are the recognition criteria for provisions?
7. At what point would a contingent liability become a provision?
8. Compare and contrast the requirements of IFRS 3 and IAS 37 in respect of restructuring provisions and
contingent liabilities.
References
Bayer AG 2014, Annual Report 2014, Bayer AG, Germany, www.bayer.com.
Ernst & Young 2011, International GAAP 2011, Chichester: John Wiley & Sons, Inc.
Ernst & Young 2015, International GAAP 2015, Chichester: John Wiley & Sons, Inc.
Exercise 5.1 RECOGNISING A PROVISION

★ When should liabilities for each of the following items be recorded in the accounts of the business
entity?
(a) Acquisition of goods by purchase on credit
(b) Salaries
(c) Annual bonus paid to management
(d) Dividends

★ The government introduces a number of changes to the value added tax system. As a result of these changes,
Company A, a manufacturing company, will need to retrain a large proportion of its administrative and
sales workforce in order to ensure continued compliance with the new taxation regulations. At the end of
the reporting period, no retraining of staff has taken place.
Required
Should Company A provide for the costs of the staff training at the end of the reporting period?

★★ Company B, a listed company, provides food to function centres that host events such as weddings and
engagement parties. After an engagement party held by one of Company B’s customers in June 2016, 100
people became seriously ill, possibly as a result of food poisoning from products sold by Company B. Legal
proceedings were commenced seeking damages from Company B, which disputed liability by claiming that
the function centre was at fault for handling the food incorrectly. Up to the date of authorisation for issue of
the financial statements for the year to 30 June 2016, Company B’s lawyers advised that it was probable that
Company B would not be found liable. However, two weeks after the financial statements were published,
Company B’s lawyers advised that, owing to developments in the case, it was probable that Company B
would be found liable and the estimated damages would be material to the company’s reported profits.
Required
Should Company B recognise a liability for damages in its financial statements at 30 June 2016? How
should it deal with the information it receives two weeks after the financial statements are published?
Exercise 5.4 DISTINGUISHING BETWEEN LIABILITIES, PROVISIONS AND CONTINGENT LIABILITIES

★★ Identify whether each of the following would be a liability, a provision or a contingent liability, or none of
the above, in the financial statements of Company A as at the end of its reporting period of 30 June 2016.
Assume that Company A’s financial statements are authorised for issue on 24 August 2016.
(a) An amount of $35 000 owing to Company Z for services rendered during May 2016.
(b) Long service leave, estimated to be $500 000, owing to employees in respect of past services.
116 PART 2 Elements

(c) Costs of $26 000 estimated to be incurred for relocating employee D from Company A’s head office
location to another city. The staff member will physically relocate during July 2016.
(d) Provision of $50 000 for the overhaul of a machine. The overhaul is needed every 5 years and the
machine was 5 years old as at 30 June 2016.
(e) Damages awarded against Company A resulting from a court case decided on 26 June 2016. The judge
has announced that the amount of damages will be set at a future date, expected to be in September
2016. Company A has received advice from its lawyers that the amount of the damages could be any-
thing between $20 000 and $7 million.

★★ In each of the following scenarios, explain whether or not Company G would be required to recognise a
provision.
(a) As a result of its plastics operations, Company G has contaminated the land on which it operates.
There is no legal requirement to clean up the land, and Company G has no record of cleaning up land
that it has contaminated.
(b) As a result of its plastics operations, Company G has contaminated the land on which it operates.
There is a legal requirement to clean up the land.
(c) As a result of its plastics operations, Company G has contaminated the land on which it operates.
There is no legal requirement to clean up the land, but Company G has a long record of cleaning up
land that it has contaminated.
Exercise 5.6 CALCULATION OF A PROVISION

★★ In May 2013, Company A relocated employee R from Company A’s head office to an office in another
city. As at 30 June 2013, the end of Company A’s reporting period, the costs were estimated to be $40 000.
Analysis of the costs is as follows:
Costs for shipping goods $ 3 000

Airfare 6 000
Temporary accommodation costs (May and June) 8 000
Temporary accommodation costs (July and August) 9 000
Reimbursement for lease break costs (paid in July;
lease was terminated in May) 2 000
Reimbursement for cost-of-living increases
(for the period 15 May 2013 to 15 May 2014) 12 000
Required
Calculate the provision for relocation costs for Company A’s financial statements as at 30 June 2013.
Assume that IAS 37 applies to this provision and that the effect of discounting is immaterial.
Exercise 5.7 COMPREHENSIVE PROBLEM

★★★ ChubbyChocs Ltd, a listed company, is a manufacturer of confectionery and biscuits. The end of its reporting
period is 30 June. Relevant extracts from its financial statements at 30 June 2014 are shown below
Current liabilities
Provisions
Provision for warranties $270 000
Non-current liabilities
Provisions
Provision for warranties 160 715
Non-current assets
Plant and equipment
At cost $ 2 000 000
Accumulated depreciation 600 000
Carrying amount 1 400 000

Plant and equipment has a useful life of 10 years and is depreciated on a straight-line basis.
Note 36 — Contingent liabilities

ChubbyChocs is engaged in litigation with various parties in relation to allergic reactions to traces of
peanuts alleged to have been found in packets of fruit gums. ChubbyChocs strenuously denies the
allegations and, as at the date of authorising the financial statements for issue, is unable to estimate the
financial effect, if any, of any costs or damages that may be payable to the plaintiffs.
The provision for warranties at 30 June 2014 was calculated using the following assumptions (there was
no balance carried forward from the prior year):
Estimated cost of repairs — products with minor defects $1 000 000

Estimated cost of repairs — products with major defects $6 000 000
Expected % of products sold during FY 2014 having no 80%
defects in FY 2015
Expected % of products sold during FY 2014 having 15%
minor defects in FY 2015
major defects in FY 2015
Expected timing of settlement of warranty payments — All in FY 2015
those with minor defects
Expected timing of settlement of warranty payments — 40% in FY 2015, 60% in FY 2016
those with major defects
Discount rate 6%. The effect of discounting for FY 2015
is considered to be immaterial
During the year ended 30 June 2015, the following occurred:

1. In relation to the warranty provision of $430 715 at 30 June 2014, $200 000 was paid out of the provi-
sion. Of the amount paid, $150 000 was for products with minor defects and $50 000 was for products
with major defects, all of which related to amounts that had been expected to be paid in the 2015 finan-
cial year.
2. In calculating its warranty provision for 30 June 2015, ChubbyChocs made the following adjustments
to the assumptions used for the prior year:
Estimated cost of repairs — products with minor defects No change

Estimated cost of repairs — products with major defects $ 5 000 000
Expected % of products sold during FY 2015 having no 85%
defects in FY 2016
minor defects in FY 2016
major defects in FY 2016
Expected timing of settlement of warranty payments — All in FY 2016
those with minor defects
Expected timing of settlement of warranty payments — 20% in FY 2016, 80% in FY 2017
those with major defects
Discount rate No change. The effect of discounting for
FY 2016 is considered to be immaterial
3. ChubbyChocs determined that part of its plant and equipment needed an overhaul — the conveyer belt
on one of its machines would need to be replaced in about May 2016 at an estimated cost of $250 000.
The carrying amount of the conveyer belt at 30 June 2014 was $140 000. Its original cost was $200 000.
4. ChubbyChocs was unsuccessful in its defence of the peanut allergy case and was ordered to pay
$1 500 000 to the plaintiffs. As at 30 June 2015, ChubbyChocs had paid $800 000.
118 PART 2 Elements

5. ChubbyChocs commenced litigation against one of its advisers for negligent advice given on the origi-
nal installation of the conveyer belt referred to in (3) above. In April 2015 the court found in favour of
ChubbyChocs. The hearing for damages had not been scheduled as at the date the financial statements
for 2015 were authorised for issue. ChubbyChocs estimated that it would receive about $425 000.
6. ChubbyChocs signed an agreement with BankSweet to the effect that ChubbyChocs would guarantee
a loan made by BankSweet to ChubbyChocs’ subsidiary, CCC Ltd. CCC’s loan with BankSweet was
$3 200 000 as at 30 June 2015. CCC was in a strong financial position at 30 June 2015.
Required
Prepare the relevant extracts from the financial statements (including the notes) of ChubbyChocs Ltd as at 30
June 2015, in compliance with IAS 37 and related International Financial Reporting Standards. Include com-
parative figures where required. Show all workings separately. Perform your workings in the following order:
(a) Calculate the warranty provision as at 30 June 2014. This should agree with the financial statements
provided in the question.
(b) Calculate the warranty provision as at 30 June 2015.
(c) Calculate the movement in the warranty provision for the year.
(d) Calculate the prospective change in depreciation required as a result of the shortened useful life of the
conveyer belt.
(e) Determine whether the unpaid amount owing as a result of the peanut allergy case is a liability or a
provision.
(f) Determine whether the receipt of damages for the negligent advice meets the definition of an asset or
a contingent asset.
(g) Determine whether the bank guarantee meets the definition of a provision or a contingent liability.
(Ignore IAS 39 in this regard.)
(h) Prepare the financial statement disclosures.

As pointed out in the chapter, one of the main types of provi- resistance of managers to disclose potentially harmful infor-
sion is the provision for restructuring costs. The requirements mation. This conclusion is reinforced by Hennes’s (2014)
of IAS 37 with respect to restructuring likely had been influ- study of 212 resolved employee discrimination lawsuits.
enced by some high profile abuses of previous rules (e.g., There is little evidence on other types of provisions. A
the case of W.R. Grace & Co. and Lucent Technologies in the recent study by Cohen et al. (2011) looks at the provision
late 1990s). But what is the evidence as to how prone is the for warranty cost. They posit that this provision can convey
restructuring provision to earnings management? Nelson et to the market managers’ information about the underlying
al. (2002) surveyed over 250 auditors working in Big audit product quality. Specifically, employing signalling theory
firms about their experience with earnings management. they argue greater warranty expense and larger provisions
One interesting insight that emerged from this survey is that indicate better product quality and hence better future sales
provisions are most susceptible to earnings management. By and return on assets. They provide evidence that is consistent
initially inflating the provision managers create a ‘cookie jar’ with this view. In addition, they find that the market regards
that can be used later to support future earnings. Consistent this provision similar to other liabilities. Finally, they pro-
with this, Gu and Chen’s (2004) analysis of non-recurring vide evidence suggesting that the warranty provision is used
items indicates that restructuring charges are the leading type opportunistically by managers of underperforming firms.
among such items. The accrual of a provision is dependent on how man-
Moehrle (2002) examines the financials of 121 firms agers and auditors interpret the concept of ‘probable’ out-
who reversed their restructuring charges (reversing firms) to flow. This can be quite subjective and prior accounting and
understand the motivation for the reversal. Reversed charges psychology research reviewed in Amer et al. (1995) suggests
work to increase reported profit and hence may be oppor- probability measures vary quite significantly across indi-
tunistically used by managers to meet market expectations. viduals. Specifically, Amer et al. (1995) examine whether
Consistent with this conjecture, he finds that reversing firms the meaning of ‘probable’ varies across loss contexts, an
experience pre-reversal negative earnings, and pre-reversal outcome that was not intended by standard setters. In par-
earnings that fall short of analyst expectations. This evidence ticular, in experimental setting auditor-subjects were asked
is consistent with ‘cookie jar’ earnings management that ena- to assess risk of default of a customer of a hypothetical audit
bles managers to reverse the charge when managers need to client. The subjects were also given background information
boost reported income to meet certain profit targets. about the health of the industry in which the hypothetical
Environmental liabilities and environmental-related dis- client operates in addition to information about the cli-
closures received considerable attention in the accounting ent’s customer. The main finding was that the threshold for
literature. Firms that contaminate sites they use for their ‘probable’ was higher when industry conditions were good
plants and operations need to estimate the ‘clean-up’ costs than when they were poorer (0.75 vs. 0.68). Hence Amer
that will be needed after cessation of activity and accrue a et al. (1995) conclude that auditors’ interpretation of what
provision. Barth and McNichols (1994) is one of the earliest is probable may be sensitive to the context in which the
studies of this provision. They provide evidence that sug- assessment is applied.
gests that clean-up provisions are understated. In a follow-up Aharony and Dotan (2004) explore whether analysts
paper Barth et al. (1997) examine the determinants of the and managers similarly interpret ‘remote’ and ‘probable’.
disclosures of clean-up provisions. They provide evidence They analysed about 300 questionnaires sent to managers,
that indicates that several factors influence these disclosures analysts and auditors in the US. They report that analysts
including, the regulatory environment, manager’s informa- regard an outflow event as ‘remote’ when the probability
tion, and threat of litigation. Lawrence and Khurana (1997) is up to 0.17, on average. Mangers’ probability assessment
investigate the accrual of clean-up provisions in US munic- of a remote event is higher, at 0.20, on average. Analysts
ipalities. They find that two thirds of sample municipalities quantify ‘probable’ as an event whose chance is 0.67, on
fail to accrue clean-up provisions and provide adequate average, while managers assign it 0.75, on average. Auditors
disclosures. provide estimates that are identical to those of managers, on
Provisions need to be accrued and recognised, provided average. These findings suggest that managers’ and auditors’
the resource outflow is probable, whereas (unrecognised) threshold for accruing a provision are higher than market
contingent liabilities arise when the outflow is only possible. perceptions and that they tend to under-report loss events by
For both accrued provisions and contingent liabilities there arguing they are remote.
are additional disclosure requirements regarding expected
amounts and timing. A powerful disincentive to provide
detailed disclosures is present in the case of legal provisions.
References
This is because disclosed information can be used by the Aharony, J., and Dotan, A., 2004. A comparative analysis of
opposing litigating party. Desir et al. (2010) examine 51 cases auditor, manager and financial analyst interpretations of
in which companies disclose details regarding the resolution SFAS 5 Disclosure Guidelines. Journal of Business Finance
of litigation cases. While 47 of these companies mention the & Accounting, 31, 475–504.
exposure in the statements immediately preceding the loss Amer, T., Hackenbrack, K., and Nelson, M.W., 1995.
resolution, only 24 quantify the magnitude of the expected Context-dependence of auditors’ interpretations of
loss. Nevertheless, only 31 firms accrue the loss before- the SFAS No. 5 probability expressions. Contemporary
hand.This evidence in Desir et al. (2010) is consistent with Accounting Research, 12(1), 25–39.
120 PART 2 Elements

Barth, M.E., and McNichols, M.C., 1994. Estimation and Hennes, K.M., 2014. Disclosure of contingent legal liabilities.
market valuation of environmental liabilities relating Journal of Accounting and Public Policy, 33(1), 32–50.
to Superfund sites. Journal of Accounting Research, 32 Lawrence, C.M., and Khurana, I.K., 1997. Superfund
(Supplement), 177–209. liabilities and governmental reporting entities: An
Barth, M.E., McNichols, M.C., Wilson, G.P., 1997. Factors empirical analysis. Journal of Accounting and Public Policy,
influencing firms’ disclosures about environmental 16(2), 155–186.
liabilities. Review of Accounting Studies, 2(1), 35–64. Moehrle, S.R., 2002. Do firms use restructuring charge
Cohen, D., Darrough, M.N., Huang, R., and Zach, T., 2011. reversals to meet earnings targets? The Accounting Review,
Warranty reserve: Contingent liability, information signal, 77(2), 397–413.
or earnings management tool?. The Accounting Review, Nelson, M.W., Elliott, J.A., and Tarpley, R.L., 2002. Evidence
86(2), 569–604. from auditors about managers’ and auditors’ earnings
Desir, R., Fanning, K., and Pfeiffer, R.J., 2010. Are revisions to management decisions. The Accounting Review, 77(s-1),
SFAS No. 5 needed? Accounting Horizons, 24(4), 525–545. 175–202.
Gu, Z., and Chen, T., 2004. Analysts’ treatment of
nonrecurring items in street earnings. Journal of Accounting
and Economics, 38 (Conference Issue), 129–170.

6 Income taxes
ACCOUNTING IAS 12 Income Taxes
STANDARDS
IN FOCUS

OBJECTIVES
1 understand the nature of income tax
2 understand differences in accounting treatments and taxation treatments for a range of
transactions
3 explain the concept of tax-effect accounting
4 calculate and account for current taxation expense
5 discuss the recognition requirements for current tax
6 account for the payment of tax
7 explain the nature of and accounting for tax losses
8 calculate and account for movements in deferred taxation accounts
9 apply the recognition criteria for deferred tax items
10 account for changes in tax rates
11 account for amendments to prior year taxes and identify other issues
12 explain the presentation requirements of IAS 12
13 implement the disclosure requirements of IAS 12.
CHAPTER 6 Income taxes 123

LO1 6.1 THE NATURE OF INCOME TAX
Income taxes are levied by governments on income earned by individuals and entities in order to raise
money to fund the provision of government services and infrastructure. The percentage payable and the
determination of taxable profit are governed by income tax legislation administered by a dedicated gov-
ernment body. Tax payable is normally determined annually with the lodgement of a taxation document,
although some jurisdictions may require payment by instalment, with estimates of tax payable being made
on a periodic basis.
This chapter analyses the accounting standard IAS 12 Income Taxes. According to paragraph 1 of IAS 12,
the standard applies in accounting for income taxes, including all domestic and foreign taxes based on tax-
able profits. It also applies to withholding taxes that are payable by a subsidiary, associate or joint arrange-
ment on distributions to a reporting entity. The standard does not deal with methods of accounting for
government grants or investment tax credits, but it does deal with accounting for tax effects arising in
respect of such transactions.
At first glance, accounting for income tax appears to be a simple matter of calculating the liability owing,
recognising the liability and expense, and recording the eventual payment of the amount outstanding.
Such a simplistic approach applies only if accounting profit is the same amount as taxable profit and the
respective profits have been determined by the same rules. Because this is generally not the case, accounting
for income taxes can be a complicated exercise; hence the need for an accounting standard.
In each country there are different legal requirements for calculating taxable profit. It is not the purpose
of this chapter to deal with these requirements. Instead the focus is on the differences between the way
in which income and expense are measured for accounting purposes and how they are measured for tax
purposes. In general, it is assumed for simplicity that income and expense for tax purposes are based on
cash flow in contrast to the use of the accrual method for accounting purposes. It is also assumed in this
chapter that the company tax rate is 30%.
LO2 6.2 DIFFERENCES BETWEEN ACCOUNTING PROFIT

AND TAXABLE PROFIT
Accounting profit is defined in IAS 12, paragraph 5, as ‘profit or loss for a period before deducting tax
expense’, profit or loss being the excess (or deficiency) of income less expenses for that period. Such
income and expenses would be determined and recognised in accordance with accounting standards and
the Conceptual Framework. Taxable profit is defined in the same paragraph as the profit for a period, deter-
mined in accordance with the rules established by the taxation authorities, upon which income taxes are
payable. Taxable profit is thus the excess of taxable income over taxation deductions allowable against that
income. Thus, accounting profit and taxable profit — because they are determined by different principles
and rules — are unlikely to be the same figure in any one period. Tax expense cannot be determined by
simply multiplying the accounting profit by the applicable taxation rate. Instead, accounting for income
taxes involves identifying and accounting for the differences between accounting profit and taxable profit.
These differences arise from a number of common transactions and may be either permanent or tempo-
rary in nature.
6.2.1 Permanent differences

Permanent differences between accounting profit and taxable profit arise when the treatment of a transac-
tion by taxation legislation and accounting standards is such that amounts recognised as part of accounting
profit are never recognised as part of taxable profit, or vice versa. In some jurisdictions, for example, enti-
ties are allowed to deduct from their taxable income more than 100% of expenditure incurred on certain
research and development activities undertaken during the taxation period. As a result of this extra deduc-
tion, taxable profit for the period is lower than accounting profit, and the extra amount is never recognised
as an expense for accounting purposes. Other examples of permanent differences include income never
subject to taxation such as dividend income, and expenditure incurred by an entity that will never be an
allowable deduction such as entertainment expenditure. Where such differences exist, taxable profit will
never equal accounting profit. No accounting requirements other than disclosure exist for these permanent
differences (see section 6.13).
6.2.2 Temporary differences

Temporary differences between accounting profit and taxable profit arise when the period in which rev-
enues and expenses are recognised for accounting purposes is different from the period in which such
revenues and expenses are treated as taxable income and allowable deductions for tax purposes. Interest
revenue recognised on an accrual basis, for example, may not be taxable income until it is received as cash.
Similarly, insurance paid in advance may be tax-deductible when paid but is not recognised in calculating
124 PART 2 Elements

accounting profit as an expense until a later period. The key feature of these differences is that they are
temporary, because sooner or later the amount of interest revenue will equal the amount of taxable
interest income, and the amount deducted against taxable income for insurance will equal the insurance
expense offset against accounting income. However, in any one individual accounting/taxation period,
these amounts will differ when calculating accounting profit and taxable profit respectively.
Differences that result in the entity paying more tax in the future (e.g. when interest is recognised for
accounting purposes in a period before it is received and included in taxable income) are known as tax-
able temporary differences. Differences that result in the entity recovering tax via additional deductible
expenses in the future (e.g. when accrued expenses are recognised for accounting purposes in a period
before they are paid and included as a tax deduction) are known as deductible temporary differences. The
existence of such temporary differences means that income tax payable that is calculated on taxable profit
will vary in the current period from that based on accounting profit, but tax payments will eventually catch
up. This is demonstrated in illustrative example 6.1.
ILLUSTRATIVE EXAMPLE 6.1 Reversal of temporary difference
Assume that the accounting profit of Aster Ltd for the year ended 30 June 2013 was £150 000, including
£5600 in interest revenue of which only £4000 had been received in cash. The company income tax rate
is 30%.
If tax is not payable on interest until it has been received in cash, the company’s taxable profit will
differ from its accounting profit, and a taxable temporary difference will exist in respect of the £1600
interest receivable. If accounting profit for the next year is also £150 000 and the outstanding interest is
received in August 2013, tax payable for the years ending 30 June 2013 and 2014 is calculated as follows:
2013 2014
Accounting profit £150 000 £150 000
Temporary difference:
Interest revenue not taxable for year ended 2013 (1 600)
Interest revenue taxable for year ended June 2014 1 600
Taxable profit £148 400 £151 600
Tax payable (30%) 44 520 45 480
Note that tax of £90 000, which is equal to 30% of £300 000 (being 2 × £150 000), is paid over the
2 years. The temporary difference created in 2013 is reversed in 2014. The same process occurs with all
temporary differences although it may take a number of periods for a complete reversal to occur.
Appendix A to IAS 12 gives examples of temporary differences arising from different treatments of trans-
actions for accounting and taxation purposes, some of which are listed below. These examples are not
all-inclusive, so the relevant taxation legislation for specific jurisdictions should be consulted to determine
if additional differences exist.
Circumstances that give rise to taxable temporary differences
Such circumstances include the following:
1. Interest revenue is received in arrears and is included in accounting profit on a time-apportionment
basis but is included in taxable profit on a cash basis.
2. Revenue from the sale of goods is included in accounting profit when goods are delivered but is included
in taxable profit only when cash is collected.
3. Depreciation of an asset is accelerated for tax purposes (the taxation depreciation rate is greater than the
accounting rate).
4. Development costs are capitalised and amortised to the statement of profit or loss and other
comprehensive income but are deducted in determining taxable profit in the period in which they are
incurred.
5. Prepaid expenses have already been deducted on a cash basis in determining the taxable profit of the
current or previous periods.
6. Depreciation of an asset is not deductible for tax purposes and no deduction will be available for tax
purposes when the asset is sold or scrapped (see section 6.9).
7. Financial assets or investment property are carried at fair value, which exceeds cost, but no equivalent
adjustment is made for tax purposes.

8. An entity revalues property, plant and equipment, but no equivalent adjustment is made for tax purposes.
9. Impairment of goodwill is not deductible in determining taxable profit, and the cost of the goodwill
would not be deductible on disposal of the business (see section 6.9).
The tax treatment of temporary differences arising from fair value accounting and revaluation to fair
value (items 7 and 8) are discussed and illustrated later in the book (see section 11.6.1).
Circumstances that give rise to deductible temporary differences
Such circumstances include the following:
1. Retirement benefit costs are deducted in determining accounting profit because service is provided by
the employee, but are not deducted in determining taxable profit until the entity pays either retirement
benefits or contributions to a fund. Similar temporary differences arise in relation to other accrued
expenses — such as product warranties, leave entitlements and interest — which are deductible on a
cash basis in determining taxable profit.
2. Accumulated depreciation of an asset in the financial statements is greater than the cumulative deprecia-
tion allowed up to the end of the reporting period for tax purposes. That is, the accounting depreciation
rate is greater than the allowable taxation depreciation rate.
3. The cost of inventories sold before the end of the reporting period is deducted in determining account-
ing profit when goods or services are delivered, but is deducted in determining taxable profit only when
cash is collected.
4. The net realisable value (see chapter 9) of an item of inventory, or the recoverable amount (see chapter
11) of an item of property, plant and equipment, is less than the previous carrying amount. The entity
therefore reduces the carrying amount of the asset, but that reduction is ignored for tax purposes until
the asset is sold.
5. Research costs (or organisation or other start-up costs) are recognised as an expense in determining
accounting profit, but are not permitted as a deduction in determining taxable profit until a later period.
6. Income is deferred in the statement of financial position but has already been included in taxable profit
in current or prior periods (for example, subscriptions received in advance).
7. A government grant that is included in the statement of financial position as deferred income will not
be taxable in a future period (see section 6.9).
8. Financial assets or investment property is carried at fair value, which is less than cost, but no equivalent
adjustment is made for tax purposes. (Temporary differences arising in these circumstances are beyond
the scope of this chapter.)
In summary, income tax payable in any one period is affected by differences between items used to
determine accounting profit and taxable profit. Some revenue items are not taxable, have already been
taxed or will not be taxed until some future period(s). Some expense items are not deductible, have already
been deducted or may be deducted in some future period(s). Additionally, extra deductions for which no
expense will ever be incurred may be allowable under taxation legislation. The illustrative examples, exer-
cises and problems in this chapter assume that the revenue from selling goods and services is taxable irre-
spective of whether cash has been received for the sale, and that the cost of sales is an allowable deduction
irrespective of whether cash has been paid to acquire those goods.
LO3 6.3 ACCOUNTING FOR INCOME TAXES

As the objective paragraph of IAS 12 points out:
The principal issue in accounting for income taxes is how to account for the current and future tax consequences of:
(a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an entity’s
statement of financial position; and
(b) transactions and other events of the current period that are recognised in an entity’s financial statements.
IAS 12 requires the tax consequences of transactions and other events to be accounted for in the same
manner and the same period as the transactions themselves. Thus, if a transaction is recognised in profit
or loss for the period, so too is the related tax payable or tax benefit. Similarly, if a transaction is adjusted
directly to equity, so too is the related tax effect. Differing accounting and taxation rules (as discussed in
section 6.2) mean that the actual payment (deduction) of tax relating to revenue (expense) items may take
place in both current and/or future accounting periods but IAS 12, paragraph 58, requires that the total
income tax expense relating to transactions is recorded in the current year irrespective of when it will be
paid or deducted.
To illustrate: an entity recognises interest revenue of £21 000 for the year ended 30 June 2014. Of this
amount, £15 000 has been received in cash and a receivable asset has been raised for the remaining £6000.
Tax legislation regards interest revenue as taxable only when it has been received. Therefore, the entity will
pay tax of £4500 (£15 000 × 30%) in the current year and tax of £1800 (£6000 × 30%) in the following
year when the £6000 is received.
If the entity were to record only the current tax payable amount as income tax expense, the profit for
the year would be overstated by £1800 (£4500 current tax as opposed to £6300 tax expense on £21 000
126 PART 2 Elements

of interest revenue). To ensure that the profit after-tax figure for the year is both relevant and reliable, IAS
12 requires the entity to record an income tax expense of £6300 (£21 000 × 30%) for the current year in
respect to the interest revenue. This comprises a current tax liability amount of £4500 and a deferred tax
(future) liability of £1800.
The need to recognise both current and future tax consequences of current year transactions means that
each transaction has two tax effects:
1. tax payable on profit earned for the year may be reduced or increased because the transaction is not
taxable or deductible in the current year
2. future tax payable may be reduced or increased when that transaction becomes taxable or deductible.
If only current tax payable is recorded as an expense, then the profit for the current year will be under-
stated or overstated by the amount of tax or benefit to be paid or received in future years. Similarly, in
the years that the tax or benefit on these transactions is paid or received, income tax expense will include
amounts relating to prior periods and therefore be understated or overstated. As IAS 12 requires income
tax expense to reflect all tax effects of transactions entered into during the year regardless of when the
effects occur, two calculations are required at the end of the reporting period:
• the calculation of current tax liability, which determines the amount of tax payable for the period
• the calculation of movements in deferred tax effects relating to assets and liabilities recognised in
the statement of financial position, which determines the net effect of deferred taxes and deductions
arising from transactions during the year.
Acknowledging the current and future tax consequences of all items recognised in the statement of
financial position (subject to certain exceptions) should make the information about the tax implications
of an entity’s operations and financial position more relevant and reliable.
LO4 6.4 CALCULATION OF CURRENT TAX

Current tax is the recognition of taxes payable to the taxation authorities in respect of a particular period.
The current tax calculation involves identifying differences between accounting revenues and taxable
income, and between accounting expenses and allowable deductions, for transactions during the year, as
well as reversing temporary differences from prior years that occur in the current period. Accounting profit
for the period is adjusted by these differences to calculate taxable profit, which is then multiplied by the
current tax rate to determine current tax payable.
When selecting the tax rate to apply, the requirements of IAS 12 paragraph 46, must be considered. This
paragraph states:
Current tax liabilities (assets) for the current and prior periods shall be measured at the amount expected to be
paid to (recovered from) the taxation authorities, using the tax rates (and tax laws) that have been enacted or
substantively enacted by the end of the reporting period.
Therefore, if a tax rate has changed — or, in some jurisdictions, if a change has been announced — the
rate applicable to the taxable profit for the period must be applied.
Identifying permanent and temporary differences in the current year’s profit is a relatively simple exer-
cise. All revenues and expenses are reviewed for amounts that are not taxable or deductible. Identifying
reversals of prior year temporary differences may require referring back to prior year worksheets, transac-
tions posted to asset and liability accounts during the current year, or reconstructions of ledger accounts.
(The latter method is used in this chapter.) Such reversals include, where applicable, accrued expenses that
have been paid and are now deductible, bad debts written off and now deductible, accrued revenue that
has been received and is now taxable, and prepaid expenses deducted in a prior period but now expensed
in accounting profit.
Once the differences have been isolated, there are two ways that the current tax could be determined:
(1) the net differences could be adjusted against accounting profit to derive taxable profit, or (2) the gross
amounts of items with differences could be added back or deducted against accounting profit. (The latter
method is adopted in this chapter.) A worksheet is used to perform this reconciliation between accounting
profit and taxable profit using the following formula:
Accounting profit (loss)

+ (−) accounting expenses not deductible for tax
+ (−) accounting expenses where the amount differs from deductible amounts
+ (−) taxable income where the amount differs from accounting revenue
− (+) accounting revenues not subject to taxation
− (+) accounting revenue where the amount differs from taxable income
− (+) deductible amounts where the amount differs from accounting expense
= taxable profit
The current tax rate is then applied to taxable profit to derive the current tax payable (illustrative example 6.2).

ILLUSTRATIVE EXAMPLE 6.2 Determination of current tax worksheet
Iris Ltd’s accounting profit for the year ended 30 June 2013 was £250 450. Included in this profit were
the following items of income and expense:
Amortisation — development project £30 000
Impairment of goodwill expense 7 000
Depreciation — equipment (15%) 40 000
Entertainment expense 12 450
Insurance expense 24 000
Doubtful debts expense 14 000
Loss on sale of equipment 6 667
Rent revenue 25 000
Annual leave expense 54 000
At 30 June 2013, the company’s draft statement of financial position showed the following balances:
30 June 30 June
2013 2012
Assets
Cash £ 55 000 £ 65 000
Accounts receivable 295 000 277 000
Allowance for doubtful debts (16 000) (18 000)
Inventories 162 000 185 000
Prepaid insurance 30 000 25 000
Rent receivable 3 500 5 500
Development project 120 000 —
Accumulated amortisation (30 000) —
Equipment 200 000 266 667
Accumulated depreciation (90 000) (80 000)
Goodwill 35 000 35 000
Accumulated impairment expense (14 000) (7 000)
Deferred tax asset ? 24 900
Liabilities
Accounts payable 310 500 294 000
Provision for annual leave 61 000 65 000
Mortgage loan 100 000 150 000
Deferred tax liability ? 57 150
Current tax liability ? 12 500
Additional information
1. Taxation legislation allows Iris Ltd to deduct 125% of the £120 000 spent on development during the year.
2. Iris Ltd has capitalised development expenditure relating to a filter project and amortises the balance
over the period of expected benefit (4 years).
3. The taxation depreciation rate for equipment is 20%.
4. The equipment sold on 30 June 2013 cost £66 667 when it was purchased 3 years ago.
5. Neither entertainment expenditure nor goodwill impairment expense is deductible for taxation purposes.
6. The insurance and annual leave expenses are deductible when paid.
7. The rent revenue is taxable when received.
8. The company income tax rate is 30%.
Calculation of current tax payable
Before completing the worksheet, all differences between accounting and taxation figures must be identified:
1. Development project
There are two differences here: a permanent difference arising from the extra 25% deduction allowed
by tax legislation, and a temporary difference arising from the treatment of the development costs. For
accounting purposes, the £120 000 has been capitalised and will be amortised over 4 years; for tax
purposes, the entire expenditure is deductible in the current year. The tax deduction for development is
therefore: £150 000 (being £120 000 + [25% × £120 000]).
128 PART 2 Elements

2. Impairment of goodwill expense
No tax deduction is allowed for impairment expense, so the taxation deduction is nil. Paragraph 21 of
IAS 12 does not permit the recognition of the deferred tax liability arising from the taxable temporary
difference created (see section 6.9). Therefore, a permanent difference exists.
3. Depreciation expense — equipment
Because equipment is being depreciated at a faster rate for taxation purposes, a temporary taxable differ-
ence will exist. The amount of depreciation deductible is £53 333.40 (being £266 667 × 20%).
4. Entertainment expense
No deduction is allowed for entertainment expenditure, so the taxation deduction is nil and there is a
permanent difference between accounting profit and taxable profit.
5. Insurance expense
Insurance expenditure is deductible when paid. The existence of a prepaid insurance asset account in the
statement of financial position indicates that the insurance payment and insurance expense figures are
different. It is therefore necessary to reconstruct the asset account to identify if any part of the expense
has already been deducted for taxation purposes. This is done as follows:
Prepaid Insurance
Balance b/d £25 000 Insurance Expense £24 000

Bank (Insurance Paid) 29 000 Balance c/d 30 000
54 000 54 000
The insurance paid figure of £29 000 represents the deduction allowable in determining taxable profit.
The expense figure of £24 000 shows that the payment made includes £5000 for insurance cover for the next
accounting period. When this amount is expensed, no deduction will be available against taxable profit.
6. Allowance for doubtful debts
If, under taxation legislation, no deduction is allowed for bad debts until they have been written off,
the taxation amount for doubtful debts will be nil. The draft statement of financial position shows
that an allowance was raised in the previous year, so any debts written off against that allowance are
deductible in the current year. To determine the amount (if any) of that write-off, the ledger account is
reconstructed as follows:
Allowance for Doubtful Debts
Balance b/d £16 000 Doubtful Debts Expense £14 000

Bad Debts Written Off 16 000 Balance c/d 18 000
32 000 32 000
The allowable deduction for bad debts written off is therefore £16 000.
7. Loss on sale of equipment
The gain or loss on the sale of equipment is different for accounting and taxation purposes, and is cal-
culated as shown in the following table.
Accounting Taxation
Cost £66 667 £66 667
Accumulated depreciation 30 000 40 000
Carrying amount 36 667 26 667
Proceeds 30 000 30 000
Gain (loss) £ (6 667) £ 3 333
The difference in the loss or gain on sale is caused by the different depreciation rates for accounting
and tax purposes, resulting in different carrying amounts. When preparing the current tax worksheet, the
accounting effect is reversed and the taxation effect is included, in this case, the accounting loss of £6667
is added and the taxation gain is also added.
8. Rent revenue
Rent revenue is taxable when received. The presence in the statement of financial position of a rent
receivable asset indicates that part of the revenue has not yet been received as cash and is not taxable
in the current year. A temporary difference therefore exists in respect of rent, as demonstrated by recon-
structing the ledger account:

Rent Receivable
Balance b/d £ 5 500 Cash received £27 000

Rent Revenue 25 000 Balance 3 500
30 500 30 500
In this instance, the cash received figure represents rent received for two different accounting periods:
£5500 outstanding at the end of the prior year, and £21 500 for the current year. Thus, the taxable
amount combines the reversal of last year’s temporary difference and the tax payable on the current
year’s income. A temporary difference still exists for the £3500 rent for this year not yet received in cash.
9. Annual leave expense
The annual leave expense is deductible when paid in cash. The provision for annual leave indicates the
existence of unpaid leave and therefore a taxation temporary difference. This is demonstrated by recon-
structing the ledger account.
Provision for Annual Leave
Leave paid £ 58 000 Balance b/d £ 65 000

Balance c/d 61 000 Leave Expense 54 000
119 000 119 000
The reconstruction reveals a payment of £58 000, which is deductible in the current year and represents
a partial reversal of the temporary difference related to the opening balance. As none of the current year
expense has been paid, no deduction is available this year and a further temporary difference is created.
This chapter assumes that sales revenue and cost of sales are taxable/deductible even when not
received/paid in cash, so there are no differences with respect to the accounts receivable or accounts
payable balances. If different assumptions applied, then the amounts of cash received for sales and cash
paid for inventory would need to be determined in order to calculate the current tax payable.
Figure 6.1 contains the current worksheet used to calculate the current tax liability for Iris Ltd.
IRIS LTD
Current Tax Worksheet
for the year ended 30 June 2013
Accounting profit £ 250 450

Add:
Amortisation of development expenditure £ 30 000
Impairment of goodwill expense 7 000
Depreciation expense – equipment 40 000
Accounting loss on sale of equipment 6 667
Taxation gain on sale of equipment 3 333
Rent received 27 000 218 450
495 567
Deduct: 468 900
Rent revenue 25 000
Bad debts written off 16 000
Insurance paid 29 000
Development costs paid 150 000
Annual leave paid 58 000
Depreciation of equipment for tax 53 333 (331 333)
Taxable profit 137 567
Current liability @ 30% £ 41 270
FIGURE 6.1 Completed current tax worksheet for Iris Ltd
130 PART 2 Elements

LO5 6.5 RECOGNITION OF CURRENT TAX
Paragraph 12 of IAS 12 states:
Current tax for current and prior periods shall, to the extent unpaid, be recognised as a liability. If the amount
already paid in respect of current and prior periods exceeds the amount due for those periods, the excess shall
be recognised as an asset.
Additionally, paragraph 58 of the standard requires current tax to be recognised as income or an expense
and included in the profit or loss for the period, except to the extent that the tax relates to a transac-
tion recognised directly in equity or to a business combination. Therefore, the following journal entry is
required to recognise the current tax payable for Iris Ltd at 30 June 2013:
30 June 2013
Income Tax Expense (Current) Dr 41 270
Current Tax Liability Cr 41 270
(Recognition of current tax liability)
LO6 6.6 PAYMENT OF TAX

Taxation legislation may require taxation debts to be paid annually upon lodgement of a taxation return
or at some specified time after lodgement (such as on receipt of an assessment notice, or at a set date or
time). Alternatively, the taxation debt may be paid by instalment throughout the taxation year. In some
jurisdictions, payments in advance relating to next year’s estimated taxable profit may be required. Where
one annual payment is required, the entry is:
Current Tax Liability Dr 41 270

Cash Cr 41 270
(Payment of current liability)
If payment by instalment is required, the process is a little more complicated. To pay by instalment, an
estimate of taxable profit needs to be made; hence the reference in paragraph 12 of IAS 12 to amounts
paid in excess of the amount due. To illustrate the process of payment by instalment, assume that Iris Ltd
(from illustrative example 6.2) has to pay tax quarterly and has paid the following amounts for the first
three quarters of the 2012–13 taxation year:
28 October 2012 £ 9 420

28 January 2013 10 380
28 April 2013 10 750
The journal entry to record the first payment is:
Current Tax Liability Dr 9 420

Cash Cr 9 420
(Payment of first quarterly taxation instalment)
Similar entries are passed at 28 January 2013 and 28 April 2013. At 30 June 2013, because the tax lia-
bility has been partially paid, an adjustment is required on the current tax worksheet to determine the
balance of tax owing in relation to the 2012–13 year (see below).
IRIS LTD
Current Tax Worksheet (extract)
Taxable profit £ 137 567

Tax payable @ 30% 41 270
Less: Tax already paid (£9 420 + £10 380 + £10 750) (30 550)
Current tax liability 10 720

The effect of the adjusting journal entry is to change the debit balance of £30 550 in the current tax
liability account (caused by the instalment payments) into a credit balance of £10 720, representing the
amount owing to the tax authority :
30 June 2013
(Recognition of current tax liability)
LO7 6.7 TAX LOSSES

Tax losses are created when allowable deductions exceed taxable income. IAS 12 envisages three possible
treatments for tax losses: they may be carried forward, carried back, or simply lost. Where taxation legisla-
tion allows tax losses to be carried forward and deducted against future taxable profits, the carry-forward
may be either indefinite or for a limited number of years. Other restrictions — such as requiring losses to
be deducted against non-taxable income on recoupment — may also apply. Carry-forward tax losses create
a deductible temporary difference and therefore a deferred tax asset in that the company will pay less tax
on future taxable profits. The recognition of a deferred tax asset for tax losses is discussed in detail in section 6.9.2.
ILLUSTRATIVE EXAMPLE 6.3 Creation and recoupment of carry-forward tax losses
The following information relates to Poppy Ltd for the year ended 30 June 2014:
Accounting loss on income statement £ 7 600

Depreciation expense 14 700
Depreciation deductible for tax 20 300
Entertainment expense (not tax-deductible) 10 000
Income tax rate 30%
The calculation of the tax loss appears below:
POPPY LTD
Accounting loss £ (7 600)

Add:
17 100
Deduct:
Depreciation deduction for tax (20 300)
Tax loss (3 200)
Deferred tax asset @ 30% £ 960
Assuming that recognition criteria are met, the adjusting journal entry is:
30 June 2014
Deferred Tax Asset (Tax Losses) Dr 960
Income Tax Expense Cr 960
(Recognition of deferred tax asset from tax loss)
If Poppy Ltd then makes a taxable profit of £23 600 for the year ending 30 June 2015, the loss is
recouped as follows:
132 PART 2 Elements

POPPY LTD
Taxable profit before tax loss £23 600

Tax loss recouped (3 200)
Taxable profit 20 400
Current tax liability @ 30% £ 6 120
The adjusting journal entry is:
30 June 2015
Deferred Tax Asset (Tax Losses) Cr 960
(Recognition of current tax liability and reversal of deferred
tax asset from tax loss)
LO8 6.8 CALCULATION OF DEFERRED TAX

As already explained, IAS 12 adopts the philosophy that the tax consequences of transactions that occur
during a period should be recognised in income tax expense for that period. Where a transaction has
two effects, both have to be recognised. The existence of temporary differences between accounting profit
and taxable profit was identified earlier in the chapter. These temporary differences result in the carrying
amounts of an entity’s assets and liabilities being different from the amounts that would arise if a state-
ment of financial position was prepared for the taxation authority. The latter are referred to as the tax
base of an entity’s assets and liabilities. At the end of the reporting period, a comparison of an entity’s
carrying amounts of assets and liabilities and their tax bases will reveal the temporary differences that
exist, and adjustments will then be made to deferred assets and liabilities. (The reference to ‘deferred’ tax
adjustments comes from the fact that assets and liabilities reflect future inflows and outflows to an entity.
The deferred tax balances are related to these future flows, and hence are deferred to the future rather than
affecting current tax.) For assets such as goodwill and entertainment costs payable, differences between
their tax bases and carrying amounts may be caused by permanent differences. Such differences will not
give rise to deferred tax adjustments.
The following steps are required to calculate deferred tax:
1. Determine the carrying amounts of items recognised in the statement of financial position.
2. Determine the tax bases of the items recognised by identifying the taxable and deductible temporary
differences relating to the future tax consequences of each item.
3. Calculate and recognise the deferred tax assets and liabilities arising from these temporary differences
after taking into account any relevant recognition exceptions (see section 6.8.5) and offset considerations
(see section 6.12.1).
4. Recognise the net movement in deferred tax assets and liabilities during the period as deferred tax ex-
pense or income in profit or loss (unless an accounting standard requires recognition directly in equity
or as part of a business combination).
The first three steps are carried out on a worksheet. The final step requires an adjusting journal
entry.
6.8.1 Determining carrying amounts

Carrying amounts are asset and liability balances net of valuation allowances, accumulated depreciation,
amortisation and impairment losses (for example, accounts receivable less allowance for doubtful debts).
6.8.2 Determining tax bases

Tax bases need to be calculated for assets and liabilities.

Tax bases of assets
The economic benefits embodied in an asset are normally taxable when recovered by an entity through the
use or sale of that asset. The entity may then be able to deduct all or part of the cost or carrying amount of
the asset against those taxable amounts when determining taxable profits.
Paragraph 7 of IAS 12 describes the tax base of an asset as:
the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an
entity when it recovers the carrying amount of the asset. If those economic benefits will not be taxable, the tax
base of the asset is equal to its carrying amount.
The following formula can be applied to derive the tax base from the carrying amount of the asset:
Carrying amount − Future taxable amounts + Future deductible amounts = Tax base
Figure 6.2 contains examples of the calculation of tax bases for assets.
Future Future
Carrying taxable deductible Tax
amount amounts* amounts base
Prepayments £3 000: fully deductible for tax £ 3 000 £(3 000) £ 0 £ 0

when paid
Trade receivables of £52 000 less £2 000 50 000 0 2 000 52 000

allowance for doubtful debts: sales revenue
is already included in taxable profit
Plant and equipment costing £10 000 has a 5 400 (5 400) 3 500** 3 500
carrying value of £5 400: accumulated tax
depreciation is £6 500
Loan receivable £25 000: loan repayment 25 000 0 0 25 000

will have no tax consequences
Interest receivable £1 000: recognised as 1 000 (1 000) 0 0

revenue but not taxable until received
* Future taxable amounts are equal to carrying amounts unless economic benefits have already been included in
taxable profit.
** The deductible amount represents the original cost of the asset less the accumulated depreciation based on taxation
depreciation rates (being £10 000 − £6 500 = £3 500).
FIGURE 6.2 Calculation of the tax base of assets
Figure 6.2 illustrates the following situations:

• Where the future benefits are taxable, the carrying amount equals the future taxable amount. Hence,
the tax base equals the future deductible amount. This can be seen in figure 6.2 for prepayments, plant
and equipment, and interest receivable.
• Where there are no future taxable amounts, generally the deductible amount is zero and the tax base
equals the carrying amount. In figure 6.2, this applies to the loan receivable. An exception is trade
receivables where, although the future taxable amount is zero, the future deductible amount is not
zero because of the existence of doubtful debts. In this case, the tax base equals the sum of the carrying
amount and the future deductible amount.
Tax bases of liabilities

Liabilities, other than those relating to unearned revenue, do not create taxable amounts. Instead, settle-
ment gives rise to deductible items.
Paragraph 8 of IAS 12 describes the tax base of a liability as:
its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future
periods. In the case of revenue which is received in advance, the tax base of the resulting liability is its carrying
amount, less any amount of the revenue that will not be taxable in future periods.
The following formula can be applied to derive the tax base from the carrying amount of the liability:
Carrying amount + Future taxable amounts − Future deductible amounts = Tax base
Figure 6.3 contains examples of the calculation of the tax base for liabilities.
134 PART 2 Elements

Future Future
Carrying taxable deductible Tax
amount amounts amounts base
Provision for annual leave £3 900: not £ 3 900 £ 0 £(3 900) £ 0

deductible for tax until paid
Trade payables £34 000: expense already 34 000 0 0 34 000

deducted from taxable income
Subscription revenue received in advance (500) (500) 0 0

£500: taxed when received
Loan payable £20 000: loan repayment will 20 000 0 0 20 000

have no tax consequences
Accrued expenses £6 700: deductible when 6 700 0 (6 700) 0

paid in cash
Accrued penalties £700: not tax-deductible 700 0 0 700
FIGURE 6.3 Calculation of the tax base of liabilities
Figure 6.3 illustrates two situations:

• Where the carrying amount equals the future deductible amount, the tax base is zero. This applies to
provisions for annual leave and accrued expenses.
• Where there is no future deductible amount, the carrying amount equals the tax base. This applies to
trade payables and the loan payable.
Some items may have a tax base but are not recognised as assets and liabilities in the statement of finan-
cial position. Paragraph 9 of IAS 12 provides the example of research costs that are recognised as an expense
in determining accounting profit in the period in which they are incurred but are not allowed as a deduction
in determining taxable profit until a later period. Additionally, under paragraph 52 the manner in which an
asset/liability is recovered/settled may affect the tax base of that asset/liability in some jurisdictions.
6.8.3 Calculating temporary differences

When the carrying amount of an asset or liability is different from its tax base, a temporary difference
exists. Temporary differences effectively represent the expected net future taxable amounts arising from the
recovery of assets and the settlement of liabilities at their carrying amounts. Therefore, a temporary differ-
ence cannot exist where there are no future tax consequences from the realisation or settlement of an asset
or liability at its carrying value.
Taxable temporary differences
A taxable temporary difference exists when the future taxable amount of an asset or liability exceeds any
future deductible amounts. This is demonstrated in illustrative example 6.4.
ILLUSTRATIVE EXAMPLE 6.4 Calculation of a taxable temporary difference
An asset, which cost 150, has an accumulated depreciation of 50.

Accumulated depreciation for tax purposes is 90 and the tax rate is 25%.
Carrying amount = 100

Future taxable amount = 100
Future deductible amount = 60
Tax base = 100 − 100 + 60
= 60 (= 150 cost less 90 tax depreciation)
Because the future taxable amount is greater than the future deductible amount, a temporary taxable
difference exists. In other words, the expectation is that the entity will pay income taxes in the future,
when it recovers the carrying amount of the asset, because it expects to earn 100 but receive a tax
deduction of 60. The entity has a liability to pay tax on that extra 40. As the payment occurs in the
future, the liability is referred to as a ‘deferred tax liability’.
Source: Adapted from IAS 12, paragraph 16.

Deductible temporary differences
A deductible temporary difference exists when the future taxable amount of an asset or liability is less than
any future deductible amounts. This is demonstrated in illustrative example 6.5.
ILLUSTRATIVE EXAMPLE 6.5 Calculation of a deductible temporary difference
Dalal Inc. recognises a liability of 100 for accrued product warranty costs. For tax purposes, the product
warranty costs will not be deductible until Dalal Inc. pays claims. The tax rate is 25%.
Carrying amount = 100
Future taxable amount = 0
Future deductible amount = 100
Tax base = 100 + 0 − 100
= 0
As the future deductible amount is greater than the future taxable amount, a deductible temporary differ-
ence exists. In other words, in settling the liability for its carrying amount, Dalal Inc. will reduce its future tax
profits and hence its future tax payments. Dalal Inc. then has an expected benefit relating to the future tax
deduction. As the benefits are to be received in the future, the asset raised is referred to as a ‘deferred tax asset’.
Source: Adapted from IAS 12, paragraph 25.
6.8.4 Calculating deferred tax liabilities and deferred tax assets

Paragraphs 15 and 24 of IAS 12 require (with some exceptions) that a deferred tax liability and a deferred
tax asset be recognised for all taxable temporary differences and all deductible temporary differences, and
that a total be determined for taxable temporary differences and for deductible temporary differences. An
appropriate tax rate can then be applied to these totals to derive the balance of deferred tax liability and
deferred tax asset at the end of the period. Paragraph 47 of the standard specifies that:
Deferred tax assets and liabilities shall be measured at the tax rates that are expected to apply to the period when
the asset is realised or the liability is settled, based on tax rates (and tax laws) that have been enacted or substan-
tively enacted by the end of the reporting period.
Thus, if the tax rate is currently 30% but will rise to 32% in the next reporting period, deferred amounts
should be measured at 32%. Should a change be enacted (or substantively enacted) between the end of
the reporting period and the time of completion of the financial statements, no adjustment needs to be
made to the tax balances recognised. However, disclosure of any material impacts should be made by note
in compliance with IAS 10 Events after the Reporting Period.
Different tax rates may be required when temporary differences are expected to reverse in different periods
and a change of tax rate is probable, or when temporary differences relate to different taxation jurisdictions.
Additionally, consideration should be given to the manner in which an asset/liability is recovered/settled in
jurisdictions where the manner of recovery/settlement determines the applicable tax rate (IAS 12 paragraph 52).
Before determining the amounts of deferred tax liabilities and deferred tax assets, consideration must be
given to the recognition criteria mandated by the accounting standard. (See section 6.9.)
6.8.5 Excluded differences

A deferred tax liability is usually recognised on taxable temporary differences, but if the taxable temporary
difference meets the criteria in paragraph 15 of IAS 12, it is exempt from deferred tax. Likewise, a deferred
tax asset is normally recognised on deductible temporary differences, but if this difference meets the cri-
teria in paragraph 24 of IAS 12, it may also be exempt from deferred tax.
Paragraph 15 states that a deferred tax liability shall be recognised for all taxable temporary differences,
except where the deferred tax liability arises from:
(a) goodwill; or
(b) the initial recognition of an asset or liability, which
(i) did not arise through a business combination, and which
(ii) at the time of the transaction, affects neither accounting profit nor taxable profit.
Paragraph 24 states that a deferred tax asset shall be recognised for all deductible temporary differences,
except where the deferred tax asset arises from the initial recognition of an asset or liability, which:
(a) did not arise through a business combination, and
(b) at the time of the transaction, affects neither accounting profit nor taxable profit.
Goodwill
Goodwill is the excess of the cost of the business combination over the acquirer’s interest in the net fair
value of the identifiable assets, liabilities and contingent liabilities (see chapter 14). A taxable temporary
difference is created because the tax base of goodwill is always nil. IAS 12 does not permit the recognition
136 PART 2 Elements

of the deferred tax liability relating to goodwill, because goodwill is a residual amount and recognising the
deferred tax amount would increase the carrying amount of goodwill (IAS 12 paragraph 21).
Initial recognition of an asset or liability
The tax base and carrying amount of an asset are usually the same on initial recognition but in the case of a
non-deductible asset, such as land, a temporary difference arises on initial recognition. Consider the example
of a non-deductible asset that is not acquired through a business combination. A non-deductible asset is an
asset whose cost is not allowed as a deduction when calculating taxable profits and therefore the tax base on
date of purchase is zero. A taxable temporary difference will arise on the initial recognition, being the differ-
ence between the carrying amount on date of purchase (the asset’s cost) and its tax base (zero).
The initial recognition, in other words, the purchase, does not affect accounting profit or taxable profit.
Thus, although a deferred tax liability is normally recognised on taxable temporary differences, no deferred
tax is recognised on this taxable temporary difference since it meets the requirements of paragraph 12 of
IAS 12 to be exempt from deferred tax.
6.8.6 Deferred tax worksheet

A deferred tax worksheet is shown in illustrative example 6.6. The purpose of the deferred tax worksheet
is to calculate the movements in the deferred tax asset and the deferred tax liability accounts during the
current period. Determining the temporary differences relating to assets and liabilities allows the closing
balances of the deferred tax accounts to be calculated. A consideration of the beginning balances and
movements during the year allows the calculation of the adjustments required to achieve those closing
balances. All assets and liabilities may be included in the worksheet; alternatively, only those expected to
have different accounting and tax bases could be shown.
ILLUSTRATIVE EXAMPLE 6.6 Deferred tax worksheet
Using the information provided in illustrative example 6.2, the deferred tax worksheet for Iris Ltd is
IRIS LTD
Deferred Tax Worksheet
as at 30 June 2013
Future Future Taxable Deductible

Carrying taxable deductible Tax temporary temporary
amount amount amount base differences differences
Relevant assets
Receivables1 £ 279 000 £ 0 £16 000 £295 000 £16 000
Prepaid insurance2 30 000 (30 000) 0 0 £ 30 000
Rent receivable3 3 500 (3 500) 0 0 3 500
Development project4 90 000 (90 000) 0 0 90 000
Equipment5 110 000 (110 000) 80 000 80 000 30 000
Goodwill6 21 000 (21 000) 0 0 21 000
Relevant liabilities
Provision for annual
leave7 61 000 0 (61 000) 0 61 000
Total temporary
differences 174 500 77 000
Excluded differences8 (21 000) —
Temporary differences 153 500 77 000
Deferred tax liability9 46 050

Deferred tax asset9 23 100
Beginning balances10 (17 150) (24 900)
Movement during
year11 — —
Adjustment10 28 900 Cr (1 800) Cr
FIGURE 6.4 Deferred tax worksheet for Iris Ltd

1. The carrying amount of receivables £279 000 (£295 000 − 16 000) represents the cash that the com-
pany expects to receive after allowing for any doubtful debts. Tax on this amount has already been
paid via sales revenue recognised in the current year, so the future taxable amount is zero. The al-
lowance for doubtful debts raised as an expense in the current year is not deductible against taxable
profit until the debts actually go ‘bad’ and are written out of the accounts receivable balance. Thus,
there is a future deduction of £5000 available. The tax base for receivables is £283 000, being the
total of all debts outstanding at 30 June 2013 (doubtful or otherwise). Because the future deductible
amount is greater than the future taxable amount, a deductible temporary difference of £5000 exists
in respect of receivables.
2. The prepaid insurance asset represents the future benefit of insurance cover at 30 June 2013. The
recovery of these benefits results in the flow of taxable economic benefits to Iris Ltd, giving a future
taxable amount of £30 000. This amount was paid in the year ended 30 June 2013 and was allowed
as a deduction against the taxable profit for that year. This means that no deduction is available
when the £30 000 is expensed in the year ended 30 June 2014, giving a tax base for the asset of £0.
As the future taxable amount exceeds the future deductible amount, a taxable temporary difference
of £30 000 exists in respect of prepaid insurance.
3. The rent receivable asset represents monies to be received at 30 June 2013. The recovery of these
benefits results in the flow of taxable economic benefits to Iris Ltd. Hence, a future taxable amount
of £3500 exists. As this is a revenue item, no future deduction is available and the tax base is £0. As
the future taxable amount exceeds the future deductible amount, a taxable temporary difference of
£3500 exists in respect of the rent receivable.
4. The development project asset represents the future economic benefits expected to arise from devel-
opment work undertaken in the current year. When those benefits are received, they are taxable. The
total expenditure on development was deducted from taxable profit in the current year, so no future
deduction is available. The tax base is £0 as the cash paid has already reduced taxable profit in the
current year. As the future taxable amount exceeds the future deductible amount, a taxable tempo-
rary difference of £90 000 exists in respect of the development project.
5. The carrying amount of equipment represents the future economic benefits expected to be received
from that asset over the remainder of its useful life, £110 000 (£200 000 − £90 000). When those
benefits are received, they are taxable. Iris Ltd will be able to claim a deduction against those taxable
benefits, but only to the extent of the tax base of the asset. As the depreciation rate for tax purposes
is greater than the accounting rate, the future deduction is only £80 000, being the original cost of
£200 000 less £120 000 (i.e. 3 years’ accumulated depreciation at 20% per annum). As the future
taxable amount exceeds the future deductible amount, a taxable temporary difference of £30 000
exists in respect of equipment.
6. The carrying amount of goodwill represents the future economic benefits expected to be received.
Those benefits are taxable when received but, unlike equipment, no deduction against the benefits is
available. The tax base of goodwill is £0 as taxation law does not allow a deduction for any amounts
paid to acquire goodwill. As the future taxable amount exceeds the future deductible amount, a taxable
temporary difference of £21 000 exists in respect of goodwill (however, see exemption in 8 below).
7. The provision for annual leave represents leave accrued by employees as at the end of the reporting
period. As the leave represents future payments, there is no future taxable amount. When those pay-
ments are made, they are fully deductible against taxable profit. The tax base at 30 June 2013 is £0
because leave payments are only deductible in the year of payment. As the future deductible amount
exceeds the future taxable amount, a deductible temporary difference of £61 000 exists in respect of
the annual leave provision.
8. The adjustment for excluded differences recognises that IAS 12 (paragraphs 15 and 24) has prohib-
ited the recognition of deferred tax amounts relating to certain temporary differences (see section
6.9.2). Paragraph 15 prohibits the recognition of the taxable temporary difference relating to good-
will, so it is removed from the total temporary differences existing at 30 June 2013.
9. The deferred tax liability figure of £46 050 is the future tax payable as a result of the existence of
taxable temporary differences of £153 500. The deferred tax asset figure of £23 100 is the future de-
ductions available as a result of the existence of deductible temporary differences of £77 000. These
figures represent the closing balances of the deferred tax accounts.
10. Deferred tax amounts may accumulate over time; for example, the taxable temporary difference for
equipment represents 3 years’ differentials between accounting and taxation depreciation charges.
This means that the deferred tax accounts have an opening balance representing prior year differ-
ences. If no adjustment is made for the opening balance, the deferred tax amounts are overstated.
Accordingly, the opening balances are deducted from the total balances in order to determine the
adjustment necessary to account for changes (additions and reversals) to deferred tax items during
the current year. These adjustments are shown on the last line of the worksheet and form the basis
of the adjusting journal entry for deferred tax. Positive figures are increases and negative figures are
decreases in the account balances.
138 PART 2 Elements

11. Normally, the deferred tax accounts are only adjusted at the end of each reporting period after the
worksheet has been completed. Occasionally, however, adjustments are made to the deferred ac-
counts during the year so the ‘movements’ line is used to adjust for such changes. Adjustments could
be made for:
• recoupment of prior year tax losses (see section 6.7)
• a change in tax rates (see section 6.10)
• an amendment to a prior year tax return (see section 6.11)
• revaluation of property, plant and equipment items (see section 6.11.2)
• business combinations (see section 6.11.3).
The flowcharts in figure 6.5 below summarise the measurement of deferred tax items according to IAS 12.
While the flowcharts show the steps in the calculation of deferred tax items, they do not present the steps in
determining whether the resultant deferred tax assets or deferred tax liabilities will be recognised. The criteria
for the recognition of deferred tax assets and deferred tax liabilities are considered next, in section 6.9.
Accounting for assets Taxable temporary

Deferred
Greater difference equal to
tax liability
the difference Multiply by
the tax rate
Is the carrying amount of the expected* to
asset greater than or less apply when
than its tax base? the asset is
Deductible realised
Deferred
Less temporary difference
tax asset
equal to the difference
Accounting for liabilities Deductible

Deferred
Greater temporary difference
tax asset
equal to the difference Multiply by
the tax rate
Is the carrying amount of the expected* to
liability greater than or less apply when
than its tax base? the liability is
Taxable temporary settled
Deferred
Less difference equal to
tax liability
the difference
FIGURE 6.5 Accounting for deferred tax items

Note: *refers to the present tax rate or tax laws (tax rates) that have been enacted or substantively enacted by reporting date.
Source: CPA Australia (2010, p. 2).
LO9 6.9 RECOGNITION OF DEFERRED TAX LIABILITIES

AND DEFERRED TAX ASSETS
The existence of temporary taxable and deductible differences may not result in the recognition of deferred
tax assets and liabilities. Paragraphs 15 and 24 of IAS 12 specify recognition criteria that must be met
before recognition occurs.
6.9.1 Deferred tax liabilities

Deferred tax liabilities must be recognised for all taxable temporary differences (except as outlined below).
A liability is recognised when it is probable that an outflow of resources embodying economic bene-
fits will result from the settlement of a present obligation, and the amount at which the settlement will
take place can be measured reliably (Conceptual Framework paragraph 4.46). There is no need to explicitly

consider the recognition criteria for a deferred tax liability, because it is always probable that resources will
flow from the entity to pay the tax associated with taxable temporary differences. As the carrying amount
of the asset or liability giving rise to the taxable temporary difference is recovered or settled, the temporary
difference will reverse and give rise to taxable amounts in future periods.
6.9.2 Deferred tax assets

Deferred tax assets must be recognised for all deductible temporary differences (subject to certain excep-
tions) and from the carry forward of tax losses, but only to the extent that it is probable that future taxable
profits will be available against which the temporary differences can be utilised.
An asset is recognised when it is probable that the future economic benefits will flow to the entity, and the
asset has a cost or value that can be measured reliably (Conceptual Framework paragraph 4.44). According
to paragraph 4.40 of the Conceptual Framework, probability refers to the degree of uncertainty about
whether the future economic benefits associated with the asset will flow to the entity. This probability must
be assessed using the best evidence available based on the conditions at the end of the reporting period. The
reversal of deductible temporary differences results in deductions against the taxable profits of future periods.
Economic benefits in the form of reductions in tax payments will flow to the entity only if it earns sufficient
taxable profits against which the deductions can be offset. Therefore, an entity recognises deferred tax assets
only when it is probable that taxable profits will be available against which the deductible temporary differ-
ences can be utilised (IAS 12 paragraph 27). The realisation of a deferred tax asset would be probable where:
• there are sufficient taxable temporary differences relating to the same taxation authority and the same
taxable entity that are expected to reverse in the same period as the deductible temporary differences,
or in periods to which a tax loss arising from the deferred tax asset can be carried back or forward
(paragraph 28)
• there would be taxable temporary differences arising if unrecognised increases in the fair values of
assets were recognised
• it is probable that there will be other sufficient taxable profits arising in future periods against which to
utilise the deductions
• other factors indicate that it is probable that the deductions can be realised.
If there are insufficient taxable temporary differences available against which to offset the deductible
temporary differences, an entity can recognise a deferred tax asset only to the extent that sufficient taxable
profits will be made in the future or that tax planning opportunities are available to create future taxable
profits (IAS 12 paragraph 29).
A history of accounting losses, or the existence of unused tax losses, provides evidence that future tax-
able profits are unlikely to be available for the utilisation of deductible temporary differences. In these
circumstances, the recognition of deferred tax assets would require either the existence of sufficient taxable
temporary differences or convincing evidence that future taxable profits will be earned. In assessing the
likelihood that tax losses will be utilised, the entity should consider whether:
• future budgets indicate that there will be sufficient taxable income derived in the foreseeable future
• the losses arise from causes that are unlikely to recur in the foreseeable future
• actions can be taken to create taxable amounts in the future
• there are existing contracts or sales backlogs that will produce taxable amounts
• there are new developments or favourable opportunities likely to give rise to taxable amounts
• there is a strong history of earnings other than those giving rise to the loss, and the loss was an
aberration and not a continuing condition.
Where, on the balance of the evidence available, it is not probable that deductible temporary differences will
be utilised in the future, no deferred tax asset is recognised. This probability assessment must also be applied
to deferred tax assets that have previously been recognised and, if it is no longer probable that the benefits of
such assets will flow to the entity, the carrying amount must be derecognised by passing the following entry:
30 June
Income Tax Expense Dr xxx
Deferred Tax Asset Cr xxx
(Derecognition of deferred tax assets where recovery is no
longer probable)
At the end of each reporting period, the entity should reassess the probability of recovery of all unrecog-
nised deferred tax assets; it should recognise these assets to the extent that it is now probable that future
taxable profit will allow the deduction of the temporary difference on its reversal. Changes in trading con-
ditions, new taxation legislation, or a business combination may all contribute to improving the chance
of recovering the deferred tax benefits. Paragraph 60 of IAS 12 requires that any adjustment to deferred
tax be recognised in the statement of comprehensive income except to the extent that it relates to items
previously charged or credited to equity.
140 PART 2 Elements

ILLUSTRATIVE EXAMPLE 6.7 Recognition of deferred tax adjustments
Using the figures calculated in illustrative example 6.6 and assuming that the recognition criteria for
deferred tax assets can be met, the adjusting journal for deferred tax movements is:
30 June 2013
Income Tax Expense Dr 30 700
Deferred Tax Asset Cr 1 800
Deferred Tax Liability Cr 28 900
(Recognition of movements in deferred tax balances
for the year)
These movements can be checked back to the current worksheet as follows:

• Deferred tax assets arise in respect of doubtful debts and annual leave. In the current year, additional
deductions of £2000 (doubtful debts) and £4000 (leave) are received. This indicates that more
deductible temporary differences had been reversed than had been created, resulting in a decrease of
£6000 in future deductions and a £1800 decrease in the deferred tax asset.
• Deferred tax liabilities arise in respect of development expenditure, equipment, insurance and rent.
In the current year, additional deductions of £90 000 (development), £13 333 (depreciation) and
£5000 (insurance) are offset by additional taxable amounts of £10 000 (sale of equipment) and
£2000 (rent revenue), giving a net extra increase in taxable temporary differences and a £28 900
increase in the deferred tax liability.
The posting of this entry results in the deferred tax ledger accounts appearing as follows:
Deferred Tax Asset
1/7/12 Balance b/d 24 900 30/6/13 Income Tax Expense 1 800

30/6/13 Balance c/d 23 100
24 900 24 900
1/7/13 Balance b/d 23 100
Deferred Tax Liability
30/6/13 Balance c/d 46 050 1/7/12 Balance b/d 17 150

30/6/13 Income Tax Expense 28 900
46 050 46 050
1/7/13 Balance b/d 46 050
If the two taxation adjusting journals — current and deferred — are combined, then the total income
tax expense recorded for the year ended 2013 by Iris Ltd is:
Income Tax Expense (Current) (see section 6.5) £ 41 270

Income Tax Expense (Deferred) (see above) 30 700
Total £ 71 970
This figure represents the total tax consequences of the transactions recorded in profit or loss for
the year. It can be checked in this way: The accounting profit for the year is £250 450. All items of rev-
enue and expense are taxable or deductible with the exception of goodwill impairment and entertain-
ment expense. The development expenditure during the year gave rise to an ‘extra’ deduction of £30 000
against taxable profit. If the accounting profit adjusted for these permanent differences is multiplied by
the tax rate, the result represents the total tax payable above (both now and in the future):
Accounting profit £250 450

Add: Non-deductible amortisation 7 000
Add: Non-deductible entertainment expense 12 450
Less: Additional deduction for development (30 000)
Taxable net profit 239 900
Tax @ 30% £ 71 970

LO10 6.10 CHANGE OF TAX RATES
When a new tax rate is enacted (or substantively enacted), the new rate should be applied in calculating
the current tax liability and adjustments to deferred tax accounts during the year. It should also be applied
to the deferred amounts recognised in prior years. A journal adjustment must be passed to increase or
reduce the carrying amounts of deferred tax assets and liabilities, in order to reflect the new value of future
taxable or deductible amounts. Paragraph 60 of IAS 12 requires the net amount arising from the restate-
ment of deferred tax balances to be recognised in the statement of comprehensive income, except to the
extent that the deferred tax amounts relate to items previously charged or credited to equity.
ILLUSTRATIVE EXAMPLE 6.8 Change of tax rate
As at 30 June 2013, the balances of deferred tax accounts for Carnation Ltd were:
Deferred Tax Asset £29 600

Deferred Tax Liability (72 800)
In September 2013, the government reduced the company tax rate from 40 pence to 30 pence in the
pound, effective from 1 July 2013. The recorded deferred tax balances represent the tax effect of future
taxable amounts and future deductible amounts at 40 pence in the pound, so they are now overstated
and must be adjusted as follows:
Deferred tax Deferred

asset tax liability
Opening balance £29 600 £ 72 800
Adjustment for change in tax rate: ([40 − 30]/40) (7 400) (18 200)
Restated balance £22 200 £ 54 600
The adjusting journal entry is:
Deferred Tax Liability Dr 18 200

Deferred Tax Asset Cr 7 400
Income Tax Expense Cr 10 800
(Recognition of the impact of a change of tax rate on deferred
tax amounts)
LO11 6.11 OTHER ISSUES

6.11.1 Amended prior year tax figures
In taxation jurisdictions where entities self-assess their taxable profit, it is possible that the taxation
authority will amend that assessment by changing the amount of taxable or deductible items. This amend-
ment could result in the entity being liable to pay extra tax or becoming eligible for a taxation refund.
Upon receipt of an amended assessment, the entity should analyse the reason for the adjustment and
consider whether both current and deferred tax are affected. For example, if an entity has used an incorrect
taxation depreciation rate, then the amendment to the correct rate will change both the prior year taxable
profit and future taxable profits across the economic life of the depreciable asset. If only current tax for the
previous year has changed, the following journal entry would be passed:

Current Tax Liability Cr xxx
(Amendment to prior year current tax on receipt of amended
assessment)
If the amendment also changes a deferred item, the new temporary difference will need to be calculated
and the carry-forward balance adjusted accordingly. In the depreciation example used above, the adjust-
ment (assuming the accounting depreciation rate is lower than the rate used to calculate taxable profit) is:
142 PART 2 Elements

Deferred Tax Liability Cr xxx
Current Tax Liability Cr xxx
(Amendment to prior year current tax and deferred tax liability
on receipt of amended assessment)
Any amendment to the deferred tax liability or the deferred tax asset arising from amended assessments
would appear on the deferred tax worksheet as a ‘movement’ adjustment.
6.11.2 Items recognised outside profit or loss

In general, the amount of current and deferred tax arising in a period must be recognised outside profit or
loss if the tax relates to items that are recognised outside profit or loss (IAS 12 paragraph 61A). Examples
of items that are recognised in other comprehensive income are:
• revaluation of items of property, plant and equipment to fair value (see chapter 11). At the time of
revaluation, an adjustment may be required to be made to the balance of the deferred tax liability
account. For example, if an item of plant is revalued upwards from £100 to £200 and the tax rate is
30%, the entity would pass the following journal entry:
Plant Dr 100
(Revaluation of plant)
Deferred Tax Liability Cr 30
Asset Revaluation Surplus Cr 70
(Revaluation of plant, recognition of deferred tax liability and
accumulation of net revaluation gain in equity)
• exchange differences arising on the translation of the financial statements of a foreign entity (see
chapter 24).
6.11.3 Deferred tax arising from a business combination

The amount of deferred tax arising in relation to the acquisition of an entity or business is recognised (sub-
ject to the recognition criteria) and included as part of identifiable assets acquired and liabilities assumed
when determining the goodwill or gain on bargain purchase arising on acquisition. (Further discussion of
the determination of goodwill and gain on bargain purchase can be found in chapter 14.) When a deferred tax
asset of the acquiree not recognised at the date of a business combination is subsequently recognised by
the acquirer, the resulting deferred tax income is recognised in the statement of profit or loss and other
comprehensive income. Additionally, paragraph 68 of IAS 12 requires that the amount of goodwill recog-
nised on acquisition must be adjusted to the amount that would be recorded had the deferred tax asset
been recognised on acquisition.
LO12 6.12 PRESENTATION IN THE FINANCIAL STATEMENTS

IAS 12 specifies the way in which tax items (revenues, expenses, assets and liabilities) are to be presented
in the financial statements, including the circumstances in which items can be offset.
6.12.1 Tax assets and tax liabilities

Tax assets and tax liabilities must be classified as current and non-current as required by IAS 1 Presentation
of Financial Statements (paragraph 60) and presented in the statement of financial position in accordance
with IAS 1 paragraphs 54(n), 54(o) and 56. Paragraph 71 of IAS 12 allows current tax assets and current
tax liabilities to be offset only when the entity has a legally enforceable right to offset the amount, and
intends either to settle on a net basis or to realise the asset and settle the liability simultaneously. A legal
right to set off the accounts would normally exist where the accounts relate to income taxes levied by the
same taxing authority.
Deferred tax assets and deferred tax liabilities can be offset only if a legally enforceable right to offset
current amounts exists; and the deferred items relate to income taxes levied by the same taxing authority
on the same taxable entity, or on different taxable entities which intend either to settle on a net basis or to
realise the asset and settle the liability simultaneously in each future period in which significant deferred
amounts will reverse (IAS 12 paragraph 74).
Consequently, entities operating in a single country will normally offset both current and deferred tax
assets and liabilities, and show only a net current tax liability or asset and a net deferred asset or liability.

6.12.2 Tax expense
The tax expense (or income) related to profit or loss for the period is required to be presented in the state-
ment of profit or loss and other comprehensive income (IAS 12 paragraph 77).
LO13 6.13 DISCLOSURES

Paragraphs 79–82A of IAS 12 contain the required disclosures relating to income taxes. These disclo-
sures are very detailed, and provide significant additional information about the makeup of income tax
expense (or income), and both taxable and deductible temporary differences. Paragraph 79 requires the
tax expense figure shown in the statement of profit or loss and other comprehensive income to be broken
down into its various components (examples of which are listed in paragraph 80), such as current tax
expense and deferred tax arising from temporary differences. Paragraph 81 requires a wide range of disclo-
sures including tax relating to equity and discontinued operations, changes in tax rates, and unrecognised
deferred tax assets and liabilities.
Paragraph 81 also requires two detailed reconciliations to be prepared:
• Paragraph 81(c) requires entities to disclose ‘an explanation of the relationship between tax expense
(income) and accounting profit’. This essentially reconciles expected tax — accounting profit multiplied
by tax rate — to the actual tax expense recognised. The reconciliation enables financial statement users
to understand why the relationship between accounting profit and income tax expense is unusual, the
factors causing the variance, and factors that could affect the relationship in the future. Entities are
allowed to reconcile in either or both of the following ways:
• a numerical reconciliation between tax expense and expected tax
• a numerical reconciliation between the average effective tax rate (tax expense divided by the accounting
profit) and the applicable tax rate.
Irrespective of the reconciliation method used, entities must disclose the basis on which the applicable
tax rate is computed.
• Paragraph 81(g) requires disclosure of the following information for deferred tax items recognised in
the statement of financial position:
in respect of each type of temporary difference, and in respect of each type of unused tax loss and unused tax credit:
(i) the amount of the deferred tax assets and liabilities recognised in the statement of financial position for each
period presented; and
(ii) the amount of the deferred tax income or expense recognised in profit or loss, if this is not apparent from the
changes in the amounts recognised in the statement of financial position.
Normally, the second part of the paragraph 81(g) disclosure is required only if a change in tax rate or
legislation has occurred during the year, or if some other event causes an adjustment to a deferred account
during the period.
When an entity has suffered tax losses in either the current or previous period, and recognised a deferred
tax asset related to those losses that is dependent on earning future taxable profits in excess of those arising
on the reversal of taxable temporary differences, paragraph 82 requires disclosure of the amount of the
deferred tax asset and the nature of the evidence supporting its recognition.
Paragraph 82A applies only in those jurisdictions where tax rates vary according to the quantum of
profit or retained earnings distributed as dividends. In this situation, paragraph 82A requires the entity to
disclose the nature and amounts (to the extent practicable) of the potential income tax consequences that
would result from the payment of dividends to its shareholders.
Figure 6.6 provides an illustration of the disclosures required by IAS 12.
FIGURE 6.6 Illustrative disclosures required by IAS 12
2016 2015 IAS 12

Note 4: Income tax expense Notes £ £ paragraph
Major components of income tax expense 79
Current tax expense 126 600 117 600 80(a)
Deferred tax from origination and reversal of temporary
differences (20 250) 11 320 80(c)
Deferred tax relating to tax rate change 250 — 80(d)
Benefit from unrecognised tax loss used to reduce current
tax expense (1 500) — 80(e)
Income tax expense 105 100 128 920 80(f)
144 PART 2 Elements

2016 2015 IAS 12

Tax relating to items charged (credited) direct to equity
Deferred tax relating to revaluation of land 12 500 — 80(h)
Reconciliation of tax expense to prima facie tax on

accounting profit 81(b)
The applicable tax rate is the company income tax rate of
30% (2012: 40%) 81(c)(i)
The prima facie tax on accounting profit differs from the
tax expense provided in the accounts as follows:
Accounting profit 402 000 397 000
Prima facie tax at 30% (2012: 40%) 120 600 158 800
Tax effect of non-deductible expenses
Goodwill impairment 3 900 5 200
Non-taxable revenue (1 500) (2 000)
Entertainment 3 600 2 300
126 600 164 300
Increase in beginning deferred taxes resulting from
reduction in tax rate 250 —
Reduction in current tax from recoupment of tax losses (1 500) —
Tax effect of net movements in items giving rise to:*
Deferred tax assets (8 250) 3 200
Deferred tax liabilities (12 000) (38 580)
Tax expense 105 100 128 920 81(d)
Change in tax rate

As of 1 July 2012, the company tax rate changed from
40% to 30% 81(d)
Unrecognised deferred tax assets

Tax losses in respect of which deferred tax has not been
recognised as it is not probable that benefits will be
received 20 000 40 000 81(e)
Unrecognised deferred tax liabilities

Aggregate of temporary differences associated with
investments in subsidiaries for which deferred tax
liabilities have not been recognised 16 000 16 000 81(f)
Deferred tax assets and liabilities

The following items have given rise to deferred
tax assets:
Employee entitlements 24 000 22 000
Total deferred tax assets 36 000 37 000
The following items have given rise to deferred tax
liabilities:
Land 12 500 —
Plant and equipment 15 000 36 000
Total deferred tax liabilities 27 500 36 000
Offset of deferred tax asset against liability 36 000 37 000
Net deferred tax asset (liability) 8 500 (1 000) 81(g) (i)
* These figures represent the net effect of movements in assets and liabilities during the year which have increased or decreased current tax. The details can be
found in disclosures required by paragraph 81(g)(ii).
(continued)

2016 2015 IAS 12

Deferred tax expenses (income) recognised in the
statement of comprehensive income for each type of
temporary difference*
Deferred tax expense in relation to:
Plant and equipment (12 000) (38 580)
Total deferred tax expense (12 000) (38 580)
Deferred tax income in relation to:
Accounts receivable 750 1 200
Employee entitlements 7 500 2 000
Total deferred tax income 8 250 3 200 81(g) (ii)
* This disclosure is required only if the movements in deferred items cannot readily be ascertained from other disclosures made with respect to deferred assets
and liabilities. This is the case in this situation because the change in tax rate adjustments has obscured the movements in deferred items.
FIGURE 6.7 Income tax notes to the consolidated financial statements of Marks & Spencer
7 Income tax expense
A. Taxation charge
2014 2013
(restated)1
£m £m
Current tax
UK corporation tax on profits for the year at 23% (last year 24%)
– current year 97.1 125.5
– adjustments in respect of prior years (55.8) (24.6)
UK current tax 41.3 100.9
Overseas current taxation
– current year 14.5 12.8
– adjustments in respect of prior years (2.7) 3.8
Total current taxation 53.1 117.5
Deferred tax
– origination and reversal of temporary differences 17.7 (6.6)
– adjustments in respect of prior years 26.2 (2.8)
– changes in tax rate (22.6) (5.7)
Total deferred tax (see note 23) 21.3 (15.1)
Total income tax expense 74.4 102.4
1. Restatement relates to the adoption of the revised IAS 19 ‘Employee Benefits’ (see note 1).
B. Taxation reconciliation
The effective tax rate was 12.8% (last year 18.7%) and is reconciled below:
2014 2013
(restated)1
£m £m
Profit before tax 580.4 547.2

Notional taxation at the standard UK corporation tax rate of 23% (last year 24%) 133.5 131.5
Depreciation and other amounts in relation to fixed assets that do not qualify for tax relief 4.3 3.0
Other income and expenses that are not taxable or allowable for tax purposes (5.4) (8.1)
Retranslation of deferred tax balances due to the change in statutory UK tax rates (22.5) (5.4)
Overseas profits taxed at rates different to those of the UK (3.7) (4.0)
Overseas tax losses where there is no relief anticipated in the foreseeable future 8.7 9.3
Adjustments to current and deferred tax charges in respect of prior periods (6.4) (3.2)
146 PART 2 Elements

B. Taxation reconciliation (continued)
2014 2013
(restated)1
£m £m
Adjustments to underlying profit:

– international store review charges where no tax relief is available 4.9 –
– property disposal gain covered by other losses arising in the year (13.0) –
– deferred tax rate change benefit – (0.3)
Non-underlying adjustment to current and deferred tax charges in respect of prior periods (26.0) (20.4)
Total income tax expense 74.4 102.4
After excluding non-underlying items the underlying effective tax rate was 18.8% (last year 22.7%).
The non-underlying adjustment to the tax charge in respect of prior periods arises from the successful outcome of litigation in
relation to the Group’s claim for UK tax relief of losses of its former European subsidiaries (£18.5m, last year £nil) and release of
provisions following settlement of historic disputes with the tax authorities (£7.5m, last year £20.4m).
On 2 July 2013, the Finance Bill received its final reading in the House of Commons and so the previously announced reduced
rates of corporation tax of 21% from 1 April 2014 to 31 March 2015 and 20% from 1 April 2015 onwards were substantively
enacted. The Group has remeasured its UK deferred tax assets and liabilities at the end of the reporting period at 20%, which
has resulted in the recognition of a deferred tax credit of £22.5m in the income statement (reducing the total effective tax rate by
3.9%), and the recognition of a deferred tax credit of £11.3m in other comprehensive income.
23 Deferred tax
Deferred tax is provided under the balance sheet liability method using a tax rate of 20% (last year 23%) for UK differences and local tax
rates for overseas differences. Details of the changes to the UK corporation tax rate and the impact on the Group are described in note 7.
The movements in deferred tax assets and liabilities (after offsetting balances within the same jurisdiction as permitted by IAS 12 –
‘Income Taxes’) during the year are shown below.
Capital Pension Other Total

Fixed assets allowances temporary short-term UK Overseas
temporary in excess of differences temporary deferred tax deferred Total
differences depreciation (restated)1 differences (restated)1 tax (restated)1
£m £m £m £m £m £m £m
At 1 April 2012 (58.2) (100.6) (38.9) 6.5 (191.2) (14.9) (206.1)

Credited/(charged) to the 5.7 10.0 (2.6) 0.7 13.8 1.3 15.1
income statement
Credited/(charged) to
equity/other
comprehensive income – – (55.1) (0.7) (55.8) 6.2 (49.6)
At 30 March 2013 (52.5) (90.6) (96.6) 6.5 (233.2) (7.4) (240.6)
At 31 March 2013 (52.5) (90.6) (96.6) 6.5 (233.2) (7.4) (240.6)
Credited/(charged) to the 3.2 (9.3) (0.8) (12.5) (19.4) (1.9) (21.3)
income statement
Credited/(charged) to
equity/other
comprehensive income – – 0.1 20.9 21.0 (1.7) 19.3
At 29 March 2014 (49.3) (99.9) (97.3) 14.9 (231.6) (11.0) (242.6)
Other short-term temporary differences relate mainly to employee share options and financial instruments.
The deferred tax liability on land and buildings temporary differences is reduced by the benefit of capital losses with a tax value
of £46.5m (last year £62.0m). Due to uncertainty over their future use, no benefit has been recognised in respect of unexpired
trading losses carried forward in overseas jurisdictions with a tax value of £38.7m (last year £30.8m).
No deferred tax has been recognised in respect of undistributed earnings of overseas subsidiaries and joint ventures, as no
material liability is expected to arise on distribution of these earnings under applicable tax legislation.
Source: Marks & Spencer plc (2014, pp. 100, 101, 119).

SUMMARY
This chapter analyses the content of IAS 12 Income Taxes and provides guidance on its implementation.
The principal issue in accounting for taxes is how to account for the current and future tax consequences of
transactions and other events of the current period. The accounting standard requires entities to recognise
(with limited exceptions) deferred tax liabilities and deferred tax assets when the recovery or settlement
of an asset or liability will result in larger or smaller tax payments than would occur if such settlement or
recovery had no tax consequence. The tax consequences of transactions are to be accounted for in the same
way as the transaction to which they are related. Therefore, for transactions recognised in the statement of
profit or loss and other comprehensive income, all related tax effects are also recognised in the statement
of profit or loss and other comprehensive income. Where a transaction requires a direct adjustment to
equity, so do any tax effects. Deferred tax assets, particularly those relating to tax losses, are recognised only
if it is probable that the entity will have sufficient taxable profit in the future against which the tax benefit
can be offset. All deferred tax liabilities must be recognised in full. IAS 12 requires extensive disclosures to
be made in relation to both current and deferred tax items.
1. What is the main principle of tax-effect accounting as outlined in IAS 12?
2. Explain the meaning of a temporary difference as it relates to deferred tax calculations and give three
examples.
3. Explain how accounting profit and taxable profit differ, and how each is treated when accounting for
income taxes.
4. In tax-effect accounting, the creation of temporary differences between the carrying amount and the
tax base for assets and liabilities leads to the establishment of deferred tax assets and liabilities in the
accounting records. List examples of temporary differences that create:
(a) deferred tax assets
(b) deferred tax liabilities.
5. In IAS 12, criteria are established for the recognition of a deferred tax asset and a deferred tax liability.
Identify these criteria, and discuss any differences between the criteria for assets and those for liabilities.
References
CPA Australia 2010, International Financial Reporting Standards Fact Sheet — IAS 12 Income Taxes, CPA
Australia, February, www.cpaaustralia.com.au.
International Accounting Standards Board 2014, IAS 12 Income Taxes, www.ifrs.org.
Marks & Spencer plc 2014, Annual Report, http://corporate.marksandspencer.com/investors/reports-results-
and-presentations.
Exercise 6.1 TAX EFFECTS OF A TEMPORARY DIFFERENCE

★ The following information was extracted from the records of Protea Ltd for the year ended 30 June 2013:
PROTEA LTD
Deferred Tax Worksheet (extract)
as at 30 June 2013
Future Future Taxable Deductible

Carrying Taxable deductible temporary temporary
amount amount amount Tax base differences differences
Relevant assets
Equipment £75 000 £(75 000) £120 000 £120 000 £45 000
The equipment cost £300 000 and is depreciated at 25% p.a. straight-line for accounting purposes, but
the allowable rate for taxation is 20% p.a.
Required
Assuming that no equipment is purchased or sold during the years ended 30 June 2014 and 30 June 2015,
calculate:
(a) the accounting expense and tax deduction for each year
(b) the impact of depreciation on the taxable profit for each year
(c) the movement in the temporary difference balance for each year.
148 PART 2 Elements

Exercise 6.2 CALCULATION OF CURRENT TAX
★ Thistle Ltd made an accounting profit before tax of £40 000 for the year ended 30 June 2014. Included in
the accounting profit were the following items of revenue and expense.
Donations to political parties (non-deductible) 5 000

Depreciation — machinery (20%) 15 000
Rent revenue 12 000
For tax purposes the following applied:
Depreciation rate for machinery 25%

Annual leave paid 6 500
Rent received 10 000
Income tax rate 30%
Required
1. Calculate the current tax liability for the year ended 30 June 2014, and prepare the adjusting journal entry.
2. Explain your treatment of rent items in your answer to requirement 1.
Exercise 6.3 CALCULATION OF DEFERRED TAX

★ The following information was extracted from the records of Orchid Ltd for the year ended 30 June 2014:
ORCHID LTD
Statement of Financial Position (extract)
as at 30 June 2014
Assets
Accounts receivable £25 000
Allowance for doubtful debts (2 000) £23 000
Machines 100 000
Accumulated depreciation — machines (25 000) 75 000
Liabilities
Interest payable 1 000
(a) The accumulated depreciation for tax purposes at 30 June 2014 was £50 000.
(b) The tax rate is 30%.
Required
Prepare a deferred tax worksheet to identify the temporary differences arising in respect of the assets and
liabilities in the statement of financial position, and to calculate the balance of the deferred tax liability and
deferred tax asset accounts at 30 June 2014. Assume the opening balance of the deferred tax accounts was £0.
Exercise 6.4 CURRENT AND DEFERRED TAX

★ Myrtle Ltd has determined its accounting profit before tax for the year ended 30 June 2013 to be £256 700.
Included in this profit are the items of revenue and expense shown below.
Royalty revenue (non-taxable) £8 000

Proceeds on sale of building 75 000
Depreciation expense — buildings 7 600
Depreciation expense — plant 22 500
Carrying amount of building sold 70 000
Development expense 15 000

The company’s draft statement of financial position at 30 June 2013 showed the following assets and
liabilities:
Assets
Cash £2 500
Accounts receivable £21 500
Less: Allowance for doubtful debts (4 100) 17 400
Inventory 31 600
Prepaid insurance 4 500
Land 75 000
Buildings 170 000
Less: Accumulated depreciation (59 500) 110 500
Plant 150 000
Less: Accumulated depreciation (67 500) 82 500
Deferred tax asset (opening balance) 9 600
333 600
Liabilities
Accounts payable 25 000
Provision for annual leave 10 000
Deferred tax liability (opening balance) 6 000
Loan 140 000
£ 181 000
(a) Quarterly income tax instalments paid during the year were:
28 October 2012 £ 18 000

28 January 2013 17 500
28 April 2013 18 000
with the final balance due on 28 July 2013.

(b) The tax depreciation rate for plant (which cost £150 000 3 years ago) is 20%. Depreciation on buildings
is not deductible for taxation purposes.
(c) The building sold during the year had cost £100 000 when acquired 6 years ago. The company
depreciates buildings at 5% p.a., straight-line. Any gain (loss) on sale of buildings is not taxable
(i.e. not deductible).
(d) During the year, the following cash amounts were paid:
Annual leave £52 000

Insurance 3 700
(e) Bad debts of £3500 were written off against the allowance for doubtful debts during the year.
(f) The £15 000 spent (and expensed) on development during the year is not deductible for tax purposes
until 30 June 2014.
(g) Myrtle Ltd has tax losses amounting to £12 500 carried forward from prior years.
(h) The company tax rate is 30%.
Required
1. Determine the balance of any current and deferred tax assets and liabilities for Myrtle Ltd as at 30 June
2013.
2. Prepare any necessary journal entries.
150 PART 2 Elements

Exercise 6.5 CALCULATION OF CURRENT TAX LIABILITY AND ADJUSTING JOURNAL ENTRY
★ The profit before tax, as reported in the statement of profit or loss and other comprehensive income
of Violet for the year ended 30 June 2014, amounted to £60 000, including the following revenue and
expense items:
Rent revenue £3 000

Government grant received (non-taxable) 1 000
Bad debts expense 6 000
Depreciation of plant 5 000
Entertainment costs (non-deductible) 1 800
Depreciation of buildings (non-deductible) 800
The statement of financial position of the company at 30 June 2014 showed the following net assets.
2014 2013
Assets
Cash 8 000 8 500
Inventory 17 000 15 500
Receivables 50 000 48 000
Office supplies 2 500 2 200
Plant 50 000 50 000
Buildings 30 000 30 000
Goodwill (net) (7 000) (7 000)
Deferred tax asset ? 4 050
Liabilities
Provision for long-service leave 6 000 4 500
Provision for annual leave 4 000 3 000
Rent received in advance 2 500 2 000
Deferred tax liability ? 3 150
(a) Accumulated depreciation of plant for tax purposes was £31 500 at 30 June 2013, and depreciation for
tax purposes for the year ended 30 June 2014 amounted to £7500.
Required
Prepare a worksheet to calculate taxable profit and the company’s current tax liability as at 30 June 2014,
and prepare the end of reporting period adjustment journal.
Exercise 6.6 CREATION AND REVERSAL OF TEMPORARY DIFFERENCES

★★ The following are all independent situations. Prepare the journal entries for deferred tax on the creation or
reversal of any temporary differences. Explain in each case the nature of the temporary difference. Assume
a tax rate of 30%.
1. The entity has an allowance for doubtful debts of £10 000 at the end of the current year relating to
accounts receivable of £125 000. The prior year balances for these accounts were £8500 and £97 500
respectively. During the current year, debts worth £9250 were written off as uncollectable.
2. The entity sold a vehicle at the end of the current year for £15 000. The vehicle cost £100 000 when
purchased 3 years ago, and had a carrying amount of £25 000 when sold. The taxation depreciation
rate for equipment of this type is 33%.
3. The entity has recognised an interest receivable asset with a beginning balance of £17 000 and an
ending balance of £19 500 for the current year. During the year, interest of £127 000 was received in
cash.
4. At the end of the current year, the entity has recognised a liability of £4000 in respect of outstanding
fines for non-compliance with safety legislation. Such fines are not tax-deductible.

Exercise 6.7 CREATION AND REVERSAL OF A TEMPORARY DIFFERENCE
★★ Rose Ltd purchased equipment on 1 July 2011 at a cost of £25 000. The equipment had an expected eco-
nomic life of 5 years and was to be depreciated on a straight-line basis. The taxation depreciation rate for
equipment of this type is 15% p.a. straight-line. On 30 June 2013, Rose Ltd reassessed the remaining eco-
nomic life of the equipment from 3 years to 2 years, and the accounting depreciation charge was adjusted
accordingly. The equipment was sold on 30 June 2014 for £15 000. The company tax rate is 30%.
Required
For each of the years ended 30 June 2012, 2013 and 2014, calculate the carrying amount and the tax base
of the asset and determine the appropriate deferred tax entry. Explain your answer.
Exercise 6.8 CALCULATION OF DEFERRED TAX, AND ADJUSTMENT ENTRY

★★★ The following information was extracted from the records of Bulb Ltd as at 30 June 2013:
Asset (liability) Carrying

amount Tax base
Accounts receivable £150 000 £175 000
Motor vehicles (165 000) 125 000
Provision for warranty (12 000) 0
Deposits received in advance (15 000) 0
The depreciation rates for accounting and taxation are 15% and 25% respectively. Deposits are taxable
when received, and warranty costs are deductible when paid. An allowance for doubtful debts of £25 000
has been raised against accounts receivable for accounting purposes, but such debts are deductible only
when written off as uncollectable.
Required
1. Calculate the temporary differences for Bulb Ltd as at 30 June 2013. Justify your classification of each
difference as either a deductible temporary difference or a taxable temporary difference.
2. Prepare the journal entry to record deferred tax for the year ended 30 June 2013 assuming no deferred
items had been raised in prior years.
152 PART 2 Elements

Accounting researchers have been interested in whether since this discretion typically does not affect current tax lia-
differences between taxable profit and pre-tax profit (the bility. Phillips et al. (2003) therefore conjecture that higher
accounting measure of profit before tax) provide information deferred tax expense is associated with more earnings man-
that is useful to investors. Additionally, accounting research agement. Consistent with this, they find that companies
has hypothesised that a greater book–tax difference may indi- are more likely to avoid earnings declines, and avoid losses
cate poorer earnings quality and/or manipulation of recorded when they show higher deferred tax expense. Ayers et al.
tax expense (Hanlon, 2005). (2010) examine the implications of book–tax differences
Within research that looks at the usefulness of tax for credit ratings. They find that larger changes in the differ-
accounting, Amir et al. (1997) examine the pricing impli- ence between pre-tax income and taxable income are asso-
cations of six types of deferred tax assets and liabilities in ciated with lower credit ratings. They interpret this result
1992–1994. These include assets and liabilities created with as follows. As the amount by which book income exceeds
respect to temporary differences in depreciation, losses car- tax income increases, credit analysts interpret this as poor
ried forward, restructuring charges, environmental charges, earnings quality, which in turn suggests greater credit risk.
employee benefits and valuation allowance (also see below). This risk may stem from the lower earnings persistence
They find consistent evidence that deferred tax assets for that is documented by Hanlon (2005) for firms with large
employee benefit and restructuring charges are positively book–tax differences.
related to stock prices. This is consistent with these assets Deferred taxes themselves can be subject to manipulation.
representing anticipated reduction in future cash payment IAS 12 and US GAAP allow for partial recognition of deferred
for tax. They, however, find mixed evidence with respect to tax assets, to the extent that managers do not believe these
the other types of deferred tax assets and liabilities. Lev and assets will be recoverable. The accounting item that reduces
Nissim (2004) explore if taxable income can help predict the carrying amount of deferred tax asset under partial pro-
growth to assess the usefulness of tax accounting. They find visioning is often called valuation allowance. By changing
that the ratio of taxable income to book income is positively their assessment of the valuation allowance managers can
associated with measures of future growth, suggesting that influence reported earnings. However, Bauman et al. (2001)
tax-based calculation of income can assist investors in pre- do not find evidence consistent with this conjecture from
dicting growth. They also find that this ratio and earnings- contextual analysis of Fortune 500 firms. Miller and Skinner
to-price are negatively related, consistent with notion that (1998) find that the valuation allowance is largely related to
earnings are more highly priced when taxable earnings are losses carried forward that may not be utilised. This is con-
higher. sistent with the view that the allowance is correctly stated,
Laux (2013) extends Amir et al. (1997) by examining on average. Nevertheless, Schrand and Wong (2003) provide
directly whether deferred tax assets (liabilities) predict some evidence that banks in a strong financial position tend
reductions (increases) in future cash payments to tax to have higher valuation allowance, suggesting they oppor-
authorities. He argues that this depends on the timing of the tunistically create hidden reserves.
recognition of revenues and expenses in pre-tax income rel- IAS 12 has removed much discretion that was previously
ative to taxable income. Specifically, he predicts lower future available to companies under local standards. Specifically,
tax payments if expenses and revenues are first recognised in in the UK, before 2005, both deferred tax assets and liabili-
pre-tax income, and only later in taxable income (e.g., war- ties were recorded only to the extent that managers believed
ranty expense). In contrast, he predicts no effect on future that a reversal would take place (see illustrative example 6.1
tax payments if the recognition of revenues and expenses in this chapter). That is, partial recognition was allowed for
in taxable income precedes recognition in pre-tax income both deferred tax liabilities and deferred tax assets. Gordon
(e.g., as in the case of unearned revenues and accelerated and Joos (2004) examine how this discretion was used by
tax depreciation). His findings are consistent with these pre- UK managers and find that it was mostly deployed in highly
dictions. Laux (2013) also examines the valuation implica- leveraged firms who report larger unrecognised deferred tax
tions of the two categories of the timeliness of recognition liabilities. This enabled them to reduce the overall reported
of expenses and revenues. He finds that only expenses and leverage of their firms, suggesting the allowance was meas-
revenues that are first recognised in pre-tax income are value ured opportunistically. The implication is that removing the
relevant. Additionally, and similarly to Amir et al. (1997), level of discretion allowed by the new standard may have
he finds that deferred tax liabilities related to deprecia- improved the quality of tax accounting.
tion are not positively associated with stock prices. This is
consistent with the possibility that these liabilities do not
reverse and so do not trigger additional cash payments. This
will be the case, for example, in growing firms who increase
References
the depreciable asset base over time. As the asset base grows, Amir, E., Kirschenheiter, M., and Willard, K., 1997. The
origination of new deferred tax liabilities exceeds the valuation of deferred taxes. Contemporary Accounting
reversal of old liabilities, implying no cash is returned to the Research, 14(4), 597–622.
tax authorities. Ayers, B. C., Laplante, S. K., and McGuire, S. T., 2010. Credit
Accounting for taxes may speak as to the quality of ratings and taxes: The effect of book–tax differences on
underlying reported earnings. Specifically, deferred taxes ratings changes. Contemporary Accounting Research, 27(2),
may be indicative of managerial discretion in accruals, 359–402.

Bauman, C. C., Bauman, M. P., and Halsey, R. F., 2001. Lev, B., and Nissim. D., 2004. Taxable income, future earnings
Do firms use the deferred tax asset valuation allowance and equity values. The Accounting Review, 79(4), 1039–1074.
to manage earnings? Journal of the American Taxation Miller, G. S., and Skinner, D. J., 1998. Determinants of the
Association, 23(s-1), 27–48. valuation allowance for deferred tax assets under SFAS No.
Gordon, E. A., and Joos, P. R., 2004. Unrecognized deferred 109. The Accounting Review, 73(2), 213–233.
taxes: evidence from the UK. The Accounting Review, 79(1), Phillips, J., Pincus, M., and Rego, S. O., 2003. Earnings
97–124. management: New evidence based on deferred tax expense.
Hanlon, M., 2005. The persistence and pricing of earnings, The Accounting Review, 78(2), 491–521.
accruals and cash flows when firms have large book–tax Schrand, C. M., and Wong, M. H., 2003. Earnings
differences. The Accounting Review, 80(1), 137–166. management using the valuation allowance for deferred
Laux, R. C., 2013. The association between deferred tax assets tax assets under SFAS No. 109. Contemporary Accounting
and liabilities and future tax payments. The Accounting Research, 20(3), 579–611.
Review, 88(4), 1357–1383.
154 PART 2 Elements

7 Financial instruments
ACCOUNTING IAS 32 Financial Instruments: Presentation
STANDARDS IFRS 7 Financial Instruments: Disclosures
IN FOCUS
IFRS 9 Financial Instruments

OBJECTIVES
1 describe the background to the development of accounting standards on financial instruments
2 define a financial instrument
3 outline and apply the definitions of financial assets and financial liabilities
4 distinguish between equity instruments and financial liabilities
5 explain the concept of a compound financial instrument
6 determine the classification of revenues and expenses arising from financial instruments
7 describe the scope of IFRS 9
8 explain the concept of an embedded derivative
9 distinguish between the categories of financial instruments specified in IFRS 9
10 apply the recognition criteria for financial instruments
11 understand and apply the measurement criteria for each category of financial instrument
12 determine when financial assets and financial liabilities may be offset
13 outline the rules of hedge accounting set out in IFRS 9 and be able to apply the rules to simple
common cash flow and fair value hedges.
14 describe the main disclosure requirements of IFRS 7.
CHAPTER 7 Financial instruments 155

Accounting for financial instruments was the most controversial area in the development of the Inter-
national Accounting Standards Board’s (IASB®) ‘stable platform’ of standards adopted in 2005. Indeed,
the controversy surrounding IAS 39 Financial Instruments: Recognition and Measurement in particular
almost derailed the IASB’s plans for adopting IFRS® Standards in Europe for financial years beginning
on or after 1 January 2005. As late as 30 June 2004, IAS 39 had still not been completed because
changes continued to be proposed or made in response to lobbying from various European interested
parties, notably the banks. The controversial aspects of the standards at that time were largely related
to hedge accounting. The controversy continued during the financial crisis of 2008 and put the IASB
under enormous pressure to amend IAS 39. In this case there was pressure to allow entities to move
away from using a fair value measurement basis and to change the requirements for impairment of
financial assets. As a result, the IASB amended the reclassification rules of IAS 39 and then very quickly
started work on a new standard to replace IAS 39. This standard, IFRS 9 Financial Instruments, was
issued in phases between November 2009 and July 2014. IFRS 9 is expected to be endorsed by the
European Commission in the first half of 2016 and so this chapter focuses on IFRS 9.
Figure 7.1 provides an extract from the Report of the Financial Crisis Advisory Group1, which illustrates
the controversy and complexity surrounding the accounting for financial instruments at the time of the
2008 financial crisis.
In response to the financial crisis in 2008, the IASB commenced its work on IFRS 9 in November 2008 and
issued the complete version of IFRS 9 in July 2014. IFRS 9 introduced a new classification and measurement
approach for financial assets, a forward-looking expected credit loss model, an improved hedge accounting
model and a better approach to deal with the so-called ‘own credit’ issue (see section 7.9.2). These changes were
made to address the concerns that the Group of Twenty (G-20, an international forum for the governments and
central bank governors from 20 major economies), the Financial Crisis Advisory Group and others had raised.
FIGURE 7.1 Effective financial reporting
Report of the Financial Crisis Advisory Group

While the post-mortems are still being written, it seems clear that accounting standards were not a
root cause of the financial crisis. At the same time, it is clear that the crisis has exposed weaknesses
in accounting standards and their application. These weaknesses reduced the credibility of financial
reporting, which in part contributed to the general loss of confidence in the financial system. The
weaknesses primarily involved (1) the difficulty of applying fair value (‘mark-to-market’) accounting
in illiquid markets; (2) the delayed recognition of losses associated with loans, structured credit
products, and other financial instruments by banks, insurance companies and other financial
institutions; (3) issues surrounding the broad range of off-balance-sheet financing structures,
especially in the US; and (4) the extraordinary complexity of accounting standards for financial
instruments, including multiple approaches to recognizing asset impairment. Some of these
weaknesses also highlighted areas in which International Financial Reporting Standards (‘IFRS’) and
US generally accepted accounting principles (‘US GAAP’) diverged.
In the early part of the crisis, the principal criticism of financial reporting focused on fair value
accounting. This criticism contended that fair value accounting contributed to the pro-cyclicality
of the financial system. Prior to the crisis, it is argued, fair value accounting led to significant
overstatement of profits; however, during the crisis, it was supposed to have led to a severe
overstatement of losses and the consequent ‘destruction of capital’. Thus, the argument went, a
vicious cycle ensued: falling asset prices led to accounting write-downs; the write-downs led to
forced asset sales by institutions needing to meet capital adequacy requirements; and the forced sales
exacerbated the fall in asset prices. In the US, moreover, critics singled out the other-than-temporary
impairment standards for available-for-sale and held-to-maturity securities as being particularly
‘destructive’ because institutions were forced to take charges against earnings as a consequence of
what they believed to be temporary ‘market irrationality’.
Proponents of fair value accounting do not deny that indeed mark-to-market accounting shows
the fluctuations of the market, but they maintain that these cycles are a fact of life and that the
use of fair value accounting does not exacerbate these cycles. Moreover, they argue that fair value
accounting standards provided ‘early warning’ signals by revealing the market’s discomfort with
inflated asset values. In their view, this contributed to a more timely recognition of problems and
mitigation of the crisis.
1 Report
of the Financial Crisis Advisory Group, 28 July 2009.
156 PART 2 Elements

Whatever the final outcome of the debate over fair value accounting, it is unlikely that, on
balance, accounting standards led to an understatement of the value of financial assets. While
the crisis may have led to some understatement of the value of mark-to-market assets, it is
important to recognize that, in most countries, a majority of bank assets are still valued at
historic cost using the amortized cost basis. Those assets are not marked to market and are not
adjusted for market liquidity. By now it seems clear that the overall value of these assets has
not been understated — but overstated. The incurred loss model for loan loss provisioning and
difficulties in applying the model — in particular, identifying appropriate trigger points for loss
recognition — in many instances has delayed the recognition of losses on loan portfolios. (The
results of the US stress tests seem to bear this out.) Moreover, the off-balance-sheet standards,
and the way they were applied, may have obscured losses associated with securitizations and
other complex structured products. Thus, the overall effect of the current mixed attribute model
by which assets of financial institutions have been measured, coupled with the obscurity of off-
balance sheet exposures, has probably been to understate the losses that were embedded in
the system.
Even if the overall effect of accounting standards may not have been pro-cyclical, we consider
it imperative that the weaknesses in the current standards be addressed as a matter of urgency.
Improvements in accounting standards cannot ‘cure’ the financial crisis by resolving underlying
economic and governance issues (for example, the massive overleveraging of the global economy,
excessive risk taking, and the undercapitalization of the banking sector). However, as demonstrated
by the positive market reaction to disclosure of the results of the US stress tests, improvements
in standards that enhance transparency and reduce complexity can help restore the confidence of
financial market participants and thereby serve as a catalyst for increased financial stability and
sound economic growth. Conversely, any changes in financial reporting that reduce transparency
and allow the impact of the crisis to be obscured would likely have the opposite effect, by further
reducing the confidence of market participants and thereby prolonging the crisis or by laying the
foundation for future problems.
Source: Financial Crisis Advisory Group (2009).
Although the IASB worked closely with the US FASB in the initial stages of the development of IFRS 9,
the efforts to develop a converged standard were ultimately unsuccessful. So unlike IAS 39 — which was
largely based on the similar FASB standard in the United States, Statement of Financial Accounting Stand-
ards No. 133 (SFAS 133) Accounting for Derivative Instruments and Hedging Activities — IFRS 9 differs in
important respects from the accounting prescribed by the FASB.
IAS 32 sets out the definitions of financial instruments, financial assets and financial liabilities, the
distinction between financial liabilities and equity instruments, and originally prescribed detailed dis-
closures. The standard was developed before IAS 39 because consensus on the recognition, derecogni-
tion, measurement and hedging rules for financial instruments was difficult to achieve. Therefore, the
standard setters first established classification and disclosure rules, anticipating that increased disclosure
by reporting entities would provide more information, not only for users, but also for the standard set-
ters. Increased disclosure helps to provide standard setters with information that assists in developing
further standards.
In 2006, IAS 32 was renamed Financial Instruments: Presentation and a new standard, IFRS 7 Financial
Instruments: Disclosures, was introduced, applicable to annual periods beginning on or after 1 January 2007.
IFRS 7 contains many of the disclosure requirements that were originally in IAS 32 and IAS 30 Disclosures
in the Financial Statements of Banks and Similar Financial Institutions. It also introduced a number of new
requirements.
Because IFRS 9, IAS 32 and IFRS 7 are complex standards, this chapter provides an overall explanation
of the requirements. It emphasises those areas most commonly affecting the majority of reporting entities,
and places less emphasis on specialised areas.
Each standard is addressed separately in this chapter.
IAS 32, IFRS 7 and IFRS 9 each contain Application Guidance, which is abbreviated in this chapter as
AG. IFRS 7 and IFRS 9 also contain Implementation Guidance.
The main definitions and accounting requirements of IAS 32 are covered in sections 7.2 to 7.6, while its
requirements on offsetting are dealt with in section 7.12. The IFRS 9 requirements on accounting for finan-
cial assets, financial liabilities and derivatives and its recognition, measurement and hedge accounting
requirements are covered in sections 7.7 to 7.13. Finally, the disclosure requirements of IFRS 7 are covered
in section 7.14.

LO2 7.2 WHAT IS A FINANCIAL INSTRUMENT?
7.2.1 Definition of a financial instrument
IAS 32, paragraph 11, defines a financial instrument as:
any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of
another entity.
Financial assets and financial liabilities are terms defined in IAS 32 (see sections 7.3.1 and 7.3.2). Finan-
cial assets are defined from the perspective of the holder of the instrument, whereas financial liabilities and
equity instruments are defined from the perspective of the issuer of the instrument.
An equity instrument is defined in paragraph 11 as:
any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
The most common type of equity instrument is an ordinary share of a company. The holder of the
shares is not entitled to any fixed return on or of its investment; instead, the holder receives the residual
after all liabilities have been settled. This applies both to periodic returns (where dividends are paid after
interest on liabilities has been paid) and capital returns (when a company is wound up, all liabilities are
settled before shareholders are entitled to any return of their investment).
7.2.2 Two sides to the story

Note that the definition of a financial instrument is two-sided — the contract must always give rise to
a financial asset of one party, with a corresponding financial liability or equity instrument of another
party. For example, a contract that gives the seller of a product the right to receive cash from the pur-
chaser creates a receivable for the seller (a financial asset) and a payable for the purchaser (a financial
liability).
7.2.3 Common types of financial instruments

Financial instruments include primary instruments such as cash, receivables, investments and paya-
bles, as well as derivative financial instruments such as financial options and forward exchange con-
tracts. Derivative financial instruments, or derivatives, are instruments that derive their value from
another underlying item such as a share price or an interest rate. (The definition of a derivative is dis-
cussed in section 7.8.)
7.2.4 Contracts to buy or sell non-financial instruments

Financial instruments do not include non-financial assets such as property, plant and equipment, or non-
financial liabilities such as provisions for restoration. Contracts to buy or sell non-financial items are
also usually not financial instruments. Many commodity contracts fall into this category (contracts to
buy or sell oil, cotton, wheat and so on). These commodity contracts are thus outside the scope of IAS
32. However, reporting entities with commodity contracts that are within the scope of IFRS 9 should
follow the disclosure requirements of IFRS 7. Certain commodity contracts are, however, included
within the scope of IAS 32. These include contracts to buy or sell non-financial items that can be set-
tled net (in cash) or by exchanging financial instruments, or in which the non-financial item is readily
convertible into cash. Contracts to buy or sell gold might fall into the latter category and so might be
caught by IAS 32 and IFRS 9.
7.2.5 Other items that are not financial instruments

Note also that the definition of a financial instrument requires there to be a contractual right or obli-
gation. Therefore, liabilities or assets that are not contractual — such as income taxes that are created
as a result of statutory requirements imposed by governments, or constructive obligations as defined
in IAS 37 Provisions, Contingent Liabilities and Contingent Assets (see chapter 5) — are not financial
instruments.
In addition, certain financial assets and liabilities are outside the scope of IAS 32. These include employee
benefits accounted for under IAS 19, and investments in subsidiaries, associates and joint ventures that are
accounted for under IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial Statements, IAS 28
Investments in Associates and Joint Ventures and IFRS 11 Joint Arrangements.
158 PART 2 Elements

LO3 7.3 FINANCIAL ASSETS AND FINANCIAL LIABILITIES
7.3.1 Financial assets
A financial asset is defined in paragraph 11 of IAS 32 as follows:
any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially
favourable to the entity; or
(d) a contract that will or may be settled in the entity’s own equity instruments and meets certain additional conditions.
Examples of common financial assets in each of the categories of the definition include:
(a) cash — either cash on hand or the right of the depositor to obtain cash from the financial institution with
which it has deposited the cash
(b) an equity instrument of another entity — ordinary shares held in another entity
(c) a contractual right
(i) to receive cash or another financial asset — trade accounts receivable, notes receivable, loans receivable
(ii) to exchange under potentially favourable conditions — an option held by the holder to purchase shares
in a specified company at less than the market price.
Part (d) of the definition was added in response to issues arising from the classification of certain com-
plex financial instruments as liabilities or equity. The IASB considered that to treat any transaction settled
in the entity’s own shares as an equity instrument would not deal adequately with transactions in which
an entity is using its own shares as ‘currency’ (e.g. where it has an obligation to pay a fixed or determinable
amount that is settled in a variable number of its own shares). In such transactions the counterparty bears
no share price risk, and is therefore not in the same position as a ‘true’ equity shareholder. (Liability/equity
classification is discussed in section 7.4.)
7.3.2 Financial liabilities

A financial liability is defined in paragraph 11 of IAS 32 as follows:
any liability that is:
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are poten-
tially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments and meets certain additional conditions.
Examples of common financial liabilities in each of the categories of the definition include:
(a) a contractual obligation
(i) to deliver cash or another financial asset — trade accounts payable, notes payable, loans payable
(ii) to exchange under potentially unfavourable conditions — an option written (i.e. issued) by the issuer to
sell shares in a specified company at less than the market price.
Part (b) of the definition was added in response to issues arising from the classification of certain com-
plex financial instruments as liabilities or equity, as discussed in section 7.3.1. (Liability/equity classification is
discussed in section 7.4.)
Table 7.1 contains a summary of common financial instruments.
TABLE 7.1 Summary of common fi nancial instruments
Financial assets Financial liabilities Equity instruments
Cash Bank overdraft Ordinary shares
Accounts receivable Accounts payable Certain preference shares
Notes receivable Notes payable
Loans receivable Loans payable
Derivatives with potentially favourable Derivatives with potentially

exchange conditions unfavourable exchange conditions
Certain preference shares

LO4 7.4 DISTINGUISHING FINANCIAL LIABILITIES
FROM EQUITY INSTRUMENTS
IAS 32 is very prescriptive in the way it distinguishes between financial liabilities and equity instruments.
This area, commonly known as the debt versus equity distinction, is of great concern to many reporting
entities because instruments classified as liabilities rather than equity affect:
• a company’s gearing and solvency ratios
• debt covenants with financial institutions (usually a requirement that specified financial ratios of
the borrower do not exceed predetermined thresholds; if they do exceed the thresholds, the financial
institution has a right to require repayment of the loan)
• whether periodic payments on these instruments are treated as interest (affecting profit or loss) or
dividends (not affecting profit or loss)
• regulatory requirements for capital adequacy (banks and other financial institutions are required by their
regulators to maintain a certain level of capital, which is calculated by reference to assets and equity).
Accordingly, reporting entities are often motivated, when raising funds, to issue instruments that are
classified as equity for accounting purposes. In the years since IAS 32 was first issued, many complex
instruments were devised by market participants specifically to achieve equity classification under IAS 32.
Some of these instruments were liabilities in substance but were able to be classified technically as equity,
notwithstanding a ‘substance over form’ test in IAS 32. As a result, the IASB amended IAS 32 to create
specific rules designed to address these complex instruments. Unfortunately, the rules are now quite com-
plicated, so this section will address the key principles of liability versus equity classification only.
7.4.1 The rules

IAS 32, paragraph 15, states:
The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition
as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contrac-
tual arrangement and the definitions of a financial liability, a financial asset and an equity instrument.
To avoid any doubt, paragraph 16 goes on to repeat and clarify the definition of a financial liability. It
states that an instrument shall be classified as an equity instrument if, and only if, both conditions (a) and
(b) below are met:
(a) The instrument includes no contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are poten-
tially unfavourable to the issuer.
(b) If the instrument will or may be settled in the issuer’s own equity instruments, it is:
(i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its
own equity instruments; or
(ii) a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another finan-
cial asset for a fixed number of its own equity instruments.
Part (a) is clearly referring to the definition of a financial liability. The rules in part (b) are trying to
establish who bears ‘equity risk’ in complex transactions where an entity issues a financial instrument that
will or may be settled in its own shares.
The concept of equity risk is useful for both part (b) of the test and generally in determining whether an
instrument is equity or a liability. Note, however, that part (a) of the test turns only on whether or not the
issuer has a contractual obligation.
Part (a) of the equity/liability test: contractual obligation
The examples in figure 7.2 apply part (a) of the equity/liability test, together with the equity risk
concept.
FIGURE 7.2 Applying part (a) of the equity/liability test
Example 1: Ordinary shares

Company A wants to raise funds of $1 million. It does so by issuing ordinary shares to the public.
The holders of those shares are exposed to equity risk (they are not entitled to any fixed return on or
of their investment, and receive the residual left over after all liabilities have been settled) in respect
of both periodic payments and capital returns. If there is no profit after interest on liabilities and
other contractual obligations have been paid, then there are no dividends. If, on winding up, there
are no assets after all liabilities have been settled, there is nothing returned to the shareholders.
This is the fundamental nature of equity risk. The ordinary shares issued by Company A are equity
instruments of Company A. Under part (a) of the test, Company A has no contractual obligation to
its ordinary shareholders.
160 PART 2 Elements

Company A would record the following journal entry on initial recognition:
Cash (financial asset) Dr 1 000 000

Ordinary Share Capital (equity) Cr 1 000 000
Example 2: Non-cumulative, non-redeemable preference shares

Company A decides to issue preference shares instead of ordinary shares. It issues 1 million preference
shares for $1 each. Each preference shareholder is entitled to a non-cumulative dividend of 5% annually.
(A non-cumulative dividend means that, if in any year a dividend is not paid, the shareholder forfeits it.)
The preference shareholders rank ahead of ordinary shareholders on the winding up of the company. The
preference shares are non-redeemable (the holders of the shares cannot get their money back).
Under part (a) of the test, Company A has no contractual obligation to the preference shareholders,
either to pay dividends or to return the cash. Therefore, the preference shares are equity instruments of
Company A. In addition, applying the concept of equity risk reveals that the preference shareholders
are exposed to equity risk, although it is lower than for the ordinary shareholders.

Preference Share Capital (equity) Cr 1 000 000
Example 3: Cumulative preference shares redeemable by the holder

Company A issues 1 million preference shares for $1 each, and each preference shareholder is
entitled to a cumulative dividend of 5% annually. The preference share-holders rank ahead of
ordinary shareholders on the winding-up of the company. The preference shares are redeemable for
cash at the option of the holder.
Under part (a) of the test, Company A now has a contractual obligation to the preference
shareholders — both in respect of dividends and to return the cash. Company A must pay the
dividends and, if in any period it cannot pay, it must make up the payment with the next dividend.
Furthermore, Company A must repay the money whenever the holder demands repayment.
Therefore, the preference shares are financial liabilities of Company A. In addition, applying the
concept of equity risk reveals that the preference shareholders are not exposed to equity risk – they
are guaranteed a periodic return of 5% and they can require that their cash be returned. They bear
a similar risk as would a lender to Company A, although a lender may rank ahead of cumulative
preference shareholders in the winding-up of the company. A lender’s risk is generally credit risk (the
risk that Company A will fail to discharge its obligations) and liquidity risk (the risk that Company
A will fail to raise funds to enable it to redeem the liability on demand).

Preference Share Liability (financial liability) Cr 1 000 000
Paragraph 17 of IAS 32 reiterates that a critical feature in differentiating a financial liability from
an equity instrument is the existence of a contractual obligation of the issuer. Paragraph 18 then
goes on to state that the substance of a financial instrument, rather than its legal form, governs its
classification on the entity’s statement of financial position. Some financial instruments, such as the
preference shares in example 3 of figure 7.2, take the legal form of equity but are liabilities in substance.
Sometimes the combined features result in the financial instrument being split into its component
parts (see section 7.5).
Another example of a financial instrument whose legal form may be equity but whose accounting clas-
sification is a financial liability is a puttable instrument. A puttable instrument gives the holder the right to
put the instrument back to the issuer for cash or another financial asset. This is so even when the amount of
cash/other financial asset is determined based on an index or another amount that may increase or decrease.
For example, certain mutual funds, unit trusts and partnerships provide their unit holders or members with a
right to redeem their interests in the issuer at any time for cash equal to their proportionate share of the net
asset value of the issuer. In 2008, the IASB amended IAS 32 to modify the definition of a financial liability so
that such puttable instruments would not automatically result in liability classification.
Paragraphs 19 and 20 of IAS 32 explain that an entity has a contractual obligation to deliver cash/other
financial assets notwithstanding:
• any restrictions on the entity’s ability to meet its obligation (such as access to foreign currency)
• that the obligation may be conditional on the counterparty exercising its redemption right (as in
example 3 of figure 7.2 — redemption is at the option of the holder and therefore could be considered

to be conditional on the holder exercising its right to redeem. However, this does not negate the fact
that the issuer has a contractual obligation to redeem the shares, because it cannot avoid its obligation
should it be required to redeem by the holder)
• that the financial instrument does not explicitly establish a contractual obligation to deliver cash/other
financial assets. A contractual obligation may be implied in the terms and conditions of the instrument.
However, the guidance in paragraph 20 should be read in a narrow way given the guidance on
preference shares. Paragraph AG26 states that non-redeemable preference shares are equity instruments,
notwithstanding a term that prevents ordinary share dividends from being paid if the preference share
dividend is not paid, or from being paid on the issuer’s expectation of profit or loss for a period. A fairly
common term in certain non-redeemable preference shares is that the dividend is ‘discretionary’ but, if
the preference dividend is not paid, then ordinary dividends cannot be paid. If these terms exist in the
preference shares of highly profitable companies, one could argue under paragraph 20 that the implicit
terms and conditions of the preference shares require the dividend to be paid. However, paragraph
AG26 states that such conditions do not create a financial liability of the issuer.
Part (b) of the equity/liability test: settlement in the entity’s own equity instruments
Paragraph 21 of IAS 32 states that a contract is not an equity instrument solely because it may result in the
receipt or delivery of the entity’s own equity instruments. As noted earlier in this section, such an instru-
ment can be classified as an equity instrument under paragraph 16(b) of IAS 32 only if it is:
(i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own
equity instruments; or
(ii) a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial
asset for a fixed number of its own equity instruments.
Part (i) will be examined first. Assume listed Company A has an obligation to deliver to Party B as many
of Company A’s own ordinary shares as will equal $100 000. The number of shares that Company A will
have to issue will vary depending on the market price of its own shares. If Company A’s shares are each
worth $1 at the date of settlement of the contract, it will have to deliver 100 000 shares. If Company A’s
shares are each worth $0.50 at the date of settlement of the contract, it will have to deliver 200 000 shares.
Company A has a contractual obligation at all times to deliver $100 000 to Party B; that is, the value is
fixed, and so the number of shares to be delivered will vary. Therefore, Company A’s financial instrument
fails the test in part (i) and the instrument is a financial liability. Applying the concept of equity risk, the
holder of the financial instrument (Party B) is not exposed to equity risk because it will always receive
$100 000 regardless of the market price of Company A’s shares. A true equity risk-taker will be exposed to
share price fluctuations — this reflects the residual nature of an equity risk-taker’s investment.
Now examine part (ii). Assume listed Company A issues a share option to Party B that entitles Party B
to buy 100 000 shares in Company A at $1 each in 3 months’ time. This financial instrument meets the
conditions for equity classification under part (ii) because it is a derivative that will be settled by issuing a
fixed number of shares for a fixed amount. Assume that, at the date of the grant of the option, Company
A’s share price is $1. If in 3 months’ time Company A’s share price exceeds $1, Party B will exercise its
option and Company A must issue its shares to Party B for $100 000. If, however, in 3 months’ time Com-
pany A’s share price falls below $1, Party B will not exercise its option and Company A will not issue any
shares. Applying the concept of equity risk reveals that the holder of the financial instrument (Party B) is
exposed to equity risk because it is not guaranteed to receive $100 000 in value. Whether or not it receives
$100 000 is entirely dependent on the market price of Company A’s shares. As a true equity risk-taker, it
is exposed to share price fluctuations; this reflects the residual nature of an equity risk-taker’s investment.
Party B will have paid a premium to Company A for the option. Paragraph 22 of IAS 32 states that this
premium is added directly to Company A’s equity, consistent with the classification of the instrument as
an equity instrument.
7.4.2 Contingent settlement provisions and settlement options

Sometimes, when a financial instrument requires an entity to deliver cash/other financial assets, the terms
of settlement are dependent on the occurrence or non-occurrence of uncertain future events that are
beyond the control of both the issuer and the holder. Examples of such events include changes in a share
market index, the consumer price index or the issuer’s future revenues. The issuer of such an instrument
does not have the unconditional right to avoid delivering the cash/other financial assets, so paragraph 25
of IAS 32 requires such instruments to be classified as financial liabilities unless they meet certain rare
exceptions. For example, assume that Company A issues preference shares to Party B, the terms of which
entitle Party B to redeem the preference shares for cash if Company A’s revenues fall below a specified
level. Because neither Company A nor Party B can control the level of Company A’s revenues, the settle-
ment provision is considered to be contingent. However, because Company A cannot avoid repaying Party
B should Company A’s revenues fall below the specified level, Company A does not have an unconditional
right to avoid repayment. Thus the preference shares are a financial liability of Company A.
162 PART 2 Elements

Some financial instruments contain a choice of settlement. For example, preference shares may be
redeemed for cash or for the issuer’s ordinary shares. Sometimes the choice is the issuer’s; sometimes it is
the holder’s. Paragraph 26 of IAS 32 requires that, when a derivative financial instrument gives one party a
choice over how it is settled, it is a financial asset or a financial liability unless all of the settlement alter-
natives would result in it being an equity instrument. An example is a share option that the issuer can
decide to settle net in cash or by exchanging its own shares for cash. Because not all of the settlement
options would result in an equity instrument being issued, the option must be classified as a financial
asset or liability. Note that the likely outcome is not taken into account; the fact that cash settlement may
be required is sufficient to create a financial asset or liability.
Paragraph 26 does not address non-derivative financial instruments. Therefore, where a non-derivative
financial instrument such as a preference share may be redeemed for cash or for the issuer’s own ordinary
shares, paragraph 26 does not apply. Instead, paragraph 16 would be applied to determine whether or not
there is (a) a contractual obligation to deliver cash/other financial assets, or (b) a contractual obligation
to deliver a variable number of the issuer’s ordinary shares. Note that both (a) and (b) must be answered
with a ‘no’ for equity classification to apply. So, for example, if the issuer of the preference share has the
option to redeem for cash or for a variable number of its ordinary shares, the first question to ask is:
Does the issuer have a contractual obligation to deliver cash? If redemption is at the issuer’s option, the
issuer has no contractual obligation to redeem at all and therefore arguably the second question about the
number of ordinary shares is irrelevant. Indeed, paragraph 16(b) asks whether or not the issuer has a con-
tractual obligation to deliver a variable number of its own shares and, since redemption is at the issuer’s
option, it has no such contractual obligation, even though the number of shares that potentially will be
issued is variable. Therefore, all other things being equal, the preference shares will be classified as equity.
On the other hand, if redemption is at the holder’s option, the instrument would be classified as a liability,
because the issuer has a contractual obligation to deliver cash/other financial assets or ordinary shares
because the holder has the right to call for redemption. This is so even if the number of ordinary shares is
fixed, because the holder’s right to redeem for cash means that paragraph 16(a) is met.
LO5 7.5 COMPOUND FINANCIAL INSTRUMENTS

Paragraph 28 of IAS 32 requires an issuer of a non-derivative financial instrument to determine whether
it contains both a liability and an equity component. Such components must be classified separately as
financial liabilities, financial assets or equity instruments.
Paragraph 29 goes on to explain that this means that an entity recognises separately the components of a
financial instrument that (a) creates a financial liability of the entity, and (b) grants an option to the holder
of the instrument to convert it into an equity instrument of the entity. A common example of such a finan-
cial instrument is a convertible bond or note that entitles the holder to convert the note into a fixed number
of ordinary shares of the issuer. From the perspective of the issuer, such an instrument comprises two com-
ponents: (a) a financial liability, being a contractual obligation to deliver cash/other financial assets in the
form of interest payments and redemption of the note; and (b) an equity instrument, being an option issued
to the holder entitling it to the right, for a specified period of time, to convert the note into a fixed number of
ordinary shares of the issuer. Note that the number of shares to be issued must be fixed, otherwise the option
would not meet the definition of an equity instrument under paragraph 16(b) as discussed in section 7.4.1.
Classification of the liability and equity components is made on initial recognition of the financial
instrument and is not revised as a result of a change in the likelihood that the conversion option may be
exercised. This is because, until such time as the conversion option is either exercised or lapses, the issuer
has a contractual obligation to make future payments.
How does the issuer measure the separate liability and equity components? Paragraphs 31 and 32 of IAS
32 prescribe that the financial liability must be calculated first, with the equity component by definition
being the residual. The example in figure 7.3 illustrates how this is done.
FIGURE 7.3 A convertible note, allocating the components between liability and equity
Example 4: Compound financial instrument — a convertible note

Company A issues 2000 convertible notes on 1 July 2013. The notes have a 3-year term and are
issued at par with a face value of €1000 per note, giving total proceeds at the date of issue of €2
million. The notes pay interest at 6% annually in arrears. The holder of each note is entitled to
convert the note into 250 ordinary shares of Company A at any time up to maturity.
When the notes are issued, the prevailing market interest rate for similar debt (similar term,
similar credit status of issuer and similar cash flows) without conversion options is 9%. This rate
is higher than the convertible note’s rate because the holder of the convertible note is prepared to
accept a lower interest rate given the implicit value of its conversion option.
(continued)

The issuer calculates the contractual cash flows using the market interest rate (9%) to work out the
value of the holder’s option, as follows:
Present value of the principal: €2 million payable in 3 years’ time: € 1 544 367
Present value of the interest: €120 000 (€2 million × 6%) payable € 303 755
annually in arrears for 3 years
Total liability component € 1 848 122
Equity component (by deduction) € 151 878
Proceeds of the note issue € 2 000 000
The journal entries at the date of issue are as follows:
Cash Dr 2 000 000

Financial Liability Cr 1 848 122
Equity Cr 151 878
The equity component is not remeasured and thus remains at €151 878 until the note is either
converted or redeemed. The liability component accrues interest of 9% until it is redeemed or
converted. If the note is converted, the remaining liability component is transferred to equity. If
the note is not converted at the end of the 3-year term, the carrying amount has accreted up to
€2 000 000 and the notes will be redeemed at €2 000 000. The equity component remains in equity.
Source: Adapted from IAS 32, Illustrative Example 9, paragraphs IE35–IE36.
LO6 7.6 INTEREST, DIVIDENDS, GAINS AND LOSSES

IAS 32 requires the statement of profit or loss and other comprehensive income classification of items
relating to financial instruments to match their statement of financial position classification. Thus, statement
of profit or loss and other comprehensive income items relating to financial liabilities and financial assets
are classified as income or expenses, or gains or losses. These are usually interest expense, interest income
and dividend income. Distributions to holders of equity instruments are debited directly to equity. Usually
these are dividends. These principles also apply to the component parts of a compound financial instrument.
Table 7.2 summarises these principles.
TABLE 7.2 Classification of revenues, expenses and equity distributions
Statement of financial Statement of profit or loss and other

position classification comprehensive income classification Statement of changes in equity
Equity instrument Dividends distributed
Financial liability Interest expense
Financial asset Interest income, dividend income
The transaction costs of an equity transaction are deducted from equity, but only to the extent to which
they are incremental costs directly attributable to the equity transaction that otherwise would have been
avoided. Examples of such costs include registration and other regulatory fees, legal and accounting fees and
stamp duties. These costs are required to be shown separately under IAS 1 Presentation of Financial Statements.
LO7 7.7 FINANCIAL ASSETS AND FINANCIAL

LIABILITIES: SCOPE
The objective of IFRS 9 is to set principles for financial reporting of financial assets and financial liabilities that
is relevant and useful to users in assessing the amounts, timing and uncertainty of an entity’s future cash flows.
As the standard is very complex, particularly in its application to financial institutions, this chapter addresses
only the more common applications of IFRS 9 and provides a general understanding of its requirements.
IFRS 9 applies to all entities and to all types of financial instruments, subject to a list of exceptions that
in themselves are complicated. Therefore, the following is only an overview of the exceptions:
1. Investments in subsidiaries, associates and joint ventures that are accounted for under IFRS 10, IAS 27 or
IAS 28. However, certain investments in such entities may be accounted for under IFRS 9 if so permitted
164 PART 2 Elements

by IFRS 10, IAS 27 or IAS 28. For example, IAS 27 permits investments in subsidiaries, associates and
joint ventures to be carried at fair value under IFRS 9 in the investor’s separate financial statements.
2. Rights and obligations under leases to which IAS 17 Leases applies. However, certain lease receivables
and finance lease payables are subject to the derecognition and impairment provisions of IFRS 9. Also,
embedded derivatives in leases are subject to IFRS 9.
3. Employers’ rights and obligations under employee benefit plans to which IAS 19 Employee Benefits
applies.
4. Rights and obligations arising under insurance contracts, with certain exceptions. Insurance contracts
are covered by their own standard, but contracts issued by insurers that are not insurance contracts
(such as investment contracts) are covered by IFRS 9. Contracts that require a payment based on cli-
matic, geological or other physical variables are commonly used as insurance policies and payment is
made based on the amount of loss to the insured entity. These contracts are caught by the standard on
insurance contracts and are outside the scope of IFRS 9 under this exemption. However, if the payment
under the contract is unrelated to the insured entity’s loss, then IFRS 9 applies. IFRS 9 also covers em-
bedded derivatives in such contracts.
5. Financial instruments issued by the entity that meet the definition of an equity instrument in IAS 32.
This applies only to the issuer of the equity instrument. The holder of such an instrument will have a
financial asset that is covered by IFRS 9.
6. Financial guarantee contracts, such as letters of credit, that provide for specified payments to be made
to reimburse the holder of the contract for a loss it incurs because a specified debtor fails to make pay-
ment when due under a debt instrument are measured either under IFRS 4 Insurance Contracts or IFRS
9 at the election of the issuer.
7. Loan commitments that cannot be settled net in cash or another financial instrument, unless the loan
commitment is measured at fair value through profit or loss (see section 7.9) under IFRS 9, in which
case it is covered by IFRS 9. Loan commitments outside the scope of IFRS 9 are still subject to the im-
pairment requirements (see section 7.11.5) of the standard.
8. Contracts between an acquirer and a vendor in a business combination to buy or sell an acquiree at a
future date.
9. Financial instruments to which IFRS 2 Share-based Payment applies.
10. Rights to payments to reimburse the entity for expenditure it is required to make to settle a liability
that it recognises as a liability under IAS 37.
11. Financial instruments within the scope of IFRS 15 Revenue from Contracts with Customers, except those
for which that standard specifies they should be accounted for under IFRS 9.
As discussed in section 7.2.4, contracts to buy or sell non-financial items are generally not financial instru-
ments. Certain commodity contracts are, however, included within the scope of IAS 32. These include
contracts to buy or sell non-financial items that can be settled net (in cash) or by exchanging financial
instruments, or in which the non-financial item is readily convertible into cash.
7.7.1 ‘Own use’ contracts

Contracts to buy or sell non-financial items do not generally meet the definition of a financial instrument.
However, many such contracts are standardised in form and traded on organised markets in much the
same way as some derivative financial instruments. The ability to buy or sell such a contract for cash, the
ease with which it may be bought or sold, and the possibility of negotiating a cash settlement of the obli-
gation to receive or deliver the commodity, do not alter the fundamental character of the contract in a way
that creates a financial instrument. However, the IASB believes that there are many circumstances where
these contracts should be accounted for as if they were financial instruments.
Accordingly, the provisions of IFRS 9 are normally applied to those contracts — effectively as if the con-
tracts were financial instruments — to buy or sell non-financial items (1) that can be settled net in cash or
another financial instrument, (2) that can be settled by exchanging financial instruments or (3) in which
the non-financial instrument is readily convertible to cash. However, there is an exception for what are
commonly termed ‘normal’ purchases and sales or ‘own use’ contracts.
The provisions of IFRS 9 are not to be applied to those contracts to buy or sell non-financial items
that can be settled net if they were entered into and continue to be held for the purpose of the receipt or
delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage require-
ments (a ‘normal’ purchase or sale). For example, an entity that enters into a contract to purchase 1000 kg
of copper in accordance with its expected usage requirements would not account for such a contract as a
derivative under IFRS 9, even if it could be settled net in cash.
IFRS 9 includes a fair value option for those so-called ‘own use’ contracts. At inception of a contract, an
entity may make an irrevocable designation to measure an own use contract at fair value through profit
or loss even if it was entered into for the purpose of the receipt or delivery of the non-financial item in
accordance with the entity’s expected purchase, sale or usage requirement. However, such designation is
only allowed if it eliminates or significantly reduces an accounting mismatch.

LO8 7.8 DERIVATIVES AND EMBEDDED DERIVATIVES
The concept of a derivative may appear daunting because there are numerous derivative financial instru-
ments in the market that seem complex and difficult to understand. However, as already noted, funda-
mentally all derivatives simply derive their value from another underlying item such as a share price or an
interest rate. Derivative financial instruments create rights and obligations that have the effect of transfer-
ring between the parties to the instrument one or more of the financial risks inherent in an underlying pri-
mary financial instrument. On inception, derivative financial instruments give one party a contractual right
to exchange financial assets or financial liabilities with another party under conditions that are potentially
favourable, while the other party has a contractual obligation to exchange under potentially unfavourable
conditions.
Figure 7.4 illustrates an option contract as an example of a derivative.
An option contract
Party A buys an option that entitles it to purchase 1000 shares in Company Z at £3 a share, at any
time in the next 6 months. The shares in Company Z are the underlying financial instruments
from which the option derives its value. The option is thus the derivative financial instrument. The
amount of £3 a share is called the exercise price of the option.
Party B sells the option to Party A. Party A is called the holder of the option, and Party B is called
the writer of the option. Party A will usually pay an amount called a premium to purchase the
option. The amount of the premium is less than what Party A would have to pay for the shares in
Company Z.
Assume that at the date of the option contract the market price of shares in Company Z is £2.60.
The financial instrument created by this transaction is a contractual right of Party A to purchase
the 1000 shares in Company Z at £3 a share (a financial asset of Party A), and a contractual
obligation of Party B to sell the shares in Company Z to Party A at £3 a share (a financial liability
of Party B). Party A’s right is a financial asset because it has the right to exchange under potentially
favourable conditions to itself. Thus, if the share price of Company Z rises above £3, Party A will
exercise its option and require Party B to deliver the shares at £3 a share. Party A will have benefited
from this transaction by acquiring the shares in Company Z at less than the market price. Conversely,
Party B’s obligation is a financial liability because it has the obligation to exchange under potentially
unfavourable conditions to itself. Thus, if the shares in Company Z rise to £3.20, Party A will
purchase the shares from Party B for £3000. If Party A had had to purchase the shares on the market,
it would have paid £3200.
Party B may have made a loss from this transaction, depending on whether it already held the
shares in Company Z, or had to go out and buy them for £3200 and then sell them to Party A for
£3000, or had entered into other derivative contracts with other parties enabling it to purchase the
shares at less than £3000.
What if the share price in Company Z never exceeds £3 over the 6-month term of the option? In
this case, Party A will not exercise the option and the option will lapse. The option is termed ‘out
of the money’ from Party A’s perspective — it has no value to Party A because the exercise price
is higher than the market price. Once the share price rises above £3, the option is termed ‘in the
money’. Party A is not compelled to exercise its option, even if it is in the money. From Party A’s
perspective, it has a right to exercise the option should it so choose. However, if Party A exercises its
option, Party B is then compelled to deliver the shares under its contractual obligation.
IAS 32 notes that the nature of the holder’s right and of the writer’s obligation is not affected by
the likelihood that the option will be exercised.
FIGURE 7.4 How an option contract works
In simple terms, parties to derivative financial instruments are taking bets on what will happen to the
underlying financial instrument in the future. In the example in figure 7.4, Party A was taking a bet that
the share price in Company Z would rise above £3 within 6 months, and Party B was taking a bet that it
would not. Party B would most likely hedge its bet by doing something to protect itself should the market
price rise above £3. It could do this by entering into another derivative with another party, enabling Party
B to purchase shares from that other party at £3. Often a chain of derivative financial instruments will be
created in this way. Party A will probably not know anything about the chain created. (Hedging is discussed
in section 7.13.)
IAS 32 does not prescribe recognition and measurement rules for derivatives; these are addressed in IFRS
9. Instead, IAS 32 includes derivatives in the definition of financial instruments. Other types of derivatives
include interest rate swaps, forward exchange contracts and futures contracts.
166 PART 2 Elements

7.8.1 Three required characteristics
Appendix A of IFRS 9 defines a derivative. Derivatives derive their value from another underlying item such
as a share price or an interest rate. The definition requires all of the following three characteristics to be met:
• its value must change in response to a change in an underlying variable such as a specified interest rate,
price, or foreign exchange rate
• it must require no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts with similar responses to changes in market factors
• it is settled at a future date.
7.8.2 Examples of derivatives

Typical examples of derivatives are futures and forward, swap and option contracts. A derivative usually
has a notional amount, which is an amount of currency, a number of shares or other units specified in
a contract. However, a derivative does not require the holder or writer to invest or receive the notional
amount at the inception of the contract. In the example in figure 7.4, where Party A buys an option that
entitles it to purchase 1000 shares in Company Z at £3 a share at any time in the next 6 months, the 1000
shares is the notional amount. However, a notional amount is not an essential feature of a derivative. For
example, a contract may require a fixed payment of £2000 if a specified interest rate increases by a speci-
fied percentage. Such a contract is a derivative even though there is no notional amount.
Many option contracts require a premium to be paid to the writer of the option. The premium is less
than what would be required to purchase the underlying shares or other underlying financial instruments
and thus option contracts meet the definition of a derivative.
7.8.3 Embedded derivatives

Derivatives may exist on a stand-alone basis, or they may be embedded in other financial instruments. An
embedded derivative is a component of a hybrid contract 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 instrument (IFRS 9 paragraph 4.3.1). An embedded derivative cannot be contractually detached
from the host contract, nor can it have a different counterparty from that of the host instrument, as it
would otherwise be considered a separate financial instrument.
Separation of embedded derivatives

A derivative should not be separated from the host contract if it is embedded in an asset host that is within the
scope of IFRS 9. Instead, an entity should apply the IFRS 9 requirements to such hybrid financial assets in their
entirety. Note that the guidance on embedded derivatives still applies to financial liabilities scoped within IFRS 9.
If an embedded derivative is separated, it is generally required to be measured at fair value. If fair value
of the separated derivative cannot be reliably measured, then the entire hybrid contract must be measured
at fair value through profit or loss (IFRS 9 paragraph 4.3.6).
For all embedded derivatives other than those where the host is an asset scoped within IFRS 9, para-
graph 4.3.3 of IFRS 9 requires them to be separated from the host contract if, and only if, the following
three conditions are met:
• the economic characteristics and risks of the embedded derivative are not closely related to the
economic characteristics and risks of the host contract
• a separate instrument with the same terms as the embedded derivative would meet the definition of a
derivative
• the hybrid contract is not measured at fair value through profit or loss. This means that a derivative
embedded in a hybrid contract measured at fair value through profit or loss is not separated, even if
it could be separated, as the separated embedded derivative would be required to be measured at fair
value through profit or loss anyway.
The following are examples of instruments scoped within IFRS 9 where the economic characteristics and
risks of the embedded derivative are not closely related to the economic characteristics and risks of the
host contract (and therefore the embedded derivative must be separated):
• a put option embedded in a debt instrument that allows the holder to require the issuer to reacquire
the instrument for an amount of cash that varies on the basis of the change in an equity or commodity
price or index. This is because the host is a debt instrument and the variables are not related to the
debt instrument
• an option to extend the remaining term to maturity of a debt instrument without a concurrent
adjustment to the market rate of interest at the time of the extension
• equity-indexed interest or principal payments embedded in a host debt instrument or insurance
contract by which the amount of interest or principal is indexed to a share price
• commodity-indexed interest or principal payments embedded in a host debt instrument or insurance
contract by which the amount of interest or principal is indexed to the price of the commodity (such
as gold).

A common example of an underlying contract not scoped within IFRS 9 where entities need to determine
whether an embedded derivative needs to be separated is one where an entity enters into a purchase of sale
contract in a currency other than its functional currency. IFRS 9 stipulates that the embedded foreign currency
derivative in the host contract is only closely related to the host contract if (i) the host contract is not leveraged
and (ii) does not contain option features and (iii) is denominated in either (a) the currency of one of the coun-
terparties to the contract or (b) the currency in which the price of the related good or service is routinely denom-
inated such as the USD for oil, or (c) a currency that is commonly used in the specific economic environment.
IFRS 9 contains further examples of such instruments. In addition, it also gives examples of instruments
where the economic characteristics and risks of the embedded derivative are closely related to the economic
characteristics and risks of the host contract. These examples are very prescriptive and not clearly principle-based.
LO9 7.9 FINANCIAL ASSETS AND FINANCIAL LIABILITIES:

CATEGORIES OF FINANCIAL INSTRUMENTS
7.9.1 Financial assets

During the credit crisis commentators argued that IAS 39 contained too many categories of financial assets,
that were not geared to the various business models, in particular of banks, and was not flexible enough to
allow preparers to reclassify, for example when their business model changes. Some also argued that IAS
39 was biased towards the fair value model rather than the cost model.
In response to this feedback the IASB issued an initial proposal with only three categories of financial assets,
no options and rigid criteria to classify financial assets which included the business model test. In the course of
the consideration of these proposals though, several options and additional categories were introduced and the
criteria for classification were changed, including an additional business model to accommodate the insurance
sector. The categories and the criteria for classification in the final standard are described below.
IFRS 9 has the following measurement categories for financial assets:
• Debt instruments at amortised cost.
• Debt instruments at fair value through other comprehensive income (FVOCI) with cumulative gains
and losses reclassified to profit or loss upon derecognition.
• Equity instruments designated as measured at FVOCI with gains and losses remaining in other
comprehensive income (OCI) without subsequent reclassification to profit or loss.
• Debt instruments, derivatives and equity instruments at fair value through profit or loss (FVPL).
The classification is based on both the entity’s business model for managing the financial assets and the
contractual cash flow characteristics of the financial asset, as set out in figure 7.5.
Debt (including hybrid contracts) Derivatives Equity
‘Contractual cash flow characteristics’ test

(at instrument level)
Pass Fail Fail Fail
‘Business model’ (BM) assessment

Held for trading?
(at an aggregate level)
1 Hold-to-collect 2 BM with objective that 3 Neither (1) Yes No

contractual results in collecting nor (2)
cash flows contractual cash flows and
selling financial assets
Conditional fair value Yes No FVOCI option

option (FVO) elected? elected?
Yes
No No
Amortised FVOCI FVOCI

FVTPL
cost (with recycling) (no recycling)
FIGURE 7.5 The categories of financial assets
168 PART 2 Elements

Table 7.3 sets out the requirements of IFRS 9 in further detail.
TABLE 7.3 The categories of financial assets
Characteristics of the Business model and

Category instrument other requirements Examples
Debt instruments The asset’s contractual The asset is held within Commercial bill
measured at amortised cash flows represent a ‘hold to collect’ investments; government
cost ‘solely payments of business model whose bonds; corporate bonds;
principle and interest’ objective is to collect accounts receivable;
(SPPI) contractual cash flows mortgage loans
Debt instruments at fair The asset’s contractual Held within a ‘hold to Commercial bill
value through other cash flows represent collect and sell’ business investments; government
comprehensive income ‘solely payments of model whose objective bonds; corporate bonds;
principal and interest’ is achieved by both mortgage loans
collecting contractual
cash flows and selling
financial assets
Equity instruments Equity instrument Designation of the equity Shares

designated as measured instrument not held for
at FVOCI trading as measured at
FVOCI with gains and
losses remaining in other
comprehensive income
Debt instruments, Any financial asset Debt instruments that Commercial bill
derivatives and equity fail the business model investments; government
instruments at fair value tests above bonds; corporate bonds
through profit or loss
Debt instruments that Share portfolio held for
are designated at fair short-term gains
value through profit
Forward exchange
or loss because it
contracts; interest rate
reduces or eliminates
swaps; call options
a measurement or
recognition inconsistency
Equity instruments that
are not designated as
measured at FVOCI
Business models
An entity’s business model for managing financial assets is a matter of fact typically observable through par-
ticular activities that the entity undertakes to achieve its stated objectives. An entity will need to use judgement to
assess its business model for managing financial assets and that assessment is not determined by a single factor
or activity. Rather, the entity must consider all relevant evidence that is available at the date of the assessment.
The business model assessment is not an instrument-by-instrument assessment, but it takes place at a higher
level of aggregation, which is the level at which the key decision makers manage groups or portfolios of finan-
cial assets to achieve the business objective. IFRS 9 distinguishes between three types of business model:
1. In a ‘hold to collect’ business model, management’s objective is to collect the instrument’s contractual
cash flows. Although IFRS 9 is slightly vague about the role of sales, expected future sales are the key
determining factor and past sales are of relevance only as a source of evidence. Portfolios in which the
expected sales are more than infrequent and significant in value do not meet the criteria of a ‘hold to
collect’ business model. A typical example of such a business model is a liquidity buffer portfolio where
an entity only sells assets in rare ‘stress case’ scenarios.
2. In the ‘hold to collect and sell’ business model, the entity’s key management personnel have made a de-
cision that both collecting contractual cash flows and selling are fundamental to achieving the objective
of the business model. For example, the objective of the business model may be to manage everyday
liquidity needs, to achieve a particular interest yield profile or to match the duration of financial assets
to the duration of the liabilities that those assets are funding. To achieve these objectives, the entity
will both collect contractual cash flows and sell the financial assets. This business model will typically
involve greater frequency and value of sales than the ‘hold to collect’ business model.

3. In other business models, financial assets are held for trading or are managed on a fair value basis. In
each case, the entity manages the financial assets with the objective of realising cash flows through the
sale of the assets and the entity’s objective will typically result in active buying and selling. Although the
entity might hold certain assets for longer periods, this, however, is purely incidental and not essential
to this business model.
Cash flow characteristics
The assessment of the characteristics of the contractual cash flows is done at the individual financial asset
level and aims to identify whether the contractual cash flows are solely payments of principal and interest
(SPPI) on the principal amount outstanding. For the purposes of the SPPI test, interest is typically the
compensation for the time value of money and credit risk, but may also include consideration for other
basic lending risks (e.g. liquidity risk) and costs (e.g. servicing or administrative costs) associated with
holding the financial asset for a period of time, as well as a profit margin.
The SPPI test is designed to screen out financial assets for which the application of the effective interest
method either is not viable from a purely mechanical standpoint (e.g. a share where the cash flows simply
cannot be reflected by the effective interest method) or does not provide useful information about the
uncertainty, timing and amount of the financial asset’s contractual cash flows (e.g. a debt instrument that
is linked to a commodity price where variability of cash flows is largely caused by the change in the
commodity price). Accordingly, the SPPI test is based on the premise that the application of the effective
interest method only provides useful information when the variability in the contractual cash flows arises
to maintain the holder’s return in line with a basic lending arrangement.
Sometimes, contractual provisions may modify the cash flows of an instrument so that it does not give
rise only to a straightforward repayment of principal and interest. However, financial assets may still meet
the SPPI test if:
• the contractual cash flow characteristic has only a de minimis (i.e. very minor) effect on the contractual
cash flows of the financial asset
• the contractual cash flow characteristic is not genuine, i.e. it affects the instrument’s contractual cash flows
only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur
• the entity can determine, quantitatively or qualitatively, that the contractual cash flows that have a
modified time value of money element of interest (e.g. a 6-month loan that pays 12-month LIBOR
has such an element) do not differ significantly from the cash flows on a benchmark instrument that
represent solely payments of principal and interest on the principal outstanding), or
• the interest rate is set by government or a regulatory authority. In such a case, the interest rate may
be considered a proxy for the time value of money element for applying the contractual cash flow
characteristics test if that regulated interest rate meets certain conditions.
Many financial assets have characteristics that could cause them to fail the SPPI test, even though they
arise in the course of regular lending operations in the economy. Therefore, the IASB included detailed
guidance in IFRS 9 — that deals with contingent events affecting cash flows, prepayment and extension
options, contractually linked instruments and non-recourse lending — in order to limit the circumstances
in which these instruments would have to be measured at fair value.
7.9.2 Financial liabilities

IFRS 9 has the following measurement categories for financial liabilities:
• Financial liabilities at amortised cost.
• Financial liabilities at fair value through profit or loss.
The classification of financial liabilities under IFRS 9 does not follow the approach for the classification
of financial assets, but follows the approach set out in Table 7.4.
TABLE 7.4 The categories of financial liabilities
Characteristics of the
Category instrument Other requirements Examples
Financial liabilities at Financial liabilities Financial liabilities that meet the Bond issues; short
fair value through profit definition of held for trading positions in trading;
or loss derivatives
Financial liabilities that are
designated at fair value through
profit or loss because it reduces
or eliminates a measurement or
recognition inconsistency
Financial liabilities at Financial liabilities Financial liabilities that do not Bond issues; trade
amortised cost fall into the above category creditors
170 PART 2 Elements

Note that derivative financial liabilities are deemed to meet the definition of held for trading and are
measured at fair value through profit or loss.
For financial liabilities that do not meet the definition of held for trading, but are designated as at fair
value through profit or loss, the element of gains or losses attributable to changes in the entity’s own credit
risk is normally recognised in OCI. This avoids the counterintuitive effect of a deterioration of an entity’s
credit standing resulting in a gain recognised in profit and loss (see section 3.5 on fair value measurement).
However, if this creates or enlarges an accounting mismatch in profit or loss, gains and losses must be
entirely presented in profit or loss.
LO10 7.10 FINANCIAL ASSETS AND FINANCIAL LIABILITIES:

RECOGNITION CRITERIA
IFRS 9 states that an entity shall recognise a financial asset or a financial liability in its statement of
financial position when, and only when, the entity becomes a party to the contractual provisions of the
instrument. The standard provides examples of applying the recognition criteria, as follows:
• Unconditional receivables and payables are recognised as assets or liabilities when the entity becomes
a party to the contract and, consequently, has a legal right to receive or a legal obligation to pay cash.
Normal trade debtors and trade creditors would fall into this category.
• Assets to be acquired and liabilities to be incurred under a firm commitment to purchase or sell
goods or services are generally not recognised until at least one of the parties has performed under the
agreement. However, this is subject to the rules set out in the scope paragraph of IFRS 9 (discussed in
section 7.7). Thus, if a firm commitment to buy or sell non-financial items is within the scope of IFRS
9, its net fair value is recognised as an asset or liability on the commitment date.
• A forward contract within the scope of the standard is also recognised as an asset or liability at the
commitment date. When an entity becomes party to a forward contract, the rights and obligations at
the commitment date are often equal, so that the net fair value of the forward is zero.
Note the following:
• Option contracts within the scope of the standard are recognised as assets or liabilities when the
holder or writer becomes a party to the contract.
• Planned future transactions, no matter how likely, are not assets and liabilities because the entity has
not become a party to a contract.

LIABILITIES: MEASUREMENT
The measurement rules in IFRS 9 address:
1. initial measurement
2. subsequent measurement
3. reclassifications
4. gains and losses
5. impairment and uncollectability of financial assets.
The rules are applied distinctly to each of the categories of financial instruments discussed in section 7.9.
7.11.1 Initial measurement

Paragraph 5.1.1 of IFRS 9 requires that, on initial recognition, financial assets and financial liabilities must
be measured at fair value. Fair value is defined by IFRS 13 as:
the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between
The concept of fair value is discussed in chapter 3.
In addition, paragraph 5.1.1 requires that transaction costs directly attributable to the acquisition
or issue of the financial asset or liability must be added to or deducted from the fair value, except for
financial assets and liabilities measured at fair value through profit or loss. Transaction costs are defined
in IFRS 9 as:
incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial
liability (see paragraph B5.4.8). An incremental cost is one that would not have been incurred if the entity had
not acquired, issued or disposed of the financial instrument.
Paragraph B5.4.8 of IFRS 9 provides further guidance. Examples of transaction costs include fees and
commissions paid to agents, advisers, brokers and dealers; levies by regulatory agencies and securities

exchanges; and transfer taxes and duties (such as stamp duties). Transaction costs do not include debt
premiums or discounts, financing costs or internal administrative or holding costs.
The fair value of a financial instrument on initial recognition is normally the transaction price (the fair
value of the consideration given or received). However, if part of the consideration given or received is for
something other than the financial instrument, then the fair value must be estimated using valuation tech-
niques. For example, if a company provides an interest-free loan to its employees, part of the consideration is
given in the form of recognition of employee services or loyalty rather than for the entire loan itself. The fair
value of the loan must be calculated by discounting the future cash flows using a market rate of interest for
a similar loan (similar as to currency, term and credit rating). Any additional amount lent is accounted for
as an expense unless it qualifies for recognition as some other type of asset. Figure 7.6 provides an example.
Initial measurement of an interest-free loan

Company Z provides interest-free loans to 10 employees for a 5-year term, payable at the end of 5
years. The total loan amount is $200 000. A market rate of interest for a similar 5-year loan is 5%.
The present value of this receivable, being the future cash flows discounted at 5%, is approximately
$157 000. Therefore, $43 000 is an employee expense to Company Z. Depending on the terms of the
loan, this employee expense is either recognised immediately (e.g. if the employee can continue to
benefit from the interest free loan even if he/she stops providing employee services), or deferred over
the period that the employee is required to provide employee services to continue to benefit from the
interest-free loan (e.g. if the loan needs to be repaid immediately on termination of employment).
Company Z would record the following journal entries:
Loans Receivable Dr 157 000

(Deferred) Expenses Dr 43 000
Cash Cr 200 000
FIGURE 7.6 Initial measurement of an interest-free loan
7.11.2 Subsequent measurement

Subsequent measurement depends on whether or not the item is a financial asset or financial liability, and
on which of the categories applies.
Financial assets are measured as follows:
1. At amortised cost — debt instruments measured at amortised cost.
2. At fair value —
(i) Debt instruments at fair value through other comprehensive income
(ii) Equity instruments designated as measured at fair value through other comprehensive income
(iii) Debt instruments, derivatives and equity instruments at fair value through profit or loss.
If any of these financial assets are hedged items, they are subject to the hedge accounting measurement
rules (see section 7.13).
Amortised cost is defined in IFRS 9 as follows:
The amount at which the financial asset or financial liability is measured at initial recognition minus the
principal repayments, plus or minus the cumulative amortisation using the effective interest method of any differ-
ence between that initial amount and the maturity amount and, for financial assets, adjusted for any loss allowance.
The effective interest method calculates the amortised cost of a financial asset or a financial liability and
allocates interest revenue or interest expense in profit or loss over the relevant period. The effective interest
rate is defined by IFRS 9 as:
The rate that exactly discounts estimated future cash payments or receipts through the expected life of the finan-
cial asset or financial liability to the gross carrying amount of a financial asset [which is the asset’s amortised cost
before deducting any loss allowance] or to the amortised cost of a financial liability.
The effective interest rate must be calculated considering all contractual terms of the instrument. It
includes all fees, transaction costs, premiums and discounts.
Illustrative example 7.1 provides an example of how amortised cost is calculated.
ILLUSTRATIVE EXAMPLE 7.1 Calculation of amortised cost (based on IFRS 9, Implementation Guidance B.26)
Cape Ventures purchases a debt instrument at 1 January 2016 with a 5-year term for its fair value of
$1000 (including transaction costs). The instrument has a principal amount of $1250 (the amount pay-
able on redemption) and carries fixed interest of 4.7% annually. The annual cash interest income is thus
$59 ($1250 × 0.047). Using a financial calculator, the effective interest rate is calculated as 10%. The
debt instrument is classified as at amortised cost.
172 PART 2 Elements

The following table sets out the cash flows and interest income for each period, using the effective
interest rate of 10%:
E. Amortised cost
B. Amortised cost at C. Interest income at end of year
A. Year beginning of year (B × 10%) D. Cash flows (B + C − D)
2016 1 000 100 59 1 041
2017 1 041 104 59 1 086
2018 1 086 109 59 1 136
2019 1 136 113 59 1 190
2020 1 190 119 59 + 1 250 –
The journal entries to record this transaction on initial recognition and throughout the life of the
instrument are as follows:
On initial recognition at 1 January 2016:
Debt instrument measured at amortised cost Dr 1 000

Cash Cr 1 000
On recognition of interest in 2016:
Debt instrument measured at amortised cost Dr 41

Cash Dr 59
Interest Income Cr 100

Cash Dr 59

Cash Dr 59

Cash Dr 59

Cash Dr 59
On redemption of investment at 31 December 2020:
Cash Dr 1 250
Debt instrument measured at amortised cost Cr 1 250

Financial liabilities are measured subsequent to initial recognition at amortised cost except for those
designated as ‘at fair value through profit or loss’, which must be measured at fair value (IFRS 9 paragraph
4.2.2). There are four exceptions to this rule:
1. Financial liabilities arising in certain circumstances when a financial asset is transferred under the
derecognition rules. These are outside the scope of this chapter.
2. Financial guarantee contracts (see section 7.7). These are initially measured at fair value and subsequently
at the higher of:
(i) the amount determined in accordance with the IFRS 9 requirements on impairment (see section
7.11.5) and
(ii) the amount initially recognised less, where appropriate, cumulative amortisation recognised in
accordance with IFRS 15 Revenue from Contracts with Customers.
A common example of a financial guarantee contract is when a parent company guarantees the debts of
its subsidiary to an external financier. The parent undertakes to pay the financier in the event that the
subsidiary is unable to pay.
3. Commitments to provide a loan at a below-market interest rate. The measurement rules are the same as
for (2) above.
4. Contingent consideration recognised in a business combination should be measured at fair value with
changes recognised in profit or loss.
If any of these financial liabilities are hedged items, they are subject to the hedge accounting measure-
ment rules (see section 7.13). If any of the financial liabilities are measured at fair value, an entity would
need to apply the specific requirements for effect of its own credit risk (see section 7.9.2).
Illustrative example 7.2 provides an example of a financial liability measured at amortised cost.
ILLUSTRATIVE EXAMPLE 7.2 A fi nancial liability measured at amortised cost
Lenglen enters into an agreement with Bartoli to lend it $1 million on 1 January 2016. Bartoli incurs
transaction costs of $25 000. The interest to be paid is 5% for each of the first 2 years and 7% for each
of the next 2 years, annually in arrears. The loan must be repaid after 4 years. The annual cash interest
expense is thus $50 000 ($1 million × 0.05) for each of the first 2 years and $70 000 ($1 million ×
0.07) for each of the next 2 years. Using a financial calculator, the effective interest rate is calculated as
6.67%. Bartoli measures the financial liability at fair value on initial recognition and subsequently at
amortised cost in accordance with IFRS 9.
The following table sets out the cash flows and interest expense for each period, using the effective
interest rate of 6.67%.
E. Amortised cost
B. Amortised cost at C. Interest income at end of year
A. Year beginning of year (B × 6.67%) D. Cash flows (B + C − D)
2016 975 000 65 014 50 000 990 014
2017 990 014 66 015 50 000 1 006 029
2018 1 066 029 67 083 70 000 1 003 112
2019 1 003 112 66 888 70 000 + 1 000 000 –
The journal entries to record this transaction on initial recognition and throughout the life of the
instrument in the books of Bartoli are as follows:
On initial recognition in 2016:
Cash Dr 975 000

Bond – Liability Dr 25 000
Bond – Liability Cr 1 000 000

Bond – Liability Cr 15 014
Cash Cr 50 000
174 PART 2 Elements


Bond – Liability Cr 16 015
Cash Cr 50 000

Cash Cr 70 000

Cash Cr 70 000
On repayment of liability in 2019:
Interest Expense Dr 0
Bond – Liability Dr 1 000 000
Cash Cr 1 000 000
7.11.3 Reclassifications
IFRS 9 contains various prescriptive rules on the reclassification of financial instruments. The rules are
aimed at preventing inconsistent gain or loss recognition and the use of arbitrage between the categories.
In summary:
• In certain rare circumstances when an entity changes its business model for managing financial assets,
non-derivative debt assets are required to be reclassified between the amortised cost, fair value through
profit or loss, and fair value through other comprehensive income categories. Changes in the business
model for managing financial assets are expected to be very rare and occur for example when an entity
acquires a new business or disposes of an existing business. A business model may develop over time
in a way that it no longer meets the requirements of the initial measurement category. Those cases are
not reclassifications and existing assets remain in the old category while new assets are classified taking
into consideration the new business model.
• Equity instruments measured at fair value through other comprehensive income and financial
liabilities should not be reclassified.
• The following changes in circumstances are not reclassifications:
• when an item is designated as (or ceases to be) an effective hedging instrument in a cash flow hedge
or net investment hedge
• changes in measurement in accordance with the guidance on designation of credit exposure as
measured at fair value through profit or loss (see section 7.13.5).
7.11.4 Gains and losses

A gain or loss on a financial asset or financial liability that is measured at fair value is recognised in profit
or loss unless:
1. it is part of a hedge relationship
2. it is an investment in an equity instrument for which the gains and losses are recognised in other com-
prehensive income
3. it is a financial liability for which the entity is required to present the effects of changes in own credit
risk in other comprehensive income, or
4. it is a debt instrument at fair value through other comprehensive income — a gain or loss is recog-
nised in profit or loss when the financial asset is derecognised, reclassified to measurement at fair
value through profit or loss, through the amortisation process or in order to recognise impairment
gains or losses.

A gain or loss on a financial instrument that is measured at amortised cost and is not part of a hedging
relationship should be recognised in profit or loss when:
1. financial assets are derecognised, reclassified to measurement at fair value through profit or loss, through
the amortisation process or in order to recognise impairment gains or losses
2. financial liabilities are derecognised through the amortisation process.
7.11.5 Impairment and uncollectability of financial assets

Background
In April 2009, as mentioned in section 7.1, the leaders of the G-20 called upon accounting standard setters
to strengthen accounting recognition of loan-loss provisions by incorporating a broader range of credit
information. During the financial crisis, the delayed recognition of credit losses associated with loans and
other financial instruments was identified as a weakness in existing accounting standards. This is primarily
because the impairment requirements under IAS 39 were based on an ‘incurred loss model’, i.e. credit
losses were not recognised until a credit loss event occurs. The IASB has sought to address the concerns
about the delayed recognition of credit losses by introducing in IFRS 9 a forward-looking expected credit
loss model.
The expected credit loss model applies to:
• financial debt assets measured at amortised cost or at fair value through other comprehensive income
under IFRS 9 (which include debt instruments such as loans, debt securities and trade receivables)
• loan commitments and financial guarantee contracts that are not accounted for at fair value through
profit or loss under IFRS 9
• contracts assets under the revenue standard IFRS 15
• lease receivables under IAS 17.
General approach
Under the general approach, entities must recognise expected credit losses in two stages. For credit expo-
sures where there has not been a significant increase in credit risk since initial recognition (Stage 1), enti-
ties are required to provide for credit losses that result from default events ‘that are possible’ within the
next 12 months. For those credit exposures where there has been a significant increase in credit risk since
initial recognition (Stage 2), a loss allowance is required for credit losses expected over the remaining life
of the exposure irrespective of the timing of the default.
An entity should determine whether the risk of a default occurring over the expected life of the financial
instrument has increased significantly between the date of initial recognition and the reporting date. In
making that assessment, an entity should not consider collateral as this only affects the expected credit loss
but not the risk of a default occurring. An entity should make this assessment considering all reasonable
and supportable information (including forward-looking information) that is available without undue
cost or effort. IFRS 9 provides a non-exhaustive list of information — such as external market indica-
tors, internal factors and borrower-specific information — that may be relevant in making the assessment.
Some factors and indicators may not be identifiable at the level of individual financial instruments and
should be assessed at a higher level of aggregation (e.g. portfolio level).
If financial assets become credit-impaired (Stage 3), interest revenue would be calculated by applying
the effective interest rate to the amortised cost (net of loss allowance) rather than the gross carrying
amount. Financial assets are assessed as credit-impaired using the following criteria in Appendix A of
IFRS 9:
(a) significant financial difficulty of the borrower
(b) a breach of contract or default in interest or principal payments
(c) a lender granting concessions related to the borrower’s financial difficulty that the lender would not
otherwise consider
(d) it becoming probable that a borrower will enter bankruptcy or other financial reorganisation (such as
administration)
(e) the disappearance of an active market for the financial asset because of financial difficulties
(f) the purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses.
IFRS 9 does not define ‘default’, but is clear that default is broader than failure to pay and entities would
need to consider other qualitative indicators of default (e.g. covenant breaches). IFRS 9 requires an entity
to apply a definition of ‘default’ that is consistent with the definition used for internal credit risk manage-
ment purposes. However, there is a presumption that default does not occur later than when a financial
asset is 90 days past due unless an entity can demonstrate that a more lagging default criterion is more
appropriate.
Figure 7.7 provides an overview of the three stages of the model, the recognition of expected credit
losses and the presentation of interest revenue.
176 PART 2 Elements

➔
Change in credit quality since initial recognition ➔
Stage 1 Stage 2 Stage 3
Performing Underperforming Non-performing
Initial recognition Assets with a significant Credit-impaired assets
increase in credit risk
Recognition of expected credit losses
12-month expected Lifetime expected credit Lifetime expected credit
credit losses losses losses
Interest revenue
Effective interest on Effective interest on Effective interest on
gross carrying amount gross carrying amount amortised cost (net of
loss allowance)
FIGURE 7.7 Overview of the model
When applying the general approach, a number of operational simplifications and presumptions are
available to help entities assess significant increases in credit risk since initial recognition:
• If a financial instrument has low credit risk (equivalent to investment grade quality), then an entity
may assume that no significant increases in credit risk have occurred.
• If forward-looking information (either on an individual or collective basis) is not available, there is a
rebuttable presumption that credit risk has increased significantly when contractual payments are more
than 30 days past due.
• The change in risk of a default occurring in the next 12 months may often be used as an
approximation for the change in risk of a default occurring over the remaining life.
Simplified approach
IFRS 9 also provides a simplified approach that does not require the tracking of changes in credit risk, but
instead requires the recognition of lifetime expected credit losses at all times.
The simplified approach must be applied to trade receivables or contract assets that do not contain a
significant financing component. However, for trade receivables or contract assets that contain a significant
financing component, and for lease receivables, entities have an accounting policy choice to apply either
the simplified approach or the general approach. Entities may want to apply the general approach despite
its complexity, because it would result in a lower loss allowance for receivables with a term of less than 12
months. This accounting policy choice should be applied consistently, but can be applied independently
to trade receivables, contract assets and lease receivables.
Purchased or originated credit-impaired financial assets
The general approach does not apply to financial assets for which there is evidence of impairment upon
purchase or origination. Instead of recognising a separate loss allowance, the expected credit loss would be
reflected in a (higher) credit-adjusted effective interest rate. Subsequently, entities would recognise in profit
or loss the amount of any change in lifetime expected credit loss as an impairment gain or loss.
Measurement of expected credit losses
Lifetime expected credit losses should be estimated based on the present value of all cash shortfalls over
the remaining life of the financial instrument. The 12-month expected credit losses are also based on the
present value of cash shortfalls over the remaining life of the financial instruments, but only take into
account the shortfalls resulting from default events that are expected to occur within the 12 months after
the reporting date.
In measuring expected credit losses, entities would need to take into account:
• The period over which to estimate expected credit losses: entities would consider the maximum
contractual period (including extension options). However, for revolving credit facilities (e.g. credit
cards and overdrafts), this period extends beyond the contractual period over which the entities are
exposed to credit risk and the expected credit losses would not be mitigated by credit risk management
actions. This is to be calculated based on historical experience.
• Probability-weighted outcomes: although entities do not need to identify every possible scenario,
they will need to take into account the possibility that a credit loss occurs, no matter how low that
possibility is. This is not the same as the most likely outcome or a single best estimate.
• Time value of money: for financial assets, the expected credit losses are discounted to the reporting
date using the effective interest rate that is determined at initial recognition and may be approximated.
For loan commitments and financial guarantee contracts, the effective interest rate of the resulting asset

will be applied and if this is not determinable, then the current rate representing the risk of the cash
flows is used.
• Reasonable and supportable information: entities need to consider information that is reasonably
available at the reporting date about past events, current conditions and forecasts of future economic
conditions.
The expected credit loss calculation considers the amount and the timing of payments, which means
that a credit loss arises even if an entity expects to be paid in full but later than when those payments are
contractually due.
Impairment losses are recognised as follows in the statement of financial position for the different cate-
gories of financial assets:
(a) Debt instruments measured at amortised cost — an entity should recognise a loss allowance in its
statement of financial position that reduces the carrying amount of these financial instruments.
(b) Debt instruments measured at fair value through other comprehensive income — an entity should
recognise the loss allowance in other comprehensive income and not reduce the carrying amount of
the financial asset in the statement of financial position.
The impairment rules do not apply to equity instruments designated as measured at fair value through
other comprehensive income and they do not apply to debt instruments, derivatives and equity instru-
ments at fair value through profit or loss.
Illustrative example 7.3 demonstrates the calculation of an impairment loss for a debt instrument meas-
ured at amortised cost.
ILLUSTRATIVE EXAMPLE 7.3 12-month expected credit loss measurement for a debt instrument measured at amortised cost
Nurul Bank originates 2000 loans with a total gross carrying amount of €50 000 000. Nurul Bank seg-
ments its portfolio into two borrower groups (Groups Bagus and Roti) based on shared credit risk char-
acteristics at initial recognition. Group Bagus comprises 1000 loans with a gross carrying amount per
client of €20 000, for a total gross carrying amount of €20 000 000. Group Roti comprises 1000 loans
with a gross carrying amount per client of €30 000, for a total gross carrying amount of €30 000 000.
There are no transaction costs and the loan contracts include no options (for example, prepayment or
call options), premiums or discounts, points paid, or other fees.
Nurul Bank measures expected credit losses based on a loss rate approach for Groups Bagus and Roti.
In order to develop its loss rates, Nurul Bank considers samples of its own historical default and loss
experience for those types of loans. In addition, Nurul Bank considers forward-looking information, and
updates its historical information for current economic conditions as well as reasonable and support-
able forecasts of future economic conditions. Historically, for a population of 1000 loans in each group,
Group Bagus’s loss rates are 0.3%, based on four defaults, and historical loss rates for Group Roti are
0.15%, based on two defaults.
Estimated
per client Total Estimated
gross estimated Historic total gross
Number carrying gross carrying per annum carrying Present value
of clients amount at amount at average amount at of observed
in sample default default defaults default loss Loss rate
Group A B C=A×B D E=B×D F G=F÷C
Bagus 1 000 €20 000 €20 000 000 4 €80 000 €60 000 0.30%
Roti 1 000 €30 000 €30 000 000 2 €60 000 €45 000 0.15%
€50 000 000 €105 000
Nurul Bank would account for the following journal entry when it originates the loans that are meas-
ured at amortised cost as follows:
Investment in debt instrument Dr 49 895 000

Impairment loss (profit or loss) Dr 105 000
Cash Cr 50 000 000
178 PART 2 Elements

The expected credit losses should be discounted using the effective interest rate; however, for the pur-
poses of this example, the present value of the observed loss is assumed.
At the reporting date, Nurul Bank expects an increase in defaults over the next 12 months compared
to the historical rate. As a result, Nurul Bank estimates five defaults in the next 12 months for loans in
Group Bagus and three for loans in Group Roti. It estimates that the present value of the observed credit
loss per client will remain consistent with the historical loss per client.
Based on the expected life of the loans, Nurul Bank determines that the expected increase in defaults
does not represent a significant increase in credit risk since initial recognition for the portfolios. Based
on its forecasts, Nurul Bank measures the loss allowance at an amount equal to 12-month expected
credit losses on the 1000 loans in each group amounting to €75 000 and €67 500 respectively. This
equates to a loss rate in the first year of 0.375% for Group Bagus and 0.225% for Group Roti.
Estimated
per client Total Estimated
gross estimated total gross
Number carrying gross carrying carrying Present value
of clients amount at amount at Expected amount at of observed
in sample default default defaults default loss Loss rate
Group A B C=A×B D E=B×D F G=F÷C
Bagus 1 000 €20 000 €20 000 000 5 €100 000 €75 000 0.375%
Roti 1 000 €30 000 €30 000 000 3 €90 000 €67 500 0.225%
€50 000 000 €142 500
Nurul Bank uses the loss rates of 0.375% and 0.225% respectively to estimate 12-month expected
credit losses on new loans in Group Bagus and Group Roti originated during the year and for which
credit risk has not increased significantly since initial recognition.
Nurul Bank would account for the increase in the 12-month expected credit losses on the debt instru-
ments as follows:

Investment in debt Cr 37 500
instrument
Illustrative example 7.4 shows the calculation of an impairment loss on a debt instrument measured at
fair value through other comprehensive income.
ILLUSTRATIVE EXAMPLE 7.4 Impairment loss on a debt instrument measured at fair value through other
Branislava Ventures purchases a debt instrument with a fair value of £1 000 000 on 15 December 2016
and measures the debt instrument at fair value through other comprehensive income (FVOCI). The
instrument has an interest rate of 5% over the contractual term of 10 years, and has a 5% effective
interest rate. At initial recognition Branislava Ventures determines that the asset is not purchased or orig-
inated credit-impaired.
Branislava Ventures would account for the following journal entry to recognise the investment in the
debt instrument measured at fair value through other comprehensive income:
Investment in debt instrument Dr 1 000 000

Cash Cr 1 000 000
On 31 December 2016 (the reporting date), the fair value of the debt instrument has decreased to
£950 000 because of changes in market interest rates. Branislava Ventures determines that there has not
been a significant increase in credit risk since initial recognition and that expected credit losses should
be measured at an amount equal to 12-month expected credit losses, which amounts to £30 000. For
simplicity, journal entries for the receipt of interest revenue are not provided.

Branislava Ventures would account for the recognition of the 12-month expected credit losses and
other fair value changes on the debt instrument as follows:

Other comprehensive income Dr 20 000
Investment in debt instrument Cr 50 000
Disclosure would be provided about the accumulated impairment amount of £30 000.
On 1 January 2017, Branislava Ventures decides to sell the debt instrument for £950 000, which is its
fair value at that date. Branislava Ventures would derecognise the fair value through other comprehen-
sive income asset and recycle amounts accumulated in other comprehensive income to profit or loss (i.e.
£20 000) as follows:
Cash Dr 950 000

Investment in debt instrument Cr 950 000
Loss (profit or loss) Dr 20 000
Other comprehensive income Cr 20 000
7.11.6 Summary of the measurement rules of IFRS 9

Table 7.5 summarises the measurement rules of IFRS 9 discussed earlier in this section.
TABLE 7.5 Summary of the measurement rules in IFRS 9
Category of financial Initial Subsequent

asset/liability measurement measurement Reclassifications Gains and losses Impairment
Debt instruments Fair value Amortised cost Only when an Recognised in profit or Changes in the
measured at plus entity changes loss, unless a hedged expected credit loss
amortised cost transaction its business item allowance recognised
costs model in profit or loss
Debt instruments at Fair value Fair value Only when an Recognised in other Changes in the
fair value through plus entity changes comprehensive expected credit loss
other comprehensive transaction its business income, but recycled allowance recognised
income costs model to profit or loss upon in profit or loss
derecognition with offset in other
Equity instruments Fair value Fair value Not permitted Recognised in other Not applicable
designated as comprehensive income
measured at FVOCI without recycling to
profit or loss
Debt instruments, Fair value Fair value Debt Recognised in profit or Not applicable
derivatives and instruments: loss, unless a hedging
equity instruments only when an instrument or hedged
at fair value through entity changes item
profit or loss its business
model
Other
instruments: not
permitted
Financial liabilities Fair value Fair value Not permitted Recognised in profit or Not applicable
at fair value through loss, unless a hedging
profit or loss instrument or hedged
item
Financial liabilities at Fair value less Amortised cost Not permitted Recognised in profit or Not applicable
amortised cost transaction loss, unless a hedged
costs item
180 PART 2 Elements

LIABILITIES: OFFSETTING
Often two entities may have both financial assets and financial liabilities in relation to each other. For
example, a customer may have returned some goods to a supplier and expects repayment (financial asset)
from the supplier while at the same time receiving invoices for new deliveries from the same supplier
(financial liability). Or an entity may have multiple accounts with the same bank, some of which may have
a debit balance (financial asset) while others may have a credit balance (financial liability). In those cases
the question arises whether those financial assets and financial liabilities can be presented net (offset).
This of course may be relevant for important key ratios such as solvency and liquidity ratios.
Paragraph 42 of IAS 32 states that a financial asset and a financial liability shall be offset and the net
amount presented when, and only when, an entity:
(a) currently has a legally enforceable right to set off the recognised amounts; and
(b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.
The underlying rationale of this requirement is that when an entity has the right to receive or pay a
single net amount and intends to do so, it has effectively only a single financial asset or financial liability.
Note that the right of set-off must be legally enforceable and therefore usually stems from a written con-
tract between two parties. In rare cases, there may be an agreement between three parties allowing a debtor
to apply an amount due from a third party against the amount due to a creditor. Assume, for example, that
Company A owes Company B £1000, and Company Z owes Company A £1000. Company A has therefore
recorded in its books the following:
Amount Receivable from Company Z Dr 1 000

Amount Owing to Company B Cr 1 000
Provided there is a legal right of set-off allowing Company A to offset the amount owing to Company
B against the amount owed by Company Z, the amounts may be offset in Company A’s accounts. Both
Company B and Company Z must be parties to this legal right of set-off with Company A.
The conditions for offsetting are strict and essentially require written legal contracts resulting in net cash
settlement. Many arrangements that create ‘synthetic’ (manufactured) offsetting do not result in offsetting
under IAS 32, which also provides examples of common cases where offsetting is not permitted.
LO13 7.13 HEDGE ACCOUNTING

Entities enter into hedge arrangements for economic reasons; namely, to protect themselves from the types
of risks discussed in section 7.14 — currency risk, interest rate risk, other price risk and so on. Entities often
enter into derivative and other contracts to manage these risk exposures. Hedging can be seen, therefore,
as a risk management activity that changes an entity’s risk profile. However, application of the normal
IFRS® Standards accounting requirements to those risk management activities often results in accounting
mismatches, when the gains or losses on a hedging instrument and hedged items are not recognised in the
same period. The idea of hedge accounting is to reduce this mismatch by changing either the measurement
or recognition of the hedged exposure, or the accounting for the hedging instrument.
Although the basic idea is simple, the development of hedge accounting standards raises difficult ques-
tions about when hedge accounting is more appropriate than the normal IFRS Standards accounting. In
practice, this meant that some of the requirements in IAS 39 were arguably arbitrary and did not allow hedge
accounting for certain risk management activities that are commonly applied by entities. Consequently, many
entities would report ‘accounting’ hedges in their financial statements that did not correspond to the hedges
that were entered into for risk management purposes, which was unhelpful for preparers and users alike.
The objective of the hedge accounting requirements in IFRS 9 is to present in the financial statements
the effect of an entity’s risk management activities. That is, hedge accounting under IFRS 9 is intended to
align the accounting more closely to risk management. While the hedge accounting rules in IFRS 9 are less
restrictive than those in IAS 39, the fact remains that hedge accounting is only permitted if all the qual-
ifying criteria are met (see section 7.13.3). Consequently, an entity would not apply hedge accounting to
risk management activities that either do not meet the qualifying criteria or that are not designated by the
entity as accounting hedges. A number of important concepts need to be understood:
1. the hedging instrument
2. the hedged item
3. the conditions for hedge accounting and the three types of hedges
4. the hedge ratio, rebalancing and discontinuation.

7.13.1 The hedging instrument
A financial instrument must meet the following essential criteria for it to be classified as a hedging instrument:
1. It must be designated as such. This means that management must document the details of the hedging
instrument and the item it is hedging, at the inception of the hedge.
2. It must be a derivative, non-derivative financial asset or non-derivative financial liability measured at
fair value through profit or loss to be designated as a hedging instrument, unless criteria 3 is met.
However, financial liabilities for which changes in the credit risk are presented in other comprehensive
income cannot be a hedging instrument.
3. It is hedging foreign currency exchange risk, in which case it can be a non-derivative.
4. At the inception of the hedging relationship, there is formal designation and documentation of the hedg-
ing relationship and the entity’s risk management objective and strategy for undertaking the hedge.
5. It must be with a party external to the reporting entity — external to the consolidated group or indi-
vidual entity being reported on. There is one exception to this rule in respect of intragroup monetary
items when certain conditions are met.
6. It cannot be split into component parts, except for separating the time value and intrinsic value in an
option contract, and the interest element and spot price in a forward contract.
7. A proportion of the entire hedging instrument, such as 50% of the notional amount, may be designated
as the hedging instrument. However, a hedging relationship may not be designated for only a portion
of the period during which the hedging instrument remains outstanding.
8. A single hedging instrument may be designated as a hedging instrument of more than one type of risk,
if there is a specific designation of the hedging instrument and of the different risk positions as hedged
items. Those hedged items can be in different hedging relationships.
IFRS 9 contains further detailed guidance, which is not discussed here in detail, that must be complied
with and that further restricts which financial instruments can be treated as hedging instrument.
Examples of hedging instruments are forward foreign currency exchange contracts, interest rate swaps
and futures contracts. Written options cannot be hedging instruments of the writer, unless they are desig-
nated as a hedge of a purchased option.
7.13.2 The hedged item

IFRS 9 defines the following terms:
• A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a highly
probable forecast transaction or a net investment in a foreign operation.
• A forecast transaction is an uncommitted but anticipated future transaction (e.g. expected future sales or
purchases).
• 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 (e.g. a purchase order to buy a machine for $50 000
in 3 months’ time).
A hedged item:
1. can be a single item, a group of items or a component of such item(s)
2. can be a combination of a derivative with a hedged item as described above
3. must be reliably measurable
4. must arise from a transaction with a party external to the reporting entity (i.e. an entity that is not consoli-
dated by the reporting entity), subject to certain exceptions regarding intragroup foreign currency balances
5. can be a risk component of financial item (e.g. only the interest, currency or credit risk on a bond) or a
risk component of a non-financial item (e.g. fuel price component in an electricity purchase contract),
subject to certain conditions
6. can be a net nil position (i.e. on a group basis the hedged items themselves offset the risk being man-
aged), subject to certain conditions
7. can be a ‘layer’ of an overall group of items (e.g. the bottom €60 million of a €100 million fixed rate
loan), subject to certain conditions.
IFRS 9 contains further detailed requirements, which are not discussed here specifically, that restrict
which exposures can be treated as hedged items.
7.13.3 The conditions for hedge accounting and the three

types of hedges
Hedge accounting recognises the offsetting effects on profit or loss of changes in the fair values of the
hedging instrument and the hedged item. Paragraph 6.4.1 of IFRS 9 sets out the following conditions that
must be met in order for hedge accounting to be applied:
1. At the inception of the hedge, there must be formal designation and documentation of the hedging
relationship and the entity’s risk-management objective and strategy for undertaking the hedge. That
documentation must include identification of:
182 PART 2 Elements

• the hedging instrument
• the hedged item
• the nature of the risk being hedged
• how the entity will assess hedge effectiveness.
2. The hedging relationship consists only of eligible hedging instruments and eligible hedged items as
described in sections 7.13.1 and 7.13.2.
3. The hedging relationship should meet the following hedge effectiveness requirements:
(a) there is an economic relationship between the hedged item and the hedging instrument
(b) credit risk does not dominate the value changes that result from that economic relationship
(c) the hedge ratio of the hedging relationship 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.
The three types of hedging relationships are:
• fair value hedge
• cash flow hedge
• hedge of a net investment in a foreign operation as defined in IAS 21. This is accounted for in a
similar manner to cash flow hedges, but will not be discussed further in this chapter.
Note the following points:
• A fair value hedge is a hedge of the exposure to changes in fair value of an asset, liability or
unrecognised firm commitment.
• A cash flow hedge is a hedge of the exposure to variability in cash flows of a recognised asset or
liability, or a highly probable forecast transaction.
• Paragraph 6.5.4 of IFRS 9 states that a hedge of the foreign currency risk of a firm commitment may
be accounted for as either a fair value hedge or a cash flow hedge.
• A simple way of remembering the difference between the two types of hedge is that a cash flow
hedge locks in future cash flows, whereas a fair value hedge does not.
• The most commonly occurring hedge transactions for average reporting entities are interest rate
hedges and foreign currency hedges.
As an example of a simple cash flow hedge, assume that Company B has a borrowing with lender Bank
L that carries a variable rate of interest. Company B is worried about its exposure to future increases in the
variable rate of interest and decides to enter into an interest rate swap with Bank S. The borrowing is the
hedged item, and the risk being hedged is interest rate risk. Under the interest rate swap, Bank S pays Com-
pany B the variable interest rate, and Company B pays Bank S a specified fixed interest rate. The interest
rate swap is the hedging instrument. The net cash flows for Company B are its payments of a fixed interest
rate, so it has locked in its cash flows. This is therefore a cash flow hedge, assuming all the required criteria
of IAS 39 are met. Figure 7.8 illustrates this example of a simple cash flow hedge.
Underlying hedged
item
Pay variable
Company B Bank L
Receive variable
Interest
Pay fixed
rate
swap
(hedging
instrument)
Bank S
FIGURE 7.8 A simple cash flow hedge
There is no exchange of principal in an interest rate swap — the cash flows are simply calculated using
the principal as the basis for the calculation. For the example illustrated in figure 7.8, assume that the
hedged item is a borrowing of $100 000 with a variable interest rate, currently 5%. The fixed rate under the
interest rate swap is 6%. For the relevant period, Company B will pay Bank L $100 000 × 5% = $5000.
Under the swap, Company B will pay a net $1000 (receive $100 000 × 5% and pay $100 000 × 6%).

Thus, Company B’s net cash outflow is $5000 + $1000 = $6000, which is the fixed rate. Note that Bank
L is not a party to the swap — it continues to receive payments from Company B under its borrowing
arrangement. Company B has locked in its cash flows at $6000, and has certainty that this is what it will
pay over the term of the swap. Currently the cash flows are higher than what it would pay under a variable
rate, but Company B has entered into the swap in the expectation that the variable rate will rise.
Table 7.6 sets out the main requirements for fair value hedges and cash flow hedges.
TABLE 7.6 Summary of the main requirements of IFRS 9 for fair value hedges and cash fl ow hedges
Fair value hedge Cash flow hedge
Hedged item Fair value exposures in a recognised asset or Cash flow variability exposures in a recognised asset
liability or unrecognised firm commitment or liability or highly probable forecast transaction
Gain or loss on Recognised immediately in profit or loss. If Fully effective portion recognised directly in
hedging instrument hedging an equity instrument at fair value other comprehensive income. Ineffective portion
through other comprehensive income then recognised immediately in profit or loss
recognise in other comprehensive income
Gain or loss on Generally, adjust hedged item and recognise in Not applicable because the exposure being hedged
hedged item profit or loss. This applies even if the hedged is future cash flows that are not recognised
item is otherwise measured at cost
However, if the hedged item is an equity
instrument at fair value through other
comprehensive income then recognise
entire gain or loss on hedged risk in other
Hedge ineffectiveness Automatically, since the entire gain or loss Must be calculated and separated from the amount
is recorded in profit on both the hedged item and the hedging recorded in equity
or loss instrument is recorded in profit or loss
Timing of recycling of Not applicable Hedge of a forecast transaction that subsequently
hedge gains/losses in results in the recognition of a financial asset or
equity to profit or loss financial liability: during the periods in which said
asset/liability affects profit or loss, e.g. when the
interest income or expense is recognised
Hedge of a forecast transaction that subsequently
results in the recognition of a non-financial asset or
non-financial liability: include immediately in the
initial cost of said asset/ liability
If the amount is an unrecoverable loss then the
entity should recognise that loss immediately in
profit or loss
A simple fair value hedge is demonstrated in illustrative example 7.5.
ILLUSTRATIVE EXAMPLE 7.5 A simple fair value hedge
Onur Holding has an investment in a debt instrument classified as at fair value through other compre-
hensive income. The cost of the investment on 1 July 2016 was $250 000. On 1 September 2016, Onur
Holding enters into a derivative futures contract to hedge the fair value of the investment. All the condi-
tions for hedge accounting are met, and the hedge qualifies as a fair value hedge because it is a hedge of
an exposure to changes in the fair value of a recognised asset. At the next reporting date, 30 September
2016, the fair value of the investment (hedged item) was $230 000, based on quoted market bid prices.
The fair value of the derivative (hedging instrument) at that date was $18 000. Onur Holding would
record the journal entries shown below.
On initial recognition of the investment 1 July 2016:
Debt instrument at fair value through other comprehensive income Dr 250 000
Cash Cr 250 000
184 PART 2 Elements

On entering into the futures contract 1 September 2016:
No entries because the net fair value is zero.
On remeasurement at 30 September 2016:
Expense (profit or loss) Dr 20 000

Debt instrument at fair value through other comprehensive income Cr 20 000
Futures Contract Dr 18 000
Income (profit or loss) Cr 18 000
The hedge continues to meet the criteria in IFRS 9, so the hedge accounting may continue. The net
effect of the hedge is that Onur Holding records a net loss in profit or loss of $2000. The ineffective
portion of the hedge ($2000) is recorded automatically in profit or loss. Note that the decline in fair
value of the debt instrument at fair value through other comprehensive income is recorded in profit or
loss, even though the normal accounting for such investments is to recognise fair value changes directly
in equity. This exception is made specifically for hedge accounting, to enable the matching effect of the
hedging instrument with the hedged item in profit or loss to occur.
A cash flow hedge of a firm commitment is demonstrated in illustrative example 7.6.
ILLUSTRATIVE EXAMPLE 7.6 Cash fl ow hedge of a fi rm commitment
On 30 June 2016, King Kong enters into a forward exchange contract to receive foreign currency (FC) of
100 000 and deliver local currency (LC) of 109 600 on 30 June 2017. It designates the forward exchange
contract as a hedging instrument in a cash flow hedge of a firm commitment to purchase a specified
quantity of paper on 31 March 2017, and the resulting payable. Payment for the paper is due on 30 June
2017. All hedge accounting conditions in IFRS 9 are met.
Note that a hedge of foreign currency risk in a firm commitment may be either a cash flow hedge
or a fair value hedge. King Kong has elected to account for it as a cash flow hedge. Under IFRS 9,
King Kong is required to adjust the cost of non-financial items acquired as a result of hedged fore-
cast transactions.
The following table sets out the spot rate, forward rate and fair value of the forward contract at rele-
vant dates.
Forward rate to Fair value of

Date Spot rate 30 June 2017 forward contract
30 June 2016 1.072 1.096 —
31 December 2016 1.080 1.092 (388)1
31 March 2017 1.074 1.076 (1 971)
30 June 2017 1.072 — (2 400)

1. This can be calculated if the applicable yield curve in the local currency is known. Assuming the rate is 6%, the fair
value is calculated as follows: ([1.092 × 100 000] − 109 600)/1.06(6/12).
Journal entries are shown below:

At 30 June 2016:
Forward Contract Dr LC0

Cash Cr LC0
(Initial recognition of forward contract)

No entries because on initial recognition, the forward contract has a fair value of zero.
At 31 December 2016:
Other comprehensive income Dr LC388

Forward Contract (liability) Cr LC388
(Recording the change in the fair value of the forward
contract)
At 31 March 2017:
Other comprehensive income Dr LC1 583

Forward Contract (liability) Cr LC1 583
(Recording the change in the fair value of the
forward contract)
Paper (purchase price) Dr LC107 400
Paper (hedging loss) Dr LC1 971
Other comprehensive income Cr LC1 971
Payable Cr LC107 400
The last entry recognises the purchase of the paper at the spot rate (1.074 × FC100 000), and removes
the cumulative loss that has been recognised in equity and includes it in the initial measurement of the
purchased paper. The paper is thus recognised effectively at the forward rate, and the hedge has been
100% effective.
The purchase of paper is no longer a forecast transaction once King Kong has recognised the paper
and the payable. If King Kong wants to continue hedge accounting after 31 March 2017, it would need
to account for a fair value hedge of the resulting payable as illustrated below.
At 30 June 2017:
Payable Dr LC107 400

Cash Cr LC107 200
Profit or Loss Cr LC200
(Recording settlement of the payable at the spot rate and
associated exchange gain)
Profit or Loss Dr LC429
Forward Contract Cr LC429
(Recording loss on forward contract between
1 April 2017 and 30 June 2017)
Forward Contract Dr LC2 400
Cash Cr LC2 400
(Recording net settlement of forward contract)
The forward contract has been effective in hedging the commitment and the payable up to this date.
King Kong accounts for the loss on the contract in profit or loss because it is applying fair value hedge
accounting to the forward contract and the payable.
If this transaction had been designated as a fair value hedge from the outset, then the entries
recorded in equity for the cash flow hedge would instead be recorded as an asset or liability. IFRS
9 would then require the initial carrying amount of the asset acquired to be adjusted for the cumu-
lative amount recognised in the statement of financial position. The adjusted journal entries would
be as follows:
At 31 December 2016:
Asset Dr LC388
Forward Contract (liability) Cr LC388
(Recording change in fair value of forward contract)
186 PART 2 Elements

At 31 March 2017:
Asset Dr LC1 583

Forward Contract (liability) Cr LC1 583
(Recording change in fair value of forward contract)
Paper (purchase price) Dr LC107 400

Paper (hedging loss) Dr LC1 971
Asset Cr LC1 971
Payable Cr LC107 400
(Recording purchase of paper and transferring
cumulative amount recognised as an asset to the
cost of the paper)
At 30 June 2017, there would not be any difference and King Kong would record the same fair value
hedge journals as shown above.
7.13.4 Hedge ratio, rebalancing and discontinuation

IFRS 9 does not require a retrospective quantitative effectiveness assessment (i.e. was the hedge effective
in the past?), but that does not mean that hedge accounting continues regardless of how effective a hedge
is. A prospective effectiveness assessment is still required, in a similar manner as at the inception of the
hedging relationship and on an ongoing basis, as a minimum at each reporting date. This process involves
the steps shown in figure 7.9.
Effective hedge
Retrospectively measure ineffectiveness

and recognise in P&L
Has the risk management objective for Yes

designated hedging relationship changed?
No
Is there still an economic relationship No
between hedged item and hedging
instrument?
Yes
Does the effect of credit risk dominate Yes
value changes that result from the
economic relationship?
No
Has the hedge ratio been adjusted for
No risk management purposes or is there an
imbalance in the hedge ratio that would
create ineffectiveness?
Yes
Rebalancing Discontinuation
FIGURE 7.9 Effectiveness assessment and rebalancing

An entity first has to assess whether the risk management objective for the hedging relationship has
changed. A change in risk management objective is a matter of fact that triggers discontinuation of the
hedge relationship. Accordingly, a hedge relationship cannot be de-designated without an underlying
change in risk management. An entity would also have to discontinue hedge accounting if it turns out
that there is no longer an economic relationship (e.g. the hedging instrument or hedged item was sold)
because in that case there would not be a hedge to account for. The same is true for the impact of credit
risk; if credit risk is now dominating the hedging relationship, then the entity has to discontinue hedge
accounting. When an entity discontinues hedge accounting then any gain or loss on cash flow hedges
deferred in other comprehensive income must be recycled to profit or loss.
The hedge ratio is the ratio between the amount of hedged item and the amount of hedging instrument.
For many hedging relationships, the hedge ratio would be 1:1 as the underlying of the hedging instrument
perfectly matches the designated hedged risk.
If the hedge ratio has been adjusted for risk management purposes or if it turns out that the hedged
item and hedging instrument do not move in relation to each other as expected (i.e. there is an imbal-
ance in the hedge ratio) then the hedge ratio may need to be adjusted to reflect this. In that case, the
entity has to assess whether it expects this to continue to be the case going forward. If so, the entity
is likely to rebalance the hedge ratio to reflect the change in the relationship between the underlying
items.
Rebalancing can be achieved by: increasing the volume of the hedged item, increasing the volume of the
hedging instrument, decreasing the volume of the hedged item, or decreasing the volume of the hedging
instrument. Rebalancing under IFRS 9 allows entities to refine their hedge ratio without having to account
for a discontinuation of the entire hedge relationship, but it may result in a partial discontinuation if the
hedged volume is reduced.
7.13.5 Alternatives to hedge accounting

IFRS 9 offers two important alternatives to hedge accounting. The first alternative is that IFRS 9 extends
the fair value through profit or loss option to contracts that meet the ‘own use’ scope exception (see section
7.7) if this eliminates or significantly reduces an accounting mismatch. In other words, by measuring ‘own
use’ contracts at fair value, it would be possible to reduce the measurement mismatch with derivatives and
other financial instruments that are also measured at fair value. This would alleviate the need for hedge
accounting.
The second alternative applies to the many financial institutions that hedge the credit risk arising from
loans or loan commitments using credit default swaps. This would often result in an accounting mis-
match, as loans and loan commitments are typically not accounted for at fair value through profit or loss.
The simplest accounting would be to designate the credit risk as a risk component in a hedging relation-
ship. However, the IASB noted that due to the difficulty in isolating the credit risk as a separate risk it does
not meet the eligibility criteria for risk components. As a result, the accounting mismatch creates profit or
loss volatility.
Under IFRS 9, an entity undertaking economic credit risk hedging may elect to account for a debt instru-
ment (such as a loan or a bond), a loan commitment or a financial guarantee contract, at fair value
through profit or loss. This election can only be made if the asset referenced by the credit derivative has
the same issuer and subordination as the hedged exposure (i.e. both the issuer’s name and seniority of the
exposure match). The accounting for the credit derivative would not change, i.e. it would continue to
be accounted at fair value through profit or loss. Consequently, even though it is not equivalent to fair
value hedge accounting, this accounting does address several concerns of entities that use credit default
swaps for hedging credit exposures.
LO14 7.14 DISCLOSURES

IFRS 7 contains many pages dealing with disclosures, but only relatively few ‘black letter’ requirements.
This chapter does not address these requirements in detail, and readers are expected to have a general
understanding of the requirements only.
The purpose of the disclosure requirements is to provide information to enhance understanding of the
significance of financial instruments to an entity’s financial position, performance and cash flows; and to
assist in assessing the amounts, timing and certainty of future cash flows associated with those instruments.
Transactions in financial instruments may result in an entity assuming or transferring to another party
one or more of the financial risks described in Table 7.7. The purpose of the required disclosures is to
assist users in assessing the extent of such risks related to financial instruments.
188 PART 2 Elements

TABLE 7.7 Financial risks pertaining to fi nancial instruments
Type of risk Description
Credit risk The risk that one party to a financial instrument will fail to discharge an obligation and
cause the other party to incur a financial loss.
Liquidity risk The risk that an entity will encounter difficulty in meeting obligations associated with
financial liabilities. This is also known as funding risk. For example, as a financial
liability approaches its redemption date, the issuer may experience liquidity risk if its
available financial assets are insufficient to meet its obligations.
Market risk • Currency risk — the risk that the value of a financial instrument will fluctuate because
of changes in foreign exchange rates.
• Interest rate risk — the risk that the value of a financial instrument will fluctuate
because of changes in market interest rates. For example, the issuer of a financial
liability that carries a fixed rate of interest is exposed to decreases in market interest
rates, such that the issuer of the liability is paying a higher rate of interest than the
market rate.
• Other price risk — the risk that the value of a financial instrument will fluctuate as a
result of changes in market prices (other than those arising from interest rate risk or
currency risk).
IFRS 7 applies to all entities for all types of financial instruments, other than those specifically excluded
from its scope. Scope exclusions include:
• interest in subsidiaries, associates and joint ventures accounted for under IFRS 10, IAS 27, or IAS 28
• 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
• share-based payment transactions to which IFRS 2 Share-based Payment applies.
IFRS 7 applies to both recognised and unrecognised financial instruments. For example, loan commit-
ments not within the scope of IFRS 9 are within the scope of IFRS 7.
IFRS 7 requires disclosure of financial instruments grouped by class. A class of financial instrument is a
lower level of aggregation than a category, such as ‘available-for-sale’ or ‘loans and receivables’ (see section
7.9). For example, government debt securities, equity securities, or asset-backed securities could all be con-
sidered classes of financial instruments.
IFRS 7 is divided into three main sections. The first section requires disclosure of the significance of
financial instruments for financial position and performance. These disclosures are grouped into:
1. statement of financial position
2. statement of other comprehensive income
3. other disclosures.
The second section requires disclosure about the nature and extent of risks arising from financial instru-
ments. These include both quantitative and qualitative disclosures. The risks are grouped into the three
categories noted above, that is, market risk, credit risk and liquidity risk. These risk disclosures shall be
given either in the financial statements or incorporated by cross-reference from the financial statements to
some other statement, such as a management commentary or risk report.
The third section requires disclosure about financial assets transferred to another entity.
Examples of the types of disclosures required in each of the sections are provided in Tables 7.8
and 7.9.
TABLE 7.8 Significance of financial instruments for financial position and performance
Statement of financial position
Overall requirement Summary of details required
Categories of financial • The carrying amount of specified categories, as defined in IFRS 9, for example,
assets and financial financial assets measured at fair value through profit or loss and financial assets
liabilities (paragraph 8) measured at amortised cost.
(continued)

Financial assets or • An entity that designates a financial asset as measured at fair value through
financial liabilities profit or loss should disclose specified details including the maximum
at fair value through exposure to credit risk, the amount by which credit derivatives mitigate
profit or loss that exposure, the amount of fair value changes attributable to changes in
(paragraphs 9, 10, credit risk and the change in the fair value of any credit derivative or similar
10A and 11) instruments.
• An entity that designates a financial liability at fair value through profit or loss
should disclose specified details including the change in fair value that is
attributable to changes in the credit risk, and the difference between the carrying
amount of the liability and the amount the entity would be contractually
required to pay at maturity.
Investments in • An entity that designates investments in equity instruments to be measured at
equity instruments fair value through other comprehensive income should disclose specified details
designated at fair including which investments have been designated and the reason for doing so,
value through other fair value of each investment, the related dividends received, and the cumulative
comprehensive gain or loss upon and reason for any disposal of such investments.
income (paragraphs
11A and 11B)
Reclassification • Disclosure is required of the circumstances around any change in business
(paragraph 12B, 12C model that lead to a reclassification of financial assets and information
and 12D) about the financial performance of those reclassified assets after the
reclassification.
Offsetting financial • Specified disclosures are required for all recognised financial instruments that
assets and financial are set off in accordance with IAS 32, such that users of the financial statements
liabilities (paragraphs can assess the (potential) effect of netting arrangements on the entity’s financial
13A to 13F) position.
Collateral (paragraphs • Collateral given: an entity must disclose the carrying amount of financial assets
14 and 15) it has pledged as collateral (security) for liabilities or contingent liabilities. The
terms and conditions of the pledge must also be disclosed.
• Collateral received: specified details must be disclosed where an entity holds
collateral (of financial and non-financial assets) and is permitted to sell or
repledge that collateral.
Allowance for credit • The loss allowance related to financial assets measured at fair value through
losses (paragraph 16A) other comprehensive income should be disclosed.
Compound financial • Disclosure is required of the existence of such features in compound financial
instruments with instruments.
multiple embedded
derivatives (paragraph
17)
Defaults and breaches • For loans payable, disclosure is required of any defaults during the period, the
(paragraphs 18 and 19) carrying amount of loans payable in default at the end of the reporting period
and whether the default was remedied before the financial statements were
authorised for issue.
Statement of other comprehensive income
Items of income, • Net gains or losses for each category of financial asset and financial liability.
expense, gains or • Total interest income and total interest expense for financial assets or liabilities
losses (paragraphs 20 that are not at fair value through profit or loss.
and 20A) • Fee income and expense arising from financial assets or liabilities not at fair
value through profit or loss, and from trust and other fiduciary activities.
• Analysis of gains and of losses recognised in the statement of comprehensive
income that resulted from the derecognition of financial assets measured at
amortised cost.
190 PART 2 Elements

TABLE 7.9 Significance of financial instruments for other disclosures
Other disclosures
Accounting policies • Disclose relevant accounting policies. Where the accounting methods are
(paragraph 21) prescribed in the relevant standards (e.g. in IFRS 9) then the entity should not
repeat these but rather disclose where it has applied choices available.
Hedge accounting • Disclose the risk management strategy, how it is applied to each risk category, a
(paragraphs 21A to description of the hedging instruments used, the determination of the economic
21D, 23A to 23F and relationship between the hedged item and hedging instrument, and qualitative or
24A to 24G) quantitative information about how risk components were determined.
• Disclose information about the terms and conditions of the hedging instruments
and how hedging activities affect the amount, timing and uncertainty of future
cash flows.
• Tabular information about the effects of hedge accounting on the financial
position and performance, which includes specified details separately by risk
category and by type of hedge (i.e. fair value hedges, cash flow hedges and
hedges of net investments in foreign operations) about:
• carrying amounts, presentation, change in fair value and nominal amounts of
the items designated as hedging instruments;
• carrying amounts, presentation and accumulated fair value changes of the
items designated as hedged items and information about hedge ineffectiveness.
Credit exposure • For financial instruments designated as measured at fair value through profit
measured at fair value or loss because a credit derivative is used to manage the credit risk of that
through profit or loss financial instrument, disclosure is required of specified information about the
(paragraph 24G) credit derivative, the amount recognised in profit or loss upon designation of the
financial instrument and information about discontinuation of the treatment.
Fair value (paragraphs • For each class of financial assets and liabilities, disclose the fair value of that
25–30) class in a way that permits it to be compared with its carrying amount.
• Other details are required in respect of gains or losses arising on initial
recognition of certain financial instruments.
It should be noted that IFRS 7 does not prescribe how statement of profit or loss and other comprehen-
sive income amounts are determined. For example, interest income on financial instruments carried at fair
value through profit or loss may be included in total interest income or it may be included in net gains or
losses for that category.
Table 7.10 shows the disclosure requirements for the risks arising from financial instruments. These dis-
closures are intended to allow users of financial statements to assess the nature and extent of the risk that
an entity is exposed to at the balance sheet date.
TABLE 7.10 Nature and extent of risks arising from fi nancial instruments
For each type of risk (a) the exposures to risk and how they arise
(credit risk, liquidity (b) the entity’s objectives, policies and processes for managing the risk and the
risk and market methods used to measure the risk
risk) disclose . . . (c) any changes in (a) or (b) from the previous period.
(paragraph 33) The policies and processes an entity uses would normally include the structure and
organisation of its risk management function, the policies for hedging or otherwise
mitigating risks, processes for monitoring hedge effectiveness, and policies and
processes for avoiding large concentrations of risk.
(continued)

For each type of risk (a) summary quantitative data about its exposure to that risk at the end of the
(credit risk, liquidity reporting period. This disclosure must be based on the information provided
risk and market internally to key management personnel of the entity (as defined in IAS 24
risk) disclose . . . Related Party Disclosures)
(paragraph 34) (b) the disclosures required by paragraphs 35A–42 (see below) to the extent not
provided in (a)
(c) concentrations of risk if not apparent from (a) and (b). Concentrations of risk arise
from financial instruments that have similar characteristics and that are affected
similarly by changes in economic or other conditions. For example, a risk
concentration may be by geographic area, by industry or by currency.
Credit risk
Scope and objectives The credit risk disclosures apply to the financial instruments to which the impairment
(paragraphs 35A–35E) requirements of IFRS 9 are applied.
The objective of the credit risk disclosures is to enable users to understand the effect
on the amount, timing and uncertainty of future cash flows by requiring:
• information about credit risk management practices
• quantitative and qualitative information
• information about the entity’s credit risk exposure.
Credit risk Disclose information about credit risk management practices and how they relate to
management practices the recognition and measurement of expected credit losses (including the methods,
(paragraphs 35F and assumptions and information used to measure those losses). For example, an entity
35G) should disclose:
• how it determined whether the credit risk of financial instruments has increased
significantly since initial recognition
• its definition of default
• how it determined that financial assets are credit-impaired
• the basis of inputs and assumptions and estimation techniques
• how forward-looking information has been incorporated.
Quantitative and Disclose quantitative and qualitative information that allows users of financial
qualitative information statements to evaluate the amounts in the financial statements arising from expected
about amounts arising credit losses, including changes in the amount of those losses and the reasons for
from expected credit those changes.
losses (paragraphs
35H–35L)
Credit risk exposure Disclose information about the entity’s credit risk exposure; that is, the credit
(paragraphs 35M, 35N risk inherent in its financial assets and commitments to extend credit, including
and 36) significant credit risk concentrations.
Collateral and other Specified details are required to be disclosed when an entity obtains financial or
credit enhancements non-financial assets during the period by taking possession of collateral it holds as
obtained (paragraph security.
38)
Liquidity risk
Liquidity risk . . . (a) a maturity analysis for financial liabilities that shows the remaining contractual
(paragraph 39) maturities
(b) a description of how the entity manages the liquidity risk inherent in (a). An
entity must use judgement to determine the appropriate time bands for a maturity
analysis, that is, for when amounts fall due. For example, an entity might
determine that the following time bands are appropriate:
• not later than 1 month
• between 1 month and 3 months
• between 3 months and 6 months
• later than 6 months.
192 PART 2 Elements

The amounts disclosed in the maturity analysis must be the contractual undiscounted
cash flows. This could be problematic for liabilities that mature later than 1 year
because the amounts disclosed in the note would likely not reconcile to the
statement of financial position where the discounted amount would be shown.
Examples of how an entity might manage liquidity risk include:
• having access to undrawn loan commitments
• holding readily liquid financial assets that can be sold to meet liquidity needs
• having diverse funding sources.
Market risk
Market risk — An entity must disclose:
sensitivity analysis (a) for each type of market risk (i.e. currency risk, interest rate risk and other price
(paragraphs 40 and risk) a sensitivity analysis showing how profit or loss or equity would have been
41) affected by changes in the relevant risk variables that were reasonably possible at
the end of the reporting period
(b) the methods and assumptions used in preparing the sensitivity analysis
(c) changes from the previous period in the methods and assumptions used.
For example, if an entity has a floating interest rate (i.e. variable) liability at the end
of the year, the entity would disclose the effect on interest expense for the current
year if interest rates had varied by reasonably possible amounts.
This effect could be disclosed as a range. For example, the entity could state that
had the interest rate varied by between 0.25% and 0.5% then total interest expense
would have increased by an amount of between $xx and $xy.
If an entity prepares a sensitivity analysis that analyses the interdependencies
between market risk variables (e.g. between interest rate risk and currency risk)
then it need not make the disclosures in (a) but must rather disclose its own
interdependent risk analysis.
Table 7.11 shows the disclosure requirements for financial assets transferred to another entity. The pur-
pose of the required disclosures is to assist users in assessing the extent of such risks related to financial
instruments.
TABLE 7.11 Transfers of fi nancial assets
Transfers of financial Disclose specified information for all transferred financial assets that are not
assets (paragraphs 42A derecognised and for any continuing involvement in a transferred asset existing at
to 42C and 42H) the reporting date.
The objective of these requirements is to provide information that enables
users of financial statements to understand the relationship between
transferred financial assets that are not derecognised in their entirety and
the associated liabilities. In addition, users should be able to evaluate the
nature of, and risks associated with, an entity’s continuing involvement in
derecognised financial assets.
Transferred financial Disclose information such as, for example, the nature of the transferred assets,
assets that are not the nature of the risks and rewards of ownership to which the reporting entity is
derecognised in their exposed, and a description of the nature of the relationship between the transferred
entirety (paragraph 42D) assets and the associated liabilities.
Transferred financial For transferred financial assets derecognised in their entirety but where the
assets that are entity has continuing involvement in those assets, disclosure of certain specified
derecognised in their qualitative and quantitative information is required for each type of continuing
entirety (paragraphs involvement.
42E–42G)

SUMMARY
IAS 32 defines financial instruments, financial assets, financial liabilities and derivatives and distinguishes
between financial liabilities and equity instruments. IFRS 7 prescribes disclosures. IAS 32 sets prescriptive
rules for distinguishing financial liabilities from equity instruments, and for accounting for compound
financial instruments that have elements of both. It requires that interest, dividends, gains and losses be
accounted for consistent with the statement of financial position classification of the related financial
assets and financial liabilities. It also sets prescriptive requirements for offsetting a financial asset and a
financial liability.
IFRS 9 requires all financial instruments including derivatives to be initially recorded at fair value.
It defines an embedded derivative and establishes rules for separating an embedded derivative from
the host contract. It creates four categories of financial instruments. Each category has its own rules
for measurement, including initial and subsequent measurement, reclassifications, gains and losses and
impairment.
IFRS 9 permits hedge accounting provided that strict criteria are met. These include meeting specified
conditions before hedge accounting can be applied, meeting the definition of a hedging instrument and
a hedged item, and identifying which of the three types of hedge the hedge transaction meets. IFRS 9 pre-
scribes when hedge accounting must be rebalanced or discontinued and how this must be accounted for.
It also contains rules for the derecognition of financial instruments, but these are not addressed in this
chapter.
IFRS 9 is a new standard that was developed to address the criticisms raised during the financial crisis in
2008. Even though IFRS 9 offers many improvements over its predecessor standard, IAS 39, accounting for
financial instruments remains controversial.
1. Discuss the concept of ‘equity risk’ and how it is useful in determining whether a financial instrument
is a financial liability or an equity instrument of the issuer.
2. Does IAS 32 contain a clear hierarchy to be used in determining whether a financial instrument is a
financial liability or an equity instrument of the issuer? Explain your answer.
3. IAS 39 applies a ‘rights and obligations approach’ to the recognition of financial instruments. Discuss.
4. Explain what an economic hedge is. Will hedge accounting always result in the same outcome as an
economic hedge?
5. Identify the main criticisms of accounting for financial instruments that emerged during the financial
crisis. To what extent had the IASB addressed these by the end of 2011?
References
Financial Crisis Advisory Group 2009, Report of the Financial Crisis Advisory Group, 28 July, www.ifrs.org.
Exercise 7.1 SCOPE OF IAS 32

Which of the following are financial instruments (i.e. a financial asset, financial liability, or equity instru-
ment in another entity) within the scope of IAS 32? Give reasons for your answer.
(a) Cash
(b) Investment in a debt instrument
(c) Investment in a subsidiary
(d) Provision for restoration of a mine site
(e) Buildings owned by the reporting entity
(f) Forward contract entered into by a bread manufacturer to buy wheat
(g) Forward contract entered into by a gold producer to hedge the future sales of gold
(h) General sales tax payable

Which of the following are financial instruments (i.e. a financial asset, financial liability, or equity instru-
ment in another entity) within the scope of IAS 39? Give reasons for your answer.
(a) Provision for employee benefits
(b) Deferred revenue
(c) Prepayments
194 PART 2 Elements

(d) Forward exchange contract
(e) 3% investment in private company
(f) A percentage interest in an unincorporated joint venture
(g) A non-controlling interest in a partnership
(h) A non-controlling interest in a discretionary trust
(i) An investment in an associate
(j) A forward purchase contract for wheat to be used by the entity to make flour
(k) As for part (j), but the entity regularly settles the contracts net in cash or takes delivery of the under-
lying wheat and sells it shortly after making a dealer’s margin
(l) Leases
(m) Trade receivables
Exercise 7.3 DISTINGUISHING FINANCIAL LIABILITIES FROM EQUITY INSTRUMENTS (1)

Company A issues 100 000 $1 convertible notes. The notes pay interest at 7%. The market rate for similar
debt without the conversion option is 9%. The note is not redeemable, but it converts at the option of the
holder into however many shares that will have a value of exactly $100 000.
Required
Determine whether this financial instrument should be classified as a financial liability or equity instru-
ment of Company A. Give reasons for your answer.
Exercise 7.4 CATEGORISING COMMON FINANCIAL INSTRUMENTS UNDER IAS 32

Categorise each of the following common financial instruments as financial assets, financial liabilities or
equity instruments — of the issuer or the holder, as specified.
(a) Loans receivable (holder)
(b) Loans payable (issuer)
(c) Ordinary shares of the issuer
(d) The holder’s investment in the ordinary shares in part (c)
(e) Redeemable preference shares of the issuer, redeemable at any time at the option of the holder
(f) The holder’s investment in the preference shares in part (e)
Exercise 7.5 FINANCIAL INSTRUMENTS CATEGORIES AND MEASUREMENT

Identify which of the four categories specified in IAS 39 each of the following items belongs to in the
books of Company H, the holder. Also identify how each item will be measured.
(a) Forward exchange contract
(b) 5-year government bond paying interest of 5%
(c) Trade accounts receivable
(d) Trade accounts payable
(e) Mandatory converting notes paying interest of 6% (the notes must convert to a variable number of
ordinary shares at the expiration of their term)
(f) Investment in a portfolio of listed shares held for capital growth
(g) Investment in a portfolio of listed shares held for short-term gains
(h) As in part (e), except that in the previous year Company H sold the majority of its held-to-maturity
investments to Company Z
(i) Borrowings of $1 million, carrying a variable interest rate
Exercise 7.6 DISTINGUISHING FINANCIAL LIABILITIES FROM EQUITY INSTRUMENTS

Company A issues 100 000 $1 redeemable convertible notes. The notes pay interest at 5%. They convert at
any time at the option of the holder into 100 000 ordinary shares. The notes are redeemable at the option
of the holder for cash after 5 years. Market rates for similar notes without the conversion option are 7%.
Required
Exercise 7.7 DISTINGUISHING FINANCIAL LIABILITIES FROM EQUITY INSTRUMENTS

Company A issues redeemable preference shares. The shares are redeemable for cash at the option of
the issuer. The shares carry a cumulative 6% dividend. In addition, the preference share dividend can be

paid only if a dividend on ordinary shares is paid for the relevant period. Company A is highly profitable
and has a history of paying ordinary dividends at a yield of about 4% annually without fail for the past
25 years. Company A issued the preference shares after considering various options to raise finance for
building a new factory. The market interest rate for long-term debt at the time the preference shares were
issued was 7%.
Required
Exercise 7.8 AMORTISED COST, JOURNAL ENTRIES

Company B issues a bond with a face value of $500 000 on 1 July 2016. Transaction costs incurred amount
to $12 000. The bond pays interest at 6% per annum, in arrears. The bond must be repaid after 5 years.
Required
Prepare the journal entries to record this transaction on initial recognition and throughout the life of the
bond in the books of Company B.
Exercise 7.9 EMBEDDED DERIVATIVES

Identify which of the following embedded derivatives must be separated from the relevant host contract.
In each case, state also how the host contract and the embedded derivative should be measured in the
books of the holder. Assume that the host instrument is not measured at fair value through profit or loss.
(a) An equity conversion feature embedded in a convertible debt instrument
(b) An embedded derivative in an interest-bearing host debt instrument, where the embedded derivative
derives its value from an underlying interest rate index and can change the amount of interest that
would otherwise be paid on the host debt instrument
(c) An embedded cap (upper limit) on the interest rate on a host debt instrument, where the cap is at or
above the market rate of interest when the debt instrument is issued
(d) As in part (c), except that the cap is below the market rate of interest.
196 PART 2 Elements

Since several categories of financial instruments are measured provide survey-based evidence that introducing fair value
at fair value, the Academic Perspective of chapter 3 should be measurement to derivative transactions both reduced spec-
read in conjunction with this section. This review therefore ulative hedging, consistent with the theoretical prediction
concerns several other key areas, including loan losses, hedge of Melumad et al. (1999), as well as economically desired
accounting, debt–equity classification and securitisation of hedging. Panaretou et al. (2013) show that the adoption of
financial instruments. the more transparent and stricter IFRS Standards hedge rules
The measurement and disclosure of accrued losses on in the UK resulted in lower information asymmetry.
loans and receivables has attracted significant interest in The equity-or-debt classification of financial instruments
accounting research. This is an important issue especially for would not be thought to have any real effects. Hopkins
the banking sector. This is because banks carry large amounts (1996) challenges this view. He conducts an experiment in
of loans and receivables in their balance sheets owing to which analysts are presented with different classifications of
their lending activities. One would expect that greater loan mandatorily redeemable preference shares (MRPS). Based
losses are negatively related to stock prices and future cash on past empirical evidence that shows that issuing new
flows. The empirical evidence, however, suggests otherwise. shares reduces stock prices, but new debt does not, he con-
In particular, Beaver et al. (1989) examine the relation jectures and finds evidence that MRPS presented in equity
between the market-to-book ratio (a measure of the excess cause subjects to assign lower stock price than the alterna-
of market value of equity over book value of equity) and the tive classification as liability. Levi and Segal (2014) identify
allowance for doubtful debt. They find that the two are posi- another real effect. They document that firms issued fewer
tively related. A possible explanation of this is that in taking MRPS following the change in US GAAP that required firms
larger loan losses banks signal to investors they acknowledge to classify MRPS as a liability rather than equity. De Jong
underlying problems and are ready to tackle them. Wahlen et al. (2006) show that following the adoption of IFRS in
(1994) finds that larger than expected loan losses are asso- the Netherlands, Dutch companies repurchased MRPS or
ciated with future earnings before loan losses. This suggests changed their terms.
that managers recognise more losses in the current period During the financial crisis of 2008 the IASB amended
when they anticipate better future performance. Wahlen IAS 39 to allow firms to retroactively reclassify financial
(1994) also performs market-based tests and finds a positive assets that previously were measured at fair value to amor-
relation between stock returns and unexpected loan losses. tized cost, provided they can maintain a long position. The
This supports the notion that investors also expect better reclassification criteria were much stricter prior to the crisis.
future performance when recorded losses exceed expecta- Many banks had taken the option up, as it allowed them
tions. Beaver and Engel (1996) decompose the allowance to avoid reporting the adverse consequences of falling asset
for loan losses into discretionary and non-discretionary prices. Lim et al. (2013) find that this retroactive classifica-
components and examine their pricing implications. Specifi- tion resulted in a loss of reliable information, as judged by
cally, they regress the allowance on a number of factors they decline in analyst forecast accuracy and an increase forecast
argue should explain the amount recognised. The predicted dispersion.
amount, which is taken from the regression line is regarded Securitisation has been subjected to academic scrutiny
as the non-discretionary element and the residual the discre- because the accounting for derecognition of financial assets
tionary element. They predict that the ‘nondiscretionary por- involves managerial discretion. Specifically, when an entity
tion of the allowance is negatively priced because it reflects sells its receivables, but retains some cash flow streams,
an impairment of the loan assets’. In contrast, the discre- accounting rules require a gain or loss to be recorded based
tionary component should be unrelated to stock price, if it on the fair value of the retained cash flow streams. Dechow
conveys no news. Alternatively, if it conveys some news, it et al. (2010) examine whether such fair value gains tend to
should be positively related to prices. They report results that be higher in circumstances where managers face stronger
are consistent with these conjectures, implying that man- incentives to inflate reported profit. They identify a sample
agers use the discretion that is available to them to convey of 305 firms that reported derecognition gains or losses.
useful information. In this sample a higher pre-securitisation profit is inversely
Hedging can be used by managers to reduce undesirable related to derecognition profit. In other words, firms whose
effects of volatility in earnings on their capacity to borrow pre-securitisation income is low tend to record higher gains
by reducing bankruptcy risk. The incentive to hedge, how- from securitisation. The retained interest in securitised assets
ever, may be affected by accounting rules. Specifically, hedge may also affect the selling entity’s risk. Barth et al. (2012)
accounting may have two countervailing effects on hedging examine the relation between bond rating (and yields) and
activity. On one hand, beyond the specific measurement retained interest in securitised assets and find that it is neg-
rules, they require disclosure, which in turn improves the ative (positive). This suggests that securitisation increases
information environment and makes the statements clearer default risk. This suggests that managers of securitising firms
to investors (DeMarzo and Duffie, 1995). Better information should employ high discount factors in calculating the gain
can therefore enable investors to appreciate the reduction in or loss on derecognition. However this does not seem to be
risk and encourage hedging. On the other hand, too restric- the case. Dechow et al. (2010) provide evidence that suggests
tive rules may discourage economically desirable hedging, if managers of gain-reporting firms in fact employ low discount
it does not qualify to be presented as such. Lins et al. (2011) rates as it enables them to inflate earnings.

References Hopkins, P. E. 1996. The effect of financial statement
classification of hybrid financial instruments on financial
Barth, M. E., Ormazabal, G., and Taylor, D. J. 2012. Asset analysts’ stock price judgments. Journal of Accounting
securitizations and credit risk. The Accounting Review, 87(2), Research, 33–50.
423–448. Levi, S., and Segal, B. 2014. The impact of debt–equity
Beaver, W., Eger, C., Ryan, S., and Wolfson, M. 1989. Financial reporting classifications on the firm’s decision to issue
reporting, supplemental disclosures, and bank share prices. hybrid securities. European Accounting Review, 24(4),
Journal of Accounting Research, 157–178. 801–822.
Beaver, W., and Engel, E. 1996. Discretionary behavior with Lim, C. Y., Lim, C. Y., and Lobo, G. J. 2013. IAS 39
respect to allowances for loan losses and the behavior of reclassification choice and analyst earnings forecast
security prices. Journal of Accounting and Economics, 22(1), properties. Journal of Accounting and Public Policy, 32(5),
177–206. 342–356.
Dechow, P. M., Myers, L. A., and Shakespeare, C. 2010. Fair Lins, K. V., Servaes, H., and Tamayo, A. 2011. Does fair value
value accounting and gains from asset securitizations: A reporting affect risk management? International survey
convenient earnings management tool with compensation evidence. Financial Management, 40(3), 525–551.
side-benefits. Journal of Accounting and Economics, 49(1), Melumad, N. D., Weyns, G., and Ziv, A. 1999. Comparing
2–25. alternative hedge accounting standards: Shareholders’
De Jong, A., Rosellón, M., and Verwijmeren, P. 2006. The perspective. Review of Accounting Studies, 4(3–4), 265–292.
economic consequences of IFRS: The impact of IAS 32 on Panaretou, A., Shackleton, M. B., and Taylor, P. A. 2013.
preference shares in the Netherlands. Accounting in Europe, Corporate risk management and hedge accounting.
3(1), 169–185. Contemporary Accounting Research, 30(1), 116–139.
DeMarzo, P. M., and Duffie, D. 1995. Corporate incentives for Wahlen, J. M. 1994. The nature of information in
hedging and hedge accounting. Review of Financial Studies, commercial bank loan loss disclosures. The Accounting
8(3), 743–771. Review, 69(3), 455–478.
198 PART 2 Elements

8 Share-based payment
ACCOUNTING IFRS 2 Share-based Payment
STANDARDS
IN FOCUS

OBJECTIVES
1 explain the objective and scope of IFRS 2
2 distinguish between cash-settled and equity-settled share-based payment transactions
3 demonstrate how equity-settled and cash-settled share-based payment transactions are
recognised
4 explain how equity-settled share-based payment transactions are measured
5 explain the concept of vesting through differentiating between vesting and non-vesting
conditions
6 explain the concept of a share option reload feature
7 explain how modifications to granted equity instruments are treated
8 demonstrate how cash-settled share-based payment transactions are measured
9 describe and apply the disclosure requirements of IFRS 2.
CHAPTER 8 Share-based payment 199

INTRODUCTION
The purpose of this chapter is to examine share-based payments. The IFRS® Standard covering share-based
payments is IFRS 2 Share-based Payment. Under IFRS 2, all transactions with employees or other parties —
whether to be settled in cash (or settled in other assets) or settled in the equity instruments of an entity — must
now be recognised in the entity’s financial statements. The standard adopts the view that all share-based pay-
ment transactions ultimately lead to expense recognition, and entities must reflect the effects of such trans-
actions in their profit or loss.
Organisations use various mechanisms to encourage their managers and employees to make decisions
that improve the returns to shareholders, including offering remuneration that is linked to the share price
of the organisation. This reflects a view that the behaviour of employees can be directed and controlled
through the use of remuneration and other similar incentives. It is theorised that remuneration incentives
linked to accounting and other performance measures will encourage managers and employees to take
decisions and actions that positively impact the financial performance of the organisation and, in turn, the
interests of shareholders of the organisation.
Share plans and share option plans are a common feature of remuneration for directors, senior man-
agers and executives, and many other employees as a means of aligning employees’ interests with those
of the shareholders, and encouraging employee retention. Share plans reward employees by giving them
shares or cash payments linked to the share price. Share option plans give the right to buy shares at a fixed
price, which means that the option will expire worthless if the share price is below the exercise price at
maturity. The value of the right to buy will increase as the share price increases once that price has been
exceeded. Both types of plan reassure the shareholders that the directors and other employees have a direct
financial interest in the share price increasing. The plans also provide an indirect incentive to remain with
the company because rights to shares and share options rarely ‘vest’ until an agreed period, usually 3 years
or more, have passed from the date on which the rights are ‘granted’. Thus, an employee who resigns will
almost certainly sacrifice the value of at least 2 years’ worth of rights under any share plan or share option
plan that is in place.
Most countries require quoted companies to publish details of their executive remuneration schemes.
For example, the remuneration report provided by the Australian arm of Woolworths (Woolworths Lim-
ited) in its 2014 annual report provides more than 20 pages of disclosure and comment on the compa-
ny’s remuneration policies. These are prefaced by a statement of Woolworths Limited’s reward principles
(see figure 8.1).
Reward principles
• Align reward to shareholder value creation
• Attract, motivate and retain key talent with market competitive reward
• Provide demanding measures for high performance, which link reward to the Company’s
strategic and financial outcomes
• Deliver reward that is differentiated by business and individual performance
FIGURE 8.1 Woolworths Limited’s reward principles

Source: Woolworths Ltd (2014, p. 46).
Companies have been criticised over the size of executive remuneration, for failing to align executive
incentives more closely with shareholder returns, and for using short terms (1 to 3 years) for share incen-
tives to vest rather than longer-term incentives (5 to 10 years). A review of Woolworths Limited’s approach
shows the inclusion of a long-term incentive component in its remuneration strategy. Companies have
also been criticised for failure to disclose details of their executive performance hurdles, such as return on
equity rates, which they usually justify on the basis of commercial sensitivity. Details of required disclosures
and examples of actual disclosures are presented in section 8.9.
Some entities may also issue shares or share options to pay for the purchase of property or for profes-
sional advice or services. Before the issue of IFRS 2, there was no requirement to identify the expenses
associated with this type of transaction or to measure and recognise such transactions in the financial
statements of an entity. Accounting standard setters have decided that recognising the cost of share-based
payments in the financial statements of entities should improve the relevance, reliability and compara-
bility of financial information and help users of financial information to understand the economic trans-
actions affecting entities.
LO1 8.1 APPLICATION AND SCOPE

IFRS 2 applies to share-based payment transactions. The standard was first issued with an effective
date for financial statements covering periods beginning on or after 1 January 2005. IFRS 2 has since
been amended for vesting conditions and cancellations, with an effective date for these amendments of
200 PART 2 Elements

1 January 2009. Equity instruments issued in a business combination in exchange for control of the
acquiree are not within the scope of IFRS 2; they are accounted for under IFRS 3 Business Combinations.
However, IFRS 2 applies to the cancellation, replacement or modification of share-based payments arising
because of a business combination or restructuring.
Also excluded under paragraph 6 of IFRS 2 are share-based payments in which the entity receives or
acquires goods or services under a contract within the scope of paragraphs 8–10 of IAS 32 Financial
Instruments: Presentation or paragraphs 2.4–2.7 of IFRS 9 Financial Instruments.
LO2 8.2 CASH-SETTLED AND EQUITY-SETTLED SHARE-BASED

PAYMENT TRANSACTIONS
IFRS 2 applies to share-based payments in which an entity acquires or receives goods or services. Goods
can include inventory, consumables, property, plant or equipment, intangibles and other non-financial
forms of assets; services, such as the provision of labour, are usually consumed immediately.
Measurement principles and specific requirements for three forms of share-based payments are dealt with
in IFRS 2. These three forms are defined in paragraph 2 and Appendix A to IFRS 2 and are summarised
as follows:
1. equity-settled share-based payment transactions, in which the entity receives goods or services as con-
sideration for its own equity instruments (including shares or share options)
2. cash-settled share-based payment transactions, in which the entity acquires goods or services by incurring
liabilities to transfer cash or other assets to the supplier (counterparty) for amounts that are based on
the value (price) of the shares or other equity instruments of the entity
3. other transactions in which the entity receives or acquires goods or services, and the terms of the arrange-
ment provide either the entity or the counterparty of the goods or services with a choice of settling the
transaction in cash (or other assets) or equity instruments.
The accounting treatment for these transactions differs depending on the form of settlement. The three
forms and the essential features of share-based payment transactions are summarised in table 8.1.
TABLE 8.1 Form and features of share-based payment transactions
Form Features
Equity-settled share-based payment Entity receives goods or services as consideration for its
own equity instruments
Cash-settled share-based payment Entity acquires goods or services by incurring liabilities for
amounts based on the value of its own equities
Other Entity receives or acquires goods or services and the entity, or

the counterparty, has the choice of whether the transaction is
settled in cash or equity
Any transfers of an entity’s equity instruments by its shareholders to parties that have supplied goods or
services to the entity are considered, under paragraph 3A of IFRS 2, to be share-based payments (unless the
transfer is clearly for a purpose other than payment for goods or services supplied to the entity). This treat-
ment also applies to transfers of equity instruments of the entity’s parent, or equity instruments of another
entity in the same group as the entity, to parties that have supplied goods or services.
A transaction with an employee who holds equity instruments of the employing entity is not within the
scope of IFRS 2 (paragraph 4). If, for example, the employee holds equity in the employer and is granted
the right to acquire additional equity at a price that is less than fair value (e.g. a rights issue), the granting
or exercise of that right by the employee is not governed by IFRS 2.
LO3 8.3 RECOGNITION

Paragraph 7 of IFRS 2 requires goods or services received in a share-based payment transaction to
be recognised when they are received. A corresponding increase in equity must be recognised if the
goods or services were received in an equity-settled share-based payment transaction. An increase
in a liability must be recognised if the goods or services were acquired in a cash-settled share-based
payment.
Usually an expense arises from the consumption of goods or services. For example, as services are nor-
mally consumed immediately, an expense is recognised as the service is rendered. If goods are consumed
over a period of time or, as in the case of inventories, sold at a later date, an expense will not be recognised

until the goods are consumed or sold. Sometimes it may be necessary to recognise an expense before the
goods or services are consumed or sold because they do not qualify for recognition as assets. For example,
this may occur if goods are acquired as part of the research phase of a project. Even though the goods may
not have been consumed, they will not qualify for recognition as assets under other accounting standards.
When the goods or services received in a share-based payment do not qualify for recognition as an asset,
they must be expensed (IFRS 2 paragraph 8).
A share-based payment transaction would, depending on the principles for asset or liability recognition,
be recognised in journal entries as shown below.
Asset or Expense Dr xxx

Equity Cr xxx
(Recognition of an equity-settled share-based payment)
Asset or Expense Dr xxx

Liability Cr xxx
(Recognition of a cash-settled share-based payment)
A significant feature of IFRS 2 is the accounting treatment it applies to transactions settled in cash,
which is different to the treatment it applies to equity-settled transactions. If a share-based payment is set-
tled in cash, the general principle employed in IFRS 2 is that the goods or services received and the liability
incurred are measured at the fair value of the liability (IFRS 2 paragraph 10). The fair value of the liability
must be remeasured at the end of each reporting period and at the date of settlement, and any changes
in fair value are recognised in profit or loss (IFRS 2 paragraph 30). For share-based payment transactions
that are equity-settled, the general principle is that the goods or services received and the corresponding
increase in equity are measured at the date the goods or services are received, using the fair value of those
goods or services. If the fair value cannot be measured reliably, the goods or services are measured indi-
rectly by reference to the fair value of the equity instruments granted.
Under this approach a differential accounting treatment of changes in the fair value of equity instru-
ments occurs, based on whether a transaction is classified as a liability or as equity. The fair value of
transactions classified as equity is measured at the date the goods or services are received and subse-
quent value changes are ignored. In contrast, the fair value of transactions classified as liabilities (debt)
are adjusted to fair value at the end of each reporting period and the resulting profit or loss is included
in income.
LO4 8.4 EQUITY-SETTLED SHARE-BASED PAYMENT

TRANSACTIONS
The goods or services received in equity-settled share-based payments and the corresponding increase
in equity must be measured at the fair value of the goods or services unless that fair value cannot be
estimated reliably (IFRS 2 paragraph 10). For transactions with parties other than employees, there is
a rebuttable presumption in IFRS 2 (paragraph 13) that the fair value of goods or services can be esti-
mated reliably. In the unusual cases where the fair value cannot be reliably estimated, paragraph 10
requires that the goods or services and the corresponding increase in equity are to be measured indi-
rectly by reference to the fair value of the equity instruments granted at the date the goods are obtained
or the service is rendered.
It is normally considered that the fair value of services received in transactions with employees cannot
be reliably measured. Thus, the fair value of the services received from employees is measured by reference
to the equity instruments granted. In summary, under IFRS 2, equity-settled share-based payments are
measured and recognised as follows:
Asset or Expense Dr Fair value of goods or

Equity Cr services received or acquired
(Recognition of a share-based payment in which fair value
of goods or services can be reliably estimated)
Asset or Expense Dr Fair value of the equity

Equity Cr instruments granted
(Recognition of a share-based payment where fair value of
goods or services cannot be reliably estimated)
202 PART 2 Elements

8.4.1 Transactions in which services are received
Certain conditions may need to be satisfied before the counterparty in a share-based payment transaction
becomes entitled to receive cash (or other assets) or equity instruments of the entity. When the conditions
have been satisfied, the counterparty’s entitlement is said to have ‘vested’. Under a share-based payment
arrangement, a counterparty’s right to receive cash, other assets or equity instruments of the entity vests
when the counterparty’s entitlement is no longer conditional on the satisfaction of any vesting conditions
(IFRS 2 Appendix A).
If the equity instruments vest immediately, the counterparty is not required to serve a specified period
of service before becoming unconditionally entitled to the equity instruments (IFRS 2 paragraph 14). On
grant date, the services received are recognised in full together with a corresponding increase in equity.
However, if the equity instruments do not vest until a period of service has been completed, under para-
graph 15 the services and the corresponding increase in equity are accounted for across the vesting period
as the services are rendered.
The granting of equity instruments in the form of share options to employees conditional on com-
pleting a 2-year period of service accounted for over the 2-year vesting period is demonstrated in illustra-
tive example 8.1.
ILLUSTRATIVE EXAMPLE 8.1 Recognition of share options as services are rendered across the vesting period
Wang Ltd grants 100 share options to each of its 50 employees. Each grant is conditional upon the
employee working for Wang Ltd for the next 2 years. It is assumed that each employee will satisfy the
vesting conditions. At grant date, the fair value of each share option is estimated as $25.
According to IFRS 2, paragraph 15(a), Wang Ltd will recognise the following amounts during the
vesting period for the services received from the employees as consideration for the share options granted.
Remuneration expense Cumulative

Year Calculation for period $ remuneration expense $
1 (100 × 50 options) × $25 × 1/2 years 62 500 62 500
2 (100 × 50 options) × $25 − $62 500 62 500 125 000
8.4.2 Transactions measured by reference to the fair

value of the equity instruments granted
Determining the fair value of equity instruments granted
Paragraph 11 of IFRS 2 states that, if share-based payments are with employees and others providing sim-
ilar services, it is not usually possible to measure the fair value of services received. If it is not possible to
reliably estimate the value of goods or services received, then the transaction is measured by reference to
the fair value of the equity instruments granted. If market prices are not available, or if the equity instru-
ments are subject to terms and conditions that do not apply to traded equity instruments, then a valuation
technique must be used to estimate what the price of the equity instruments would have been, in an arm’s
length transaction, on the measurement date.
While IFRS 2 (Appendix B11–41) discusses the inputs to option-pricing models such as the Black–
Scholes–Merton formula, the choice of model is left to the entity. The valuation technique chosen must
be consistent with generally accepted valuation methodologies for pricing financial instruments. It must
also incorporate the terms and conditions of the equity instruments (e.g. whether or not an employee
is entitled to receive dividends during the vesting period), and any other factors and assumptions that
knowledgeable, willing market participants would consider in setting the price (IFRS 2 paragraph 17). For
instance, many employee share options have long lives, and they are usually exercisable after the vesting
period and before the end of the option’s life. Option-pricing models calculate a theoretical price by using
key determinants of the options.
Appendix B6 of IFRS 2 supplies the following list of factors that option-pricing models take into account
as a minimum:
• exercise price of the option
• life of the option
• current price of the underlying shares
• expected volatility of the share price
• dividends expected on the shares
• risk-free interest rate for the life of the option.

Expected volatility is a measure of the amount by which a price is expected to fluctuate during a period.
The value of the option is generally greater if the share price is more volatile. High volatility implies that
future share price movements are likely to be large. A large increase in the share price will make the option
far more valuable than a small increase and so the upside risk is valuable to the option’s holder. If the
share price falls below the striking price then it makes no difference to the option’s holder whether it is
slightly lower or significantly lower. Volatility is typically expressed in annualised terms, for example, daily,
weekly or monthly price observations. Often there is likely to be a range of reasonable expectations about
future volatility, dividends and exercise date behaviour. If so, an expected value would be calculated by
weighting each amount within the range by its associated probability of occurrence.
Expectations about the future are generally based on experience and modified if the future is reasonably
expected to differ from the past. For instance, if an entity with two distinctly different lines of business
disposes of the one that was significantly less risky than the other, historical volatility may not be the best
information on which to base reasonable expectations for the future. In other circumstances, historical
information may not be available. For example, unlisted entities will have no historical share price data;
likewise, newly listed entities will have little share price data available.
Whether expected dividends should be taken into account when measuring the fair value of shares or
options granted depends on whether the counterparty is entitled to dividends. Generally, the assumption
about expected dividends is based on publicly available information.
The risk-free interest rate is the implied yield currently available on zero-coupon government issues of
the country in whose currency the exercise price is expressed, with a remaining term equal to the expected
term of the option (IFRS 2 Appendix B37). It may be necessary to use an appropriate substitute if no such
government issues exist or if circumstances indicate that the implied yield on zero-coupon government
issues is not representative of the risk-free interest rate (e.g. in high inflation economies).
Woolworths Limited (introduced earlier the chapter) discloses its use of an option pricing model in
the determination of the fair value of options and performance rights. The company distinguishes vesting
conditions that are based on earnings per share (EPS) measures from those that are based on total share-
holder return (TSR). The company uses the Black–Scholes option pricing model to deal with the valua-
tion of rights arising under EPS and Monte Carlo simulation for the valuation of TSR-related rights. The
detailed application of both Black–Scholes and Monte Carlo simulation would be difficult to explain in
further detail, so little more is said. These are, however, well-established and supported models that enable
Woolworths to base valuations on the assumptions that have to be made in the valuation process. Thus,
shareholders are alerted to the fact that the valuations are matters of judgement, but that there is a clear
structure in place for drawing a final conclusion.
LO5 8.5 VESTING

8.5.1 Treatment of vesting conditions
If a grant of equity instruments is conditional on satisfying certain vesting conditions such as remaining
in the entity’s employment for a specified period of time, then the vesting conditions are not taken
into account when estimating the fair value of the equity instruments. Instead, the vesting conditions
are accounted for by adjusting the number of equity instruments included in the measurement of the
transaction amount. Thus, the amount recognised for goods or services received as consideration for the
equity instrument is based on the number of equity instruments that eventually vest. On a cumulative
basis, this means that if a vesting condition is not satisfied then no amount is recognised for goods or
services received.
In a situation where employees leave during the vesting period, the number of equity instruments
expected to vest varies. This is demonstrated in illustrative example 8.2.
ILLUSTRATIVE EXAMPLE 8.2 Grant where the number of equity instruments expected to vest varies
Seers Company grants 100 share options to each of its 50 employees. Each grant is conditional on the
employee working for the company for the next 3 years. The fair value of each share option is estimated
as $25. On the basis of a weighted average probability, the company estimates that 10% of its employees
will leave during the 3-year period and therefore forfeit their rights to the share options.
During the year immediately following grant date (year 1) three employees leave, and at the end of
year 1 the company revised its estimate of total employee departures over the full 3-year period from
10% (five employees) to 16% (eight employees).
During year 2 a further two employees leave, and the company revised its estimate of total employee
departures across the 3-year period down to 12% (six employees). During year 3 a further employee
leaves, making a total of six (3 + 2 + 1) employees who have departed. A total of 4400 share options
(44 employees × 100 options per employee) vested at the end of year 3.
204 PART 2 Elements

Remuneration Cumulative
expense for remuneration
Year Calculation period $ expense $
1 (5000 options × 84%) × $25 × 1/3 years 35 000 35 000
2 ([5000 options × 88%] × $25 × 2/3 years) − $35 000 38 333 73 333
3 (4400 options x $25) − $73 333 36 667 110 000
Source: Adapted from IFRS 2, IG11.
In addition to continuing in service with the entity, employees may be granted equity instruments that
are conditional on the achievement of a performance condition. Where the length of the vesting period
varies according to when the performance condition is satisfied, the estimated length of the vesting period,
at grant date, is based on the most likely outcome of the performance condition (IFRS 2 paragraph 15(b)).
A grant of shares with a performance condition linked to the level of an entity’s earnings and in which
the length of the vesting period varies is demonstrated in illustrative example 8.3.
ILLUSTRATIVE EXAMPLE 8.3 Grant with a performance condition linked to earnings
At the beginning of year 1, Benning Ltd grants 100 shares to each of its 50 employees, conditional on
the employee remaining in the company’s employ during the 3-year vesting period. The shares have a
fair value of $20 per share at grant date. No dividends are expected to be paid over the 3-year period.
Additionally, the vesting conditions allow the shares to vest at the end of:
• year 1 if the company’s earnings have increased by more than 18%
• year 2 if earnings have increased by more than 13% averaged across the 2-year period
• year 3 if earnings have increased by more than 10% averaged across the 3-year period.
By the end of year 1, Benning Ltd’s earnings have increased by only 14% and three employees have
left. The company expects that earnings will continue to increase at a similar rate in year 2 and the
shares will vest at the end of year 2. It also expects that a further three employees will leave during year
2, and therefore that 44 employees will vest in 100 shares each at the end of year 2.
1 (44 employees × 100 shares) × $20 × 1/2 years 44 000 44 000
By the end of year 2 the company’s earnings have increased by only 10%, resulting in an average of
only 12% ([14% + 10%]/2) and so the shares do not vest. Two employees left during the year. The com-
pany expects that another two employees will leave during year 3 and that its earnings will increase by at
least 6%, thereby achieving the average of 10% per year.
2 ([43 employees × 100 shares] × $20 × 2/3 years) − $44 000 13 333 57 333
Another three employees leave during year 3 and the company’s earnings have increased by 8%,
resulting in an average increase of 10.67% over the 3-year period. Therefore, the performance condition
has been satisfied. The 42 remaining employees (50 − [3 + 2 + 3]) are entitled to receive 100 shares each
at the end of year 3.
3 ([42 employees × 100 shares] × $20) − $57 333 26 667 84 000

An entity may also grant equity instruments to its employees with a performance condition, and where
the exercise price varies. This particular situation is demonstrated in illustrative example 8.4.
Because the exercise price varies depending on the outcome of a performance condition that is not a
market condition, the effect of the performance condition (in this case, the possibility that the exercise
price might be either $40 or $30) is not taken into account when estimating the fair value of the share
options at grant date. Instead, the entity estimates the fair value of the share options at grant date and ulti-
mately revises the transaction amount to reflect the outcome of the performance condition.
ILLUSTRATIVE EXAMPLE 8.4 Grant of equity instruments where the exercise price varies
At the beginning of year 1 Phillipe Ltd granted 5000 share options with an exercise price of $40 to a
senior executive, conditional upon the executive remaining with the company until the end of year 3.
The exercise price drops to $30 if Phillipe Ltd’s earnings increase by an average of 10% per year over the
3-year period. On grant date the estimated fair value of the share options with an exercise price of $40 is
$12 per option and, if the exercise price is $30, the estimated fair value of the options is $16 per option.
During year 1 the company’s earnings increased by 12% and they are expected to continue to increase
at this rate over the next 2 years. During year 2 the company’s earnings increased by 13% and the com-
pany continued to expect that the earnings target would be achieved. During year 3 the company’s earn-
ings increased by only 3%. The earnings target was therefore not achieved and so the 5000 vested share
options will have an exercise price of $40. The executive completed 3 years’ service and so satisfied the
service condition.
1 5000 options × $16 × 1/3 years 26 667 26 667
2 (5000 options × $16 × 2/3 years) − $26 667 26 666 53 333
3 (5000 options × $12) − $53 333 6 667 60 000
Paragraph 21 of IFRS 2 requires that market conditions (such as a target share price) be taken into
account when estimating the fair value of equity instruments. The goods or services received from a coun-
terparty that satisfies all other vesting conditions (such as remaining in service for a specified period of
time) are recognised whether or not the market condition is satisfied.
A grant of equity instruments with a market condition is demonstrated in illustrative example 8.5.
ILLUSTRATIVE EXAMPLE 8.5 Grant with a market condition
At the beginning of year 1 Smallville Ltd grants 5000 share options to a senior executive, conditional on
that executive remaining in the company’s employ until the end of year 3. The share options cannot be
exercised unless the share price has increased from $15 at the beginning of year 1 to above $25 at the
end of year 3. If the share price is above $25 at the end of year 3, the share options can be exercised at
any time during the next 7 years (that is, by the end of year 10). The company applies an option-pricing
model that takes into account the possibility that the share price will exceed $25 at the end of year 3 and
the possibility that the share price will not exceed $25 at the end of year 3. It estimates the fair value of
the share options with this embedded market condition to be $9 per option. The executive completes 3
years’ service with Smallville Ltd.
1 5000 options × $9 × 1/3 years 15 000 15 000
2 (5000 options × $9 × 2/3 years) − $15 000 15 000 30 000
3 (5000 options × $9) − $30 000 15 000 45 000
206 PART 2 Elements

As noted earlier, because the executive has satisfied the service condition, the company is required to
recognise these amounts irrespective of the outcome of the market condition.
8.5.2 Treatment of non-vesting conditions

Vesting conditions comprise service and performance conditions only, and other features of a share-based
payment are not vesting conditions.
All non-vesting conditions are taken into account when estimating the fair value of equity instruments
granted (paragraph 21A). Under this provision, for grants of equity with non-vesting conditions, an entity
must recognise the goods or services received from a counterparty that satisfy all vesting conditions that
are not market conditions (such as services from an employee who remains in service for a specified
period of time). This applies whether or not the non-vesting conditions are satisfied.
The process of determining whether or not a condition is a non-vesting condition, or a service or perfor-
mance condition, is illustrated in the flowchart in figure 8.2.
Does the condition determine whether the

entity receives the services that entitle the
counterparty to the share-based payment?
No Yes
Does the condition require only a

Non-vesting
specified period of service to
condition
be completed?
No Yes
Performance Service
condition condition
FIGURE 8.2 Distinguishing vesting and non-vesting conditions

Source: Adapted from Australian Accounting Standards Board (AASB) 2008–1, IG11.
LO6 8.6 TREATMENT OF A RELOAD FEATURE

Employee share options often include features that are not found in exchange-traded options. One such
feature is a reload which entitles the employee to be automatically granted new options when the previ-
ously granted options are exercised using shares rather than cash to satisfy the exercise price. Although a
reload feature can add considerably to an option’s value, it is not considered feasible to value the reload
feature at grant date. Under paragraph 22 of IFRS 2, a reload feature is not taken into account when esti-
mating the fair value of the options granted at measurement date. Instead, a reload feature is accounted for
as a new option if and when a reload option is subsequently granted.
After vesting date
Having recognised the goods or services received and a corresponding increase in equity, paragraph 23
of IFRS 2 prevents an entity from making a subsequent adjustment to total equity after vesting date. For
example, if an amount is recognised for services received from an employee, it may not be reversed if the
vested equity instruments are later forfeited or, in the case of share options, if the options are not subse-
quently exercised. This restriction applies only to total equity; it does not preclude an entity from transfer-
ring amounts from one component of equity to another.
If the fair value of the equity instruments cannot be estimated reliably
In the event that the fair value of equity instruments cannot be reliably estimated, they must instead be
measured at their intrinsic value (IFRS 2 paragraph 24(a)). Intrinsic value is measured at the date goods
are obtained or services are rendered, at the end of each subsequent reporting period, and at the date of
final settlement. Any change in intrinsic value must be recognised in profit or loss. For a grant of share
options, the share-based payment arrangement is finally settled when the options are exercised, forfeited,
or when they lapse. The amount to be recognised for goods or services is based on the number of equity
instruments that ultimately vest or are exercised. The estimate must be revised if subsequent information

indicates that the number of share options expected to vest differs from previous estimates. On vesting
date, the estimate is then revised to equal the number of equity instruments that ultimately vest.
LO7 8.7 MODIFICATIONS TO TERMS AND CONDITIONS ON

WHICH EQUITY INSTRUMENTS WERE GRANTED
An entity might choose to modify the terms and conditions on which it granted equity instruments.
For example, it might change (reprice/retest) the exercise price of share options previously granted to
employees at prices that were higher than the current price of the entity’s shares. It might accelerate the
vesting of share options to make the options more favourable to employees; or it might remove or alter a
performance condition. If the exercise price of options is modified, the fair value of the options changes.
A reduction in the exercise price would increase the fair value of share options. Irrespective of any mod-
ifications to the terms and conditions on which equity instruments are granted, paragraph 27 of IFRS 2
requires the services received, measured at the grant-date fair value of the equity instruments, to be recog-
nised unless those equity instruments do not vest.
The incremental effects of modifications that increase the total fair value of the share-based payment
arrangement, or that are otherwise beneficial to the employee, must also be recognised. The incremental
fair value is the difference between the fair value of the modified equity instrument and that of the orig-
inal equity instrument, both estimated at the date of modification (IFRS 2 Appendix B43(a)). Similarly,
if the modification increases the number of equity instruments granted, the fair value of the additional
equity instruments, measured at the date of modification, must be included in the amount recognised for
services received.
If the modification occurs during the vesting period, the incremental fair value is included in the
measurement of the amount recognised for services received from the modification date until the date
when the modified equity instruments vest. This is in addition to the amount based on the grant-date
fair value of the original equity instruments that is recognised over the remainder of the original vesting
period. If the modification occurs after the vesting date, the incremental fair value is recognised immedi-
ately, or over the vesting period if the employee is required to complete an additional period of service
before becoming unconditionally entitled to the modified equity instruments.
The terms or conditions of the equity instruments granted may be modified in a manner that reduces the
total fair value of the share-based payment arrangement or that is not otherwise beneficial to the employee.
If this occurs, then IFRS 2 (Appendix B44) requires the services received as consideration to be accounted
for as if that modification had not occurred (i.e. the decrease in fair value is not to be taken into account).
Illustrative example 8.6 demonstrates the accounting treatment of a repricing modification to the terms
and conditions of share options.
ILLUSTRATIVE EXAMPLE 8.6 Grant of equity instruments that are subsequently repriced
Merton Ltd grants 100 share options to each of its 50 employees, conditional upon the employee
remaining in service over the next 3 years. The company estimates that the fair value of each option is
$15. On the basis of a weighted average probability, the company also estimates that 10 employees will
leave during the 3-year vesting period and therefore forfeit their rights to the share options.
A Four employees leave during year 1, and the company estimates that a further seven employees will
leave during years 2 and 3. By the end of year 1 the company’s share price has dropped, and it decides
to reprice the share options. The repriced share options will vest at the end of year 3. At the date of
repricing, Merton Ltd estimates that the fair value of each of the original share options is $5 and the
fair value of each repriced share option is $8. The incremental value is $3 per share option, and this
amount is recognised over the remaining 2 years of the vesting period along with the remuneration
expense based on the original option value of $15.
A 1 (50 − 11) employees × 100 options × $15 × 1/3 years 19 500 19 500
B During year 2, a further four employees leave, and the company estimates that another four employees
will leave during year 3 to bring the total expected employee departures over the 3-year vesting period
to 12 employees.
208 PART 2 Elements

B 2 ([50 − 12] employees × 100 options) × ([$15 × 2/3 years] + 24 200 43 700
[$3 × 1/2 years]) − $19 500
C A further three employees leave during year 3. For the remaining 39 employees (50 − [4 + 4 + 3]),
the share options vested at the end of year 3.
C 3 ([50 − 11] employees × 100 options × [$15 + $3]) − $43 700 26 500 70 200
8.7.1 Repurchases
If vested equity instruments are repurchased, IFRS 2 (paragraph 29) specifies that the payment made to the
employee is accounted for as a deduction from equity. If the payment exceeds the fair value of the equity
instruments repurchased, the excess is recognised as an expense.
LO8 8.8 CASH-SETTLED SHARE-BASED PAYMENT

TRANSACTIONS
Paragraphs 30–33 of IFRS 2 set out the requirements for share-based payments in which an entity incurs a
liability for goods or services received, based on the price of its own equity instruments. These are known
as cash-settled share-based payments. The fair value of the liability involved is remeasured at the end of
each reporting period and the date of settlement, and any changes in the fair value are recognised in profit
or loss for the period. In contrast, the fair value of equity-settled share-based payments is determined at
grant date, and remeasurement of the granted equity instruments at the end of each subsequent reporting
period and settlement date does not occur.
Examples of cash-settled share-based payments included in paragraph 31 of IFRS 2 are share appreci-
ation rights that might be granted to an employee as part of a remuneration package. Share appreciation
rights entitle the holder to a future cash payment (rather than an equity instrument) based on increases
in the share price. Another example is where an employee is granted rights to shares that are redeemable,
providing the employee with a right to receive a future cash payment.
There is a presumption in IFRS 2 that the services rendered by employees in exchange for the share
appreciation rights have been received. Where share appreciation rights vest immediately, the services
and the associated liability must also be recognised immediately. Where the share appreciation rights
do not vest until the employees have completed a specified period of service, the services received and
the associated liability to pay for those services are recognised as the service is rendered. The liability is
measured, initially and at the end of each reporting period until settled, at the fair value of the share
appreciation rights by applying an option-pricing model that takes into account the terms and con-
ditions on which share appreciation rights were granted, and the extent to which employees have ren-
dered service (paragraph 33).
Illustrative example 8.7 provides an example of the accounting treatment for cash-settled share appreci-
ation rights.
ILLUSTRATIVE EXAMPLE 8.7 Cash-settled share appreciation rights
Brierley Ltd grants 100 share appreciation rights (SARs) to each of its 50 employees, conditional upon
the employee staying with the company for the next 3 years. The company estimates the fair value of
the SARs at the end of each year as shown below. The intrinsic values of the SARs at the date of exer-
cise (which equal the cash paid out) at the end of years 3, 4 and 5 are also shown. All SARs held by
employees remaining at the end of year 3 will vest.

Year Fair value Intrinsic value
1 $14.40
2 $15.50
3 $18.20 $15.00
4 $21.40 $20.00
5 $25.00
A During year 1, three employees leave and the company estimates that six more will leave during
years 2 and 3.
B Four employees leave during year 2, and the company estimates that three more will leave during
year 3.
Year Calculation Expense $ Liability $
A 1 (50 − 9) employees × 100 SARs × $14.40 × 1/3 years 19 680 19 680
B 2 ([50 − 10] employees × 100 SARs × $15.50 × 2/3 years) − $19 680 21 653 41 333
C Two employees leave during year 3.

D At the end of year 3, 15 employees have exercised their SARs.
E Another 14 employees exercise their SARs at the end of year 4.
F The remaining 12 employees exercise their SARs at the end of year 5.
Year Calculation Expense $ Liability $
C 3 ([50 − 9 − 15] employees × 100 SARs × $18.20) − $41 333 5 987 47 320
D 15 employees × 100 SARs × $15 22 500
E 4 ([26 − 14] employees × 100 SARs × $21.40) − $47 320 (21 640) 25 680
14 employees × 100 SARs × $20 28 000
F 5 (0 employees × 100 SARs × $25) − $25 680 (25 680) 0

12 employees × 100 SARs × $25 30 000
Total 80 500
8.8.1 Share-based payment transactions with cash alternatives

Some share-based payments may provide either the entity or the counterparty with the choice of having
the transaction settled in cash (or other assets) or the issue of equity instruments. If the entity has incurred
a liability to settle in cash or other assets, the transaction is treated as a cash-settled share-based payment.
If no liability has been incurred, paragraph 34 of IFRS 2 requires that the transaction be treated as an equity-
settled share-based payment.
Share-based payment transactions where the counterparty has settlement choice
If the counterparty to a share-based payment has the right to choose whether a transaction is settled in
cash or equity instruments, a compound financial instrument has been created that includes a debt com-
ponent and an equity component. The debt component represents the counterparty’s right to demand a
cash settlement, and the equity component represents the counterparty’s right to demand settlement in
equity instruments.
IFRS 2 (paragraphs 35, 36) requires that transactions with employees be measured at fair value on
measurement date, by taking into account the terms and conditions on which rights to cash and equity
were granted. For transactions with others in which the fair value of goods or services is measured directly,
the equity component is measured as the difference between the fair value of the goods or services received
and the fair value of the debt component at the date they are received. The fair value of the debt com-
ponent is measured before the fair value of the equity component (paragraph 37), as the counterparty
must forfeit the right to receive cash in order to receive equity instruments. The measurement of com-
pound financial instruments with employees (and other counterparties) is summarised in table 8.2.
210 PART 2 Elements

TABLE 8.2 Measurement of compound financial instruments
Counterparty Measurement approach
Employees Measure fair value (FV) of the debt component then FV of the equity
component, at measurement date, taking into account the terms and
conditions on which rights to cash or equity were granted
Parties other than employees Equity component is the difference between FV of goods or services
received and FV of the debt component, at the date the goods or services
are received
The goods or services received in respect of each component of the compound financial instrument must
be accounted for separately. For the debt component, the goods or services and a liability to pay for them
is recognised as the counterparty supplies the goods or services, in the same manner as other cash-settled
share-based payments. For the equity component, the goods or services received and the increase in equity
are recognised as the counterparty supplies the goods or services, in the same manner as other equity-
settled share-based payments.
At settlement date, the liability must be remeasured to fair value (IFRS 2 paragraph 39). If equity instru-
ments are issued rather than a cash settlement paid, the liability must be transferred directly to equity as
consideration for the equity instruments. If the counterparty takes cash settlement, the payment is applied
in settlement of the liability. Any equity component previously recognised remains within equity although
it can be transferred within equity.
A grant of shares with a cash alternative subsequently added that provides an employee with a settle-
ment choice is demonstrated in illustrative example 8.8.
ILLUSTRATIVE EXAMPLE 8.8 Grant of shares with a cash alternative subsequently added
At the beginning of year 1, Scotland Ltd granted 10 000 shares with a fair value of $24 per share to a
senior manager, conditional on the manager remaining in the company’s employ for 3 years. By the end
of year 2 the share price had dropped to $15 per share. At that date the company added a cash alter-
native to the grant, giving the manager the right to choose whether to receive the 10 000 shares or cash
equal to the value of the shares on vesting date. On vesting date the share price had dropped to $12.
Year Calculation Asset/expense $ Equity $ Liability $
1 10 000 shares × $24 × 1/3 years 80 000 80 000
The addition of the cash alternative at the end of year 2 created an obligation to settle in cash. Scotland
Ltd must recognise the liability to settle in cash based on the fair value of the shares at the modification
date and the extent to which the specified services have been received. The liability must be remeasured
at the end of each subsequent reporting period and at the date of settlement.
2 (10 000 shares × $24 × 2/3 years) − $80 000 80 000 80 000
10 000 shares × $15 × 2/3 years (100 000) 100 000*
3 (10 000 shares × $24) − $160 000 80 000 30 000 50 000*

(10 000 shares × $12) − $150 000 (30 000) (30 000)
Total 210 000 90 000 120 000**
* At the date of modification when the cash alternative is added the total liability is $150 000 ($15 x 10 000 shares). At
this date a potential liability must be recognised.
** Total liability at date of settlement is $120 000 ($12 x 10 000 shares).

Share-based payment transactions where the entity has settlement choice
Where an entity has a choice of settling in cash or equity instruments, it must determine whether it has
a present obligation to settle in cash. Paragraph 41 of IFRS 2 states that an entity has a present obli-
gation to settle in cash if the choice of settlement in equity instruments has no commercial substance
(perhaps the entity is legally prohibited from issuing shares), it has a past practice or a stated policy of
settling in cash, or if it generally settles in cash whenever the counterparty asks for cash settlement. If a
present obligation exists, the transaction must be accounted for as a cash-settled share-based payment. If
a present obligation to settle in cash does not exist, the transaction is accounted for as an equity-settled
arrangement.
On settlement, if the entity elects to settle in cash, paragraph 43(a) of IFRS 2 requires the cash pay-
ment to be accounted for as the repurchase of an equity interest, resulting in a deduction from equity.
Where there is an equity settlement, no further accounting adjustments are required. If, on settlement,
the entity selects the settlement alternative with the higher fair value, an additional expense for the
excess value given must be recognised. The excess value is either the difference between the cash paid
and the fair value of the equity instruments that would have been issued, or the difference between the
fair value of the equity instruments issued and the amount of cash that would have been paid, which-
ever is applicable.
LO9 8.9 DISCLOSURE

The global financial crisis which emerged in 2008 has resulted in much criticism about the inadequacy of
disclosure in regard to performance hurdles and incentives used in share-based payment transactions. Cor-
porate executives, on the other hand, complain about the onerous reporting and disclosure requirements
necessary under the accounting rules. One difficulty faced by regulators is how to reduce the volume of
required information yet still retain meaningful and useful disclosure.
Paragraphs 44–52 of IFRS 2 prescribe various disclosures relating to share-based payments. The
objective of these disclosures is to provide significant additional information to assist financial state-
ment users to understand the nature and extent of share-based payment arrangements that existed
during the reporting period. The three principles that underpin the disclosures required by IFRS 2 are
shown in table 8.3.
TABLE 8.3 Principles underpinning the disclosures in IFRS 2
Disclosure principle IFRS 2

paragraph
The nature and extent of the share-based payment arrangements. 44
How the fair value of goods or services received, or the fair value of equity instruments 46
granted during the period, was determined.
The effect of share-based payment transactions on the entity’s profit or loss for the period and 50
on its financial position.
Paragraph 45 of IFRS 2 specifies the disclosures necessary to give effect to the principle in paragraph 44
as including at least the following:
• 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, such as vesting requirements,
the maximum term of options granted, and the methods of settlement.
An entity with substantially similar types of share-based payments may aggregate this information
unless separate disclosure of each arrangement is necessary to enable users to understand the nature and
extent of the arrangements.
Other specific disclosures required by paragraph 45 are the number and weighted average exercise prices
of share options for options that:
• are outstanding at the beginning of the period
• are granted during the period
• are forfeited during the period
• are exercised during the period
212 PART 2 Elements

• have expired during the period
• are outstanding at the end of the period
• are exercisable at the end of the period.
In relation to share options exercised during the period, the weighted average share price at the
date of exercise must be disclosed. If the options were exercised on a regular basis throughout
the period, the weighted average share price during the period may be disclosed instead. For share
options outstanding at the end of the period, the range of exercise prices and weighted average
remaining contractual life must be disclosed. If the range of exercise prices is wide, the outstanding
options must be divided into ranges that are meaningful for assessing the number and timing of
additional shares that may be issued and the cash that may be received upon exercise of those
options.
If the fair value of goods or services received as consideration for equity instruments of the entity has
been measured indirectly by reference to the fair value of the equity instruments granted, the following
information must be disclosed (paragraph 47):
• the weighted average fair value of share options granted during the period, at the measurement date,
and information on how the fair value was measured including:
– the option-pricing model used and the inputs to that model including the weighted average share
price, exercise price, expected volatility, option life, expected dividends, the risk-free interest rate, and
any other inputs to the model including the assumptions made to incorporate the effects of expected
early exercise
– how expected volatility was determined, including an explanation of the extent to which expected
volatility was based on historical volatility
– whether, and how many, other features of the option grant (such as a market condition) were incorpo-
rated into the measurement of fair value
• for equity instruments other than share options granted during the period, the number and weighted
average fair value at the measurement date, and information on how that fair value was measured,
including:
– if not measured on the basis of an observable market price, how fair value was determined
– whether and how expected dividends were incorporated
– whether and how any other features of the equity instruments were incorporated
• for share-based payment arrangements that were modified during the period:
– an explanation of the modifications
– the incremental fair value granted as a result of the modifications and information on how the incre-
mental fair value granted was measured.
If the entity has measured the fair value of goods or services received during the period directly, it is
required to disclose how that fair value was determined (e.g. at market price).
If the entity has rebutted the assumption that the fair value of goods or services received can be esti-
mated reliably, it is required to disclose that fact (paragraph 49) together with an explanation of why the
presumption was rebutted.
Paragraph 51 gives effect to the principle that an entity must disclose information that enables
financial statement users to understand the effect of share-based payments on the entity’s profit or
loss for the period and on its financial position. This paragraph requires disclosure of at least the
following:
• the total expense recognised for the period arising from share-based payments in which the
goods or services received did not qualify for recognition as assets, including separate disclosure
of that portion of the total expense that arises from transactions accounted for as equity-settled
share-based payments
• 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.
Finally, paragraph 52 requires the disclosure of such other additional information as may be needed to
enable the users of the financial statements to understand the nature and extent of the share-based pay-
ment arrangements; how the fair value of goods or services received, or the fair value of equity instruments
granted, was determined; and the effect of share-based payments on the entity’s profit or loss and on its
financial position.
A review of the corporate annual reports shows the large volume of space devoted to share-based
payment disclosure. For example, it has already been stated that Woolworth Limited’s 2014 remuner-
ation report covers more than 20 pages, much of which relates to share-based payments. In addition,
there is an extensive note to the consolidated financial statements that adds a further 8 pages of
disclosure.

SUMMARY
IFRS 2 deals with the recognition and measurement of share-based payment transactions. Share-based pay-
ments are arrangements in which an entity receives or acquires goods or services as consideration for, or
based on the price of (respectively) its own equity instruments. The main features of the standard are that it:
• requires financial statement recognition of the goods or services acquired or received under share-
based payment arrangements, regardless of whether the settlement is cash or equity or whether the
counterparty is an employee or another party.
• employs the general principle for cash-settled transactions that the goods or services received and the
liability incurred are measured at the fair value of the liability; and, until it is settled, the fair value of
the liability is remeasured at the end of each reporting period and at the date of settlement and any
changes in fair value are recognised in profit or loss.
• employs the general principle for equity-settled transactions that the goods or services received and the
corresponding increase in equity are measured at the grant date, and at the fair value of the goods or
services received; and if the fair value cannot be measured reliably, the goods or services are measured
indirectly by reference to the fair value of the equity instruments granted.
• allows an entity to choose appropriate option-valuation models to determine fair values and to tailor
those models to suit the entity’s specific circumstances.
• includes a lengthy set of disclosure requirements aimed at enabling financial statement users to
understand the nature, extent and effect of share-based payments, and how the fair value of goods or
services received or equity instruments granted was determined.
1. Why do standard setters formulate rules on the measurement and recognition of share-based payment
transactions?
2. What is the difference between equity-settled and cash-settled share-based payment transactions?
3. What is the different accounting treatment for instruments classified as debt and those classified as equity?
4. Outline the accounting treatment for the recognition of an equity-settled share-based payment
transaction.
5. Explain when a counterparty’s entitlement to receive equity instruments of an entity vests.
6. What are the minimum factors required under IFRS 2 to be taken into account in option-pricing
models?
7. Distinguish between vesting and non-vesting conditions.
8. Explain what the ‘retesting’ of share options means.
9. Explain the measurement approach for cash-settled share-based payment transactions.
10. Are the following statements true or false?
(a) Goods or services received in a share-based payment transaction must be recognised when they are
received.
(b) Historical volatility provides the best basis for forming reasonable expectations of the future price
of share options.
(c) Share appreciation rights entitle the holder to a future equity instrument based on the profitability
of the issuer.
References
International Accounting Standards Board 2009, IFRS 2 Share-based Payments, IFRS Foundation, London,
www.ifrs.org.
Woolworths Ltd 2014, Annual Report 2014, Woolworths Limited, Australia, www.woolworthslimited.com.au.
Exercise 8.1 SCOPE OF IFRS 2

★ Which of the following is a share-based payment transaction within the scope of IFRS 2? Give reasons for
your answer.
(a) Goods acquired from a supplier (counterparty) by incurring a liability based on the market price of the
goods
(b) An invoiced amount for professional advice provided to an entity, charged at an hourly rate, and to be
settled in cash
(c) Services provided by an employee to be settled in equity instruments of the entity
(d) Supply of goods in return for cash or equity instruments at the discretion of the counterparty
(e) Dividend payment to employees who are holders of an entity’s shares
214 PART 2 Elements

Exercise 8.2 EQUITY-SETTLED SHARE-BASED PAYMENT TRANSACTIONS
★ On 1 January 2016, Park Ltd announces a grant of 250 share options to each of its 20 senior executives.
The grant is conditional on the employee continuing to work for Park Ltd for the next 3 years. The fair
value of each share option is estimated to be $14. On the basis of a weighted average probability, Park Ltd
estimates that 10% of its senior executives will leave during the vesting period.
Required
Prepare a schedule setting out the annual and cumulative remuneration expense to be recognised by Park
Ltd for services rendered as consideration for the share options granted.
Exercise 8.3 ACCOUNTING FOR A GRANT WHERE THE NUMBER OF EQUITY INSTRUMENTS EXPECTED TO
★★ VEST VARIES
Tiger Ltd grants 80 share options to each of its 200 employees. Each grant is conditional on the employee
working for the company for the 3 years following the grant date. On grant date, the fair value of each
share option is estimated to be $12. On the basis of a weighted average probability, the company estimates
that 20% of its employees will leave during the 3-year vesting period.
During year 1, 15 employees leave and the company revises its estimate of total employee departures
over the full 3-year period from 20% to 22%.
Required
Prepare a schedule setting out the annual and cumulative remuneration expense for year 1.
Exercise 8.4 ACCOUNTING FOR A GRANT OF SHARE OPTIONS WHERE THE EXERCISE PRICE VARIES
★★ At the beginning of 2015, Whistler Ltd grants 3000 employee share options with an exercise price of $45
to its newly appointed chief executive officer, conditional on the executive remaining in the company’s
employ for the next 3 years. The exercise price drops to $35 if Whistler Ltd’s earnings increase by an
average of 10% per year over the 3-year period. On grant date, the estimated fair value of the employee
share options with an exercise price of $35 is $22 per option. If the exercise price is $45, the options have
an estimated fair value of $17 each.
During 2015, Whistler Ltd’s earnings increased by 8% and are expected to continue to increase at this
rate over the next 2 years.
Required
Prepare a schedule setting out the annual remuneration expense to be recognised by Whistler Ltd and the
cumulative remuneration expense for 2015.
Exercise 8.5 ACCOUNTING FOR A GRANT WITH A MARKET CONDITION

★★ At the beginning of 2016, Bay Ltd grants 10 000 share options to a senior marketing executive, conditional
on that executive remaining in the company’s employ until the end of 2018. The share options cannot be
exercised unless the share price has increased from $20 at the beginning of 2016 to above $30 at the end
of 2018. If the share price is above $30 at the end of 2016, the share options can be exercised at any time
during the following 5 years. Bay Ltd applies a binomial option-pricing model that takes into account the
possibility that the share price will exceed $30 at the end of 2018 and the possibility that the share price
will not exceed $30 at the end of 2018. The fair value of the share options with this market condition is
estimated to be $14 per option.
Required
Calculate the annual and cumulative remuneration expense to be recognised by Bay Ltd for 2016.
Exercise 8.6 SHARE-BASED PAYMENT WITH A NON-VESTING CONDITION

★★★ An employee is offered the opportunity to contribute 10% of his annual salary of $3000 across the next 2
years to a plan under which he receives share options. The employee’s accumulated contributions to the
plan may be used to exercise the options at the end of the 2-year period. The estimated annual expense for
this share-based payment arrangement is $200.
Required
Prepare the necessary journal entry or entries to recognise this arrangement at the end of the first year.

Exercise 8.7 ACCOUNTING FOR CASH-SETTLED SHARE-BASED PAYMENT TRANSACTIONS
★★★ Abernethy Ltd grants 1000 share appreciation rights (SARs) to 10 senior managers, to be taken in cash
within 2 years of vesting date on condition that the managers do not leave in the next 3 years. The SARs
vest at the end of year 3. Abernethy Ltd estimates the fair value of the SARs at the end of each year in
which a liability exists as shown below. The intrinsic value of the SARs at the date of exercise at the end of
year 3 is also shown.
Year Fair value Intrinsic value Number of managers who exercised their SARs
1 $ 4.40
2 $ 5.50
3 $10.20 $9.00 4
During year 1, one employee leaves and Abernethy Ltd estimates that a further two will leave before the end
of year 3. One employee leaves during year 2 and the corporation estimates that another employee will depart
during year 3. One employee leaves during year 3. At the end of year 3, four employees exercise their SARs.
Required
Prepare a schedule setting out the expense and liability that Abernethy Ltd must recognise at the end of
each of the first 3 years.
216 PART 2 Elements

Share-based payments received attention in academic research options. Dechow et al. (1996) argue that if adverse conse-
almost exclusively with respect to share-based compensation. quences to the expensing are present, then one should find
One strand in this research challenges the accounting treatment support in the behaviour of stock prices of firms that issue
of expensing this form of compensation and whether the use large amounts of employee stock options. They therefore
of fair value is relevant and reliable. A second strand has tried examine stock returns around events that increased the prob-
to understand the economic consequences of share-based com- ability of adopting the new expensing rule. However, their
pensation. A third strand reviewed here concerns how share- analysis fails to find a more pronounced effect on stock
based compensation may affect earnings management. prices for firms that issue more employee stock options.
In contrast to ordinary salary expense, share-based com- They therefore conclude that markets did not anticipate any
pensation has the important element of incentive that adverse real effect of the new accounting rule.
aligns employee interest with that of shareholders. That is, Another economic consequence of share-based payment is
share-based payments carry both cost and value to issuing its scope to motivate risk-averse managers to engage in more
employers (Hall and Murphy, 2002). It is therefore interesting risky projects for the benefit of well-diversified investors.
to find if investors agree with the treatment of expensing. Rajgopal and Shevlin (2002) test this theory in the Oil and
An argument against expensing and in favour of recogni- Gas industry. They find a positive link between share-based
tion of an (intangible) asset is that share-based compensa- compensation to managers and exploration activity, their
tion may generate benefits (or, value) that exceed its cost. proxy to managerial risk-taking. Cheng (2004) finds that
In addition, unlike cash payments, the related expense is share-based compensation encourages managers to engage
measured by reference to fair values, which raises a concern in research and development (R&D) activity. Because R&D
whether the recorded amount is sufficiently reliable. Bell may be quite risky in nature (Kothari et al., 2002; Amir et al.,
et al. (2002) examine how investors perceive share-based 2007), this provides additional evidence as to the positive
expense in a sample of 85 profitable firms. They find that link between share-based compensation and risk-taking.
market value of equity is positively related to the share-based While share-based compensation works to align the incen-
compensation. Hanlon et al. (2003) argue that the positive tives of managers with those of shareholders, managers may
effects documented by Bell et al. (2002) arise only in cer- feel they are over-exposed to the specific risk of the com-
tain circumstances. They posit that share-based compensa- pany they run. To remedy this, they may want to diversify by
tion is positively related to future performance only when selling vested options and shares (Ofek and Yermack, 2007).
firms issue employee stock options that are at a level that This, in turn, may provide them the incentive to manage
is appropriate for their underlying economic conditions and earnings prior to the sale of their shares to positively affect
corporate governance mechanisms. Consistent with this pre- share price. To explore this possibility, Cheng and Warfield
diction, Hanlon et al. (2003) find positive (negative) associ- (2005) examine the propensity of earnings to meet certain
ation with future performance for share-based compensation targets, such as analyst forecasts. They find that firms that
that is determined by (deviates from) these fundamentals. award high levels of share-based compensation to their
These two studies therefore suggest that the benefits of share- managers are more likely to meet or beat analyst forecasts.
based compensation exceed the costs, at least in certain cir- Additionally they find that managers that meet or beat ana-
cumstances. Aboody (1996) examines the relation between lyst forecasts tend to sell more shares afterward than man-
the value of outstanding stock options and share prices. He agers that do not meet analyst forecasts. Bergstresser and
finds a negative relation, suggesting options are net cost to Philippon (2006) provide complementary evidence. They
employers. This evidence therefore justifies expensing. However, find that managers whose overall compensation is more sen-
he also finds a positive relation when options are measured sitive to changes in stock prices typically managers that are
closer to the grant date. One interpretation of this is that awarded large share-based compensation, tend to manage
benefits exceed costs at the outset, but are then incorporated accruals to a greater degree.
into earnings and prices faster than the cost. In an attempt
to separate between the incentive and cost effect Aboody et al.
(2004) proxy for the benefit effect by using analyst predic-
tions of future growth. Once controlling for growth, they
References
find that share-based expense is negatively related to stock Aboody, D. 1996. Market valuation of employee stock options.
prices and stock returns, as would be expected from an expense. Journal of Accounting and Economics, 22(1), 357–391.
Hence, from this strand of research we get mixed evidence Aboody, D., Barth, M. E., and Kasznik, R. 2004. SFAS No. 123
as to whether share-based compensation is a net expense stock-based compensation expense and equity market
or net benefit. Nevertheless, establishing the above relations values. The Accounting Review, 79(2), 251–275.
(whether positive or negative) suggests that share-based com- Amir, E., Guan, Y., and Livne, G. 2007. The association of
pensation is useful and reliable. R&D and capital expenditures with subsequent earnings
Dechow et al. (1996) turn attention to the economic con- variability. Journal of Business Finance & Accounting, 34(1–2),
sequences of share-based compensation. Many opponents to 222–246.
the treatment of expensing argue that this could limit their Bell, T. B., Landsman, W. R., Miller, B. L., and Yeh, S. 2002.
access to equity and debt markets, which in turn would neg- The valuation implications of employee stock option
atively affect their performance. In 1993 the FASB issued its accounting for profitable computer software firms. The
Exposure Draft proposing the expense of employee stock Accounting Review, 77(4), 971–996.

Bergstresser, D., and Philippon, T. 2006. CEO incentives Hanlon, M., Rajgopal, S., and Shevlin, T. 2003. Are executive
and earnings management. Journal of Financial stock options associated with future earnings? Journal of
Economics, 80(3), 511–529. Accounting and Economics, 36(1), 3–43.
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218 PART 2 Elements

9 Inventories
ACCOUNTING IAS 2 Inventories
STANDARDS
IN FOCUS

OBJECTIVES
1 discuss the nature of inventories
2 explain how to measure inventories
3 explain what is included in the cost of inventory
4 account for inventory transactions using both the periodic and the perpetual methods
5 explain and apply end-of-period procedures for inventory under both periodic and perpetual
methods
6 explain why cost flow assumptions are required and apply both FIFO and weighted average cost
formulas
7 explain the net realisable value basis of measurement and account for adjustments to net
realisable value
8 identify the amounts to be recognised as inventory expenses
9 implement the disclosure requirements of IAS 2.
CHAPTER 9 Inventories 219

LO1 9.1 THE NATURE OF INVENTORIES
For retail and manufacturing entities inventory is one of the most important assets, and may make up
a significant proportion of current assets. The cost of sales during the period is normally the largest
expense of such entities.
The main accounting standard analysed in this chapter is IAS 2 Inventories. The standard was
originally issued in December 1993 when it replaced IAS 2 Valuation and Presentation of Inventories
in the Context of the Historical Cost System (issued in October 1975) and has been amended several
times.
According to paragraph 2 of IAS 2, the standard applies to all inventories except financial instru-
ments and biological assets related to agricultural activity and agricultural produce at the point of
harvest (IAS 41 Agriculture). Work in progress would be scoped in IFRS 15 Revenue from Contracts with
Customers unless it gives rise to inventories (or assets within the scope of another standard).
Paragraph 6 of IAS 2 defines inventories as follows:
Inventories are assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or in the rendering of
services.
Note the following points:
1. The assets are held for sale in the ordinary course of business. The accounting standards do not
define ‘ordinary’, but IFRS 5 Non-current Assets Held for Sale and Discontinued Operations requires
that non-current assets held for sale are to be distinguished from inventories. This indicates that the
term ‘inventories’ should be applied only to those assets that are always intended for sale or use in
producing saleable goods or services.
2. Accounting for assets held for use by the entity is covered by other accounting standards according
to their nature. IAS 16 Property, Plant and Equipment covers tangible assets such as production equip-
ment; IAS 38 Intangible Assets covers intangible assets such as patents.
3. Supplies or materials such as stationery would not be treated as inventories unless they are held for
sale or are used in producing goods for sale.
4. In accordance with IAS 16 paragraph 8, spare parts, standby equipment and servicing equipment are
classified as inventory unless they meet the definition of property, plant and equipment. This standard
clearly envisages that spare parts as inventory are those items consumed regularly during the production
process, such as bobbin winders on commercial sewing machines.
5. ‘In the case of a service provider, inventories include the costs of the service . . . for which the entity
has not yet recognised the related revenue’ (IAS 2 paragraph 8).
6. The assets are current assets if they satisfy the following criteria set out in paragraph 66 of IAS 1
Presentation of Financial Statements:
• the asset is expected to be realised in, or is intended for sale or consumption in the entity’s normal
operating cycle
• it is held primarily for the purpose of being traded
• it is expected to realise the asset within 12 months after the reporting period, or
• it is cash or a cash equivalent as defined in IAS 7 Statement of Cash Flows unless the asset is restricted
from being exchanged or used to settle a liability for at least 12 months after the reporting period.
‘The operating cycle of an entity is the time between the acquisition of assets for processing and their
realisation in cash or cash equivalents’ (IAS 1 paragraph 68). In some industries, such as retailing, the
operating cycle may be very short, but for others, like winemaking, the operating cycle could cover a
number of years. When the entity’s operating cycle is not clearly identifiable, its duration is assumed to
be 12 months (IAS 1 paragraph 68).
To illustrate: Nokia Group, based in Finland, prepares its financial statements in accordance with
International Financial Reporting Standards (IFRS® Standards). The extract from Nokia’s notes to the
consolidated financial statements at 31 December 2014, as shown in figure 9.1, indicates what is con-
tained in inventories.
In this chapter, accounting for inventory is considered as follows:
• initial recognition of inventory — determining the cost of inventory acquired or made
• recording of inventory transactions using either the periodic or perpetual inventory methods,
including end-of-period procedures and adjustments
• assignment of costs to inventory using the first-in, first-out (FIFO) or weighted average cost
formulas
• measurement subsequent to initial recognition — determining the amount at which the asset is
reported subsequent to acquisition, including any write-down to net realisable value.
220 PART 2 Elements

21 INVENTORIES
2014 2013
EURm EURm
Continuing operations
Raw materials, supplies and other 228 147
Work in progress 441 136
Finished goods 606 521
Total 1 275 804
FIGURE 9.1 Extract from the consolidated financial statements of Nokia

Source: Nokia 2015 (Nokia in 2014, p. 163).
LO2 9.2 MEASUREMENT OF INVENTORY UPON INITIAL

RECOGNITION
According to paragraph 9 of IAS 2, ‘Inventories shall be measured at the lower of cost and net realis-
able value.’ As the purpose of acquiring or manufacturing inventory items is to sell them at a profit,
inventory will initially be recognised at cost. Two specific industry groups have been exempted from
applying the lower of cost and net realisable value rule, namely:
(a) producers of agricultural and forest products, agricultural produce after harvest and minerals and mineral
products, to the extent that they are measured at net realisable value in accordance with well-established
practices in those industries . . .
(b) commodity broker-traders who measure their inventories at fair value less costs to sell . . . (IAS 2 paragraph 3)
In these cases, movements in net realisable value or fair value less costs to sell incurred during the
period are recognised in profit or loss. Where inventories in these industries are measured by reference to
historical cost, the lower of cost and net realisable value rule mandated by paragraph 9 would still apply.
In both cases, the standard stresses that these inventories are only scoped out from the measurement
requirements of IAS 2; the standard’s other requirements, such as disclosure, continue to apply.
LO3 9.3 DETERMINATION OF COST

The first step in accounting for inventory is its initial recognition at cost. IAS 2, paragraph 10, specifies
three components of cost:
• costs of purchase
• costs of conversion
• other costs incurred in bringing the inventories to their present location and condition.
Costs of conversion appear only in manufacturing entities where raw materials and other supplies are
purchased and then converted to other products.
9.3.1 Costs of purchase

Paragraph 11 of IAS 2 states that ‘the costs of purchase of inventories comprise the purchase price,
import duties and other taxes (other than those subsequently recoverable by the entity from the taxing
authorities), and transport, handling and other costs directly attributable to the acquisition of finished
goods, materials and services. Trade discounts, rebates and other similar items are deducted in deter-
mining the costs of purchase.’
Transaction taxes
Many countries levy taxes on transactions involving the exchange of goods and services, and require
entities engaging in such activities to collect and remit the tax to the government. If such a ‘goods and
services tax’ or ‘value added tax’ exists, care must be taken to exclude these amounts from the costs of
purchase if they are recoverable by the entity from the taxing authorities.
Trade and cash discounts
Trade discounts are reductions in selling prices granted to customers. Such discounts may be granted
as an incentive to buy, as a means to quit ageing inventory or as a reward for placing large orders for
goods. Because the discount reduces the purchase cost, it is deducted when determining the cost of
inventory.

Cash or settlement discounts are offered as incentives for early payment of amounts owing on
credit sales. Credit terms appear on invoices or contracts and often take the form ‘2/7, n/30’, which
means that the buyer will receive a 2% discount if the invoice is paid within 7 days of the invoice
date or will get 30 days to pay without discount. Some entities may also impose an interest penalty
for late payment. In November 2004, the International Financial Reporting Interpretations Com-
mittee (IFRIC®) issued an agenda decision that ‘settlement discounts should be deducted from the
cost of inventories’. The tentative agenda decision also clarified that ‘rebates that specifically and gen-
uinely refund selling expenses would not to be deducted from the cost of inventories’ (IASB, 2004).
Deferred payment terms

Where an item of inventory is acquired for cash or short-term credit, determination of the purchase price
is relatively straightforward. In the case that some or all of the cash payment is deferred, as noted in par-
agraph 18 of IAS 2, the purchase cost contains a financing element — the difference between the amount
paid and a purchase on normal credit terms — which must be recognised as interest expense over the
period of deferral.
9.3.2 Costs of conversion

IAS 2, paragraph 12, identifies costs of conversion as being the costs directly related to the units of produc-
tion, such as direct labour, plus a systematic allocation of fixed and variable production overheads that are
incurred in converting materials into finished goods. Variable production overheads are indirect costs of
production that vary directly with the volume of production and are allocated to each unit of production
on the basis of actual use of production facilities. Fixed overheads, such as depreciation of production
machinery, remain relatively constant regardless of the volume of production and are allocated to the cost
of inventory on the basis of normal production capacity. Where a production process simultaneously pro-
duces one or more products, the costs of conversion must be allocated between products on a systematic
and rational basis (IAS 2 paragraphs 12–14).
Costing methodologies are a managerial accounting issue and outside the scope of this book.
9.3.3 Other costs

Other costs can be included only if they are ‘incurred in bringing the inventories to their present location
and condition’ (IAS 2 paragraph 15). Such costs could include specific design expenses incurred in pro-
ducing goods for individual customers. IAS 23 Borrowing Costs allows borrowing costs such as interest to
be included in the cost of inventories, but only where such inventories are a qualifying asset; that is, one
which ‘takes a substantial period of time to get ready for its intended use or sale’ (IAS 23 paragraph 5).
Inventory items would rarely meet this criterion.
9.3.4 Excluded costs

The following costs are specifically listed in paragraph 16 of IAS 2 as costs that cannot be included in the
cost of inventories and must be recognised as expenses when incurred:
• abnormal amounts of wasted materials, labour or other production costs
• storage costs, unless necessary in the production process before a further production stage
• administrative overheads that do not contribute to bringing inventories to their present location and
condition
• selling costs.
9.3.5 Cost of inventories of a service provider

Service providers, such as cleaners, would normally measure any inventories at the cost of production.
Because a service is being provided, such costs would consist primarily of labour and other personnel
costs for those employees directly engaged in providing the service. The costs of supervisory personnel and
directly attributable overheads may also be included, but paragraph 19 of IAS 2 prohibits the inclusion
of labour and other costs relating to sales and general administrative personnel. Profit margins or non-
attributable overheads that are built into the prices charged by service providers cannot be included into
the cost of inventories.
Such inventory assets would be recognised only for services ‘in-progress’ at the end of the reporting
period for which the service provider has not as yet recognised any revenue (e.g. where a catering firm
has provided meals for 10 days as at the end of the reporting period, but bills the client on a fortnightly
basis).
222 PART 2 Elements

ILLUSTRATIVE EXAMPLE 9.1 Determination of cost
Western Ltd, an Australian company, received the following invoice from De Ferrari Garments Ltd, an
Italian garment manufacturer.
De Ferrari Garments
DF
Invoice: 37962
DF 112a Industrial Estate

GENOA ITALY Date: 18/04/13
Western Ltd Shipping details

2 Baskerville Street Tiamaru -ex Genoa Port 17/4/13
PERTH WA 6108 to Fremantle Australia
Australia
Customer no. Order no. Order date Dispatch Dispatch Delivered Terms
date no. by of sale
17632-A 726BI 16/3/13 17/4/13 19635-6 TNT Freight FOB shipping
Qty Description Unit price VAT/Tax Value of

ordered excl. VAT amount goods
Code Qty sent
GTF-16 100 60 Basic T-shirt size 16 8.25 495.00

GTA-14 1200 1200 Glamour Tee size 14 11.22 13464.00
SZ6-10 600 560 Superseded T-shirt size 10 * 5.90 3304.00
*15% discount on list price applies
VAT % VAT incl. Value of goods dispatched 17263

15% 00.00 Freight costs 695
Total payable 17958
Credit terms 2/15 net 60 days
The goods arrived at Fremantle port on 29 May 2013 and were held in a bond store pending payment of
import duties and taxes. After the payment of storage costs of A$145, import duty at 1.5% of the total value
of goods in Australian dollars, goods and services tax (GST) of 10% and local freight charges of A$316,
the goods were finally delivered to Western Ltd’s warehouse on 6 June 2013. The invoice was received on
8 June and a liability of $A23 628.95 recorded using the exchange rate of A$1 = €0.76 at that date. The
invoice was paid in full on 8 July by the remittance of $A23 322.08 (at an exchange rate of A$1 = €0.77).
Western Ltd paid A$167 to acquire the euros. Upon receipt of the goods, Western Ltd attaches its own logo
to the T-shirts and repackages them for sale. The cost of this further processing is A$2.54 per T-shirt.
Problem
What is the cost of this inventory?
Solution
The cost of inventory would include the following amounts:
Purchase price € 17 263.00

Shipping costs 695.00
€ 17 958.00
Conversion to Australian dollars:
€17 958 ÷ 0.76 23 628.95
Storage costs − bond store 145.00

Import duty ($22 714.47 × 1.5%) 340.72
Freight costs 316.00
Foreign exchange commission 167.00
Logo and repackaging (1820 items × $2.54) 4 622.80
Total cost A$ 29 220.47
Where a cost per unit for each type of T-shirt is required, some method of allocating the ‘generic’ costs
of shipping, storage, freight and foreign exchange commission would need to be employed. In this case,
such costs could be allocated on a per garment basis. For example, the cost per unit for the Basic T-shirts
would be:
A$
Purchase price (€8.25 ÷ A$0.76) 10.86
Import duty (1.5% ÷ $10.86) 0.16
Shipping and other costs* 0.85
Logo and repackaging 2.54
Cost per unit $14.41
*(A$145 + 316 + 167 + [€695 ÷ 0.76] = A$1542.47/1820 garments = A$0.85 per garment)
Note that the exchange gain of $306.87 arising from the change in euro–dollar exchange rates between
the recognition of the liability and its payment cannot be incorporated in the calculation of cost as it is
not associated with the acquisition transaction. Additionally, the GST of 10% payable is not included as
it is a transaction tax receivable by Western Ltd against GST collected on sale of inventory.
9.3.6 Cost of agricultural produce harvested from biological

assets
IAS 41 Agriculture requires inventories of agricultural produce, such as wheat and oranges, to be initially
measured at their fair value less costs to sell at the point of harvest. IAS 2, paragraph 20, deems this value
to be the cost for the purposes of applying the requirements of the inventory standard.
9.3.7 Cost measurement techniques

Techniques for the measurement of cost, such as the standard cost method or the retail method, may be
used for convenience as long as the resulting values approximate cost. Manufacturing entities determine
a ‘standard’ cost of materials, direct and indirect labour and overheads for each product based on normal
levels of efficiency and capacity utilisation. Adjustments are made at the end of the reporting period to
account for variances between standard and actual costs. The retail method is used to measure inventories
of large numbers of rapidly changing items with similar margins for which it is impractical to use other
costing methods. Supermarket and department store chains most often employ this method of approxi-
mating cost. Cost is determined by reducing the sales value of the inventory by an appropriate percentage
gross margin or an average percentage margin. In applying this method, care must be taken to ensure that
gross margins are adjusted for goods that have been discounted below their original selling price.
LO4 9.4 ACCOUNTING FOR INVENTORY

There are two main methods of accounting for inventory: the periodic method and the perpetual method.
9.4.1 Periodic method

Under the periodic method, the amount of inventory is determined periodically (normally annually) by
conducting a physical count and multiplying the number of units by a cost per unit to value the inventory
on hand. This amount is then recognised as a current asset. This balance remains unchanged until the
next count is taken. Purchases and returns of inventory during the reporting period are posted directly to
expense accounts. Cost of sales during the year is determined as follows:
Cost of sales = Opening inventory + Purchases + Freight inwards − Purchase returns

− Cash discounts received − Closing inventory
224 PART 2 Elements

Accounting for inventory using the periodic method is cost effective and easy to apply, but its major
disadvantage is that the exact quantity and cost of inventory cannot be determined on a day-to-day
basis, and this might result in lost sales or unhappy customers. Additionally, it is not possible to
identify stock losses or posting errors, resulting in accounting figures that might be inaccurate or
misleading.
9.4.2 Perpetual method

Under the perpetual method, inventory records are updated each time a transaction involving inven-
tory takes place. Thus, up-to-date information about the quantity and cost of inventory on hand will
always be available, enabling the entity to provide better customer service and maintain better control
over this essential asset. This system is more complicated and expensive than the periodic method,
but, with the advent of user-friendly computerised accounting packages and point-of-sale machines
linked directly to accounting records, most businesses today can afford to and do use the perpetual
method.
The perpetual method requires a subsidiary ledger to be maintained, either manually or on computer,
with a separate record for each inventory item detailing all movements in both quantity and cost. This
subsidiary record is linked to the general ledger account for inventory, and regular reconciliations are
carried out to ensure the accuracy and completeness of the accounting records. This reconciliation process is
discussed in section 9.5.
ILLUSTRATIVE EXAMPLE 9.2 Comparing the periodic and the perpetual inventory methods
Kotka Ltd sells garden furniture settings. This example illustrates the journal entries necessary to record
the normal inventory transactions that would occur during an accounting period, and the reporting of
gross profit from the sale of inventory under both accounting systems.
The inventory account in the general ledger of Kotka Ltd at the beginning of the year under both
methods is shown below.
Inventory
1/1/14 Balance b/d 6 700

(10 units @ $670)
The following transactions took place during the year:

(a) Purchased 354 settings (FOB shipping) at $670 each on credit terms of 2/10, n/30 from Grimstad
Pty Ltd.
(b) Sold, on credit, 352 settings for $975 each.
(c) Returned four settings to the supplier.
(d) Seven settings were returned by customers.
The journal entries necessary to record these transactions under both inventory accounting methods are
shown below.
KOTKA LTD
Journal entries
Perpetual inventory method Periodic inventory method
(a) Purchased 354 settings (FOB shipping) at $670 each on credit terms of 2/10, n/30 from Grimstad
Pty Ltd.
Dr Cr Dr Cr
Inventory 237 180 Purchases 237 180
A/cs Payable 237 180 A/cs Payable 237 180
(b) Sold, on credit, 352 settings for $975 each.
Dr Cr Dr Cr
A/cs Receivable 343 200 A/cs Receivable 343 200
Sales Revenue 343 200 Sales Revenue 343 200
Cost of Sales 235 840
Inventory 235 840

(c) Returned four settings to the supplier.
Dr Cr Dr Cr
Inventory 2 680 Purchase Returns 2 680
(d) Seven settings were returned by customers.
Dr Cr Dr Cr
Sales Returns 6 825 Sales Returns 6 825
A/cs Receivable 6 825 A/cs Receivable 6 825
Inventory 4 690
Cost of Sales 4 690
Important differences to note between the two methods of accounting for inventory are as follows:
• Purchases are posted directly to the asset account under the perpetual method, and are posted to
expense accounts under the periodic method.
• When goods are sold, a second entry is necessary under the perpetual method to transfer the cost of
those goods from the inventory account to the expense account, cost of sales.
• When goods are returned to suppliers, the return is adjusted directly to inventory under the perpetual
method, and is posted to a purchase returns account under the periodic method.
• When goods are returned from customers, a second journal entry is necessary under the perpetual
method to transfer the cost of these goods out of the cost of sales account and back into the inventory
account.
• Under the periodic method, freight is normally posted to a separate account. Under the perpetual
method, freight is included in the cost of inventory.
• If inventory items being returned to the supplier have been paid for, an accounts receivable account
would be opened pending a cash refund from the supplier.
• If sales returns have been paid for, an accounts payable entry would be raised to recognise the need to
refund cash to the customer.
• Under the periodic method, cash settlement discounts would be posted to a separate ledger
account. Under the perpetual method, settlement discounts would be deducted from the cost of
inventory.
After posting the journal entries, the general ledger account would appear as shown below.
Perpetual inventory method Periodic inventory method
Inventory Inventory
1/1/14 Balance b/d 6 700 Cost of Sales 235 840 1/1/14 Balance b/d 6 700
Cost of Sales 4 690 Balance c/d 10 050
248 570 248 570
Balance b/d 10 050
Assuming that the physical count at the end of the reporting period found 15 settings on hand at a cost
of $670 each, the gross profit earned on these would be determined as follows:
KOTKA LTD
Determination of Gross Profit
Perpetual inventory method
Sales revenue 343 200

Less: Sales returns and allowances (6 825)
Net sales revenue 336 375
Cost of sales (231 150)
Gross profit $ 105 225
226 PART 2 Elements

Periodic inventory method
Sales revenue 343 200

Less: Sales returns (6 825)
Net sales revenue 336 375
Cost of sales
Opening inventory 6 700
Add: Purchases 237 180
243 880
Less: Purchase returns (2 680)
Goods available for sale 241 200
Less: Closing inventory (10 050)
Gross profit $ 105 225
Note that, in this example, the same gross profit is reported irrespective of the inventory recording
method adopted. However, where adjustments are made for damaged or lost inventory, the gross profit
will be different under the perpetual method.
LO5 9.5 END-OF-PERIOD ACCOUNTING

To ensure that reported figures for inventory, cost of sales and other expenses are accurate and complete,
certain procedures must be carried out at the end of each accounting period. It is essential that good
internal controls are in place to ensure that inventory is protected from fraud or loss and that inventory
figures are complete and accurate. This section examines the physical count, end-of-year cut-off and essen-
tial reconciliation procedures.
9.5.1 Physical count

Under the periodic method, inventory must be counted at the end of each accounting period to determine
the carrying value of closing inventory. Periodic counts are made under the perpetual method to verify
the accuracy of recorded quantities for each inventory item, although not necessarily at the end of the
reporting period, if inventory differences are historically found to be immaterial.
The way in which the physical count is conducted will depend on the type of inventory and the
accounting system of the entity. Stockpiled inventory such as mineral sands may require the use of sur-
veyors to measure quantities on hand and assay tests to determine mineral content.
The following are some steps that are generally taken to ensure the accuracy of a physical count:
• The warehouse, retail store or storage facility should be arranged so as to facilitate counting and clearly
segregate non-inventory items.
• Cut-off procedures should be put in place and final numbers of important documents such as dispatch
notes and invoices are recorded. (Cut-off procedures are discussed in greater detail in section 9.5.2.)
• Prenumbered count sheets, tags or cards should be produced detailing inventory codes and
descriptions. A supervisor should record all numbers used and account for spoiled documents to
ensure that the count details are complete. Alternatively, where inventory items have bar codes,
electronic scanners can be used to record the count.
• Counting should be done in teams of at least two people: one counter and one checker. All team
members should sign the count records.
• Any damaged or incomplete items located during the count should be clearly listed on the count records.
• The supervisor should ensure that all goods have been counted before the count sheets are collected.
Perpetual method
Once the physical count is complete, under the perpetual method the quantities on hand are then com-
pared to recorded quantities and all discrepancies investigated. Recording errors cause discrepancies; for
example, the wrong code number or quantity might have been entered, or a transaction might not have
been processed in the correct period. Alternatively, discrepancies may reveal losses of goods caused by
damage or fraud. Recording errors can be corrected, but the value of goods that have been lost should be
written off using the following entry:
Inventory Losses Dr 5 000

Inventory Cr 5 000
(Recognition of inventory losses during the period)

Unless they are immaterial, inventory losses must be disclosed separately in the notes to the financial
statements (see section 9.9).
Periodic method
Once the count is completed, under this method the count quantities are then assigned with a cost and
the carrying value of inventory is recorded. This adjustment can be done in a number of ways, but the
simplest is to post the following two journal entries:
Opening Inventory (Cost of Sales) Dr 79 600

Inventory Cr 79 600
(Transfer of opening balance to expense)
Inventory Dr 87 100
Closing Inventory (Cost of Sales) Cr 87 100
(Recognition of final inventory balance)
Under the periodic method, inventory losses and fraud cannot be identified and recorded as a separate
expense. The movement in inventory balances plus the cost of purchases is presumed to represent the cost
of sales during the reporting period.
9.5.2 Cut-off procedures

Under both periodic and perpetual methods there is a need to ensure that, when a physical count
is conducted, there is a proper cut-off of the record keeping so that the accounting records reflect
the results of the physical count and include all transactions relevant to the accounting period, while
excluding those that belong to other periods. For all inventory transactions (sales, purchases and
returns), it is possible for inventory records to be updated before transaction details are posted to
the general ledger accounts. For example, goods are normally entered into inventory records when
the goods are received, but accounts payable records will not record the liability until the invoice
arrives because shipping documents may not record price details. Under the periodic method, there is
a need to ensure a proper cut-off between the general ledger recording of goods received, shipped and
returned, and the inventory counted. Under the perpetual method, there is a need to ensure that all
inventory movements are properly recorded in the perpetual records, so a valid comparison is made
between inventory counted and the perpetual record quantities. Further, if the perpetual method is not
integrated with the general ledger, there is also a need to ensure a proper cut-off between the general
ledger and the perpetual records. Thus, at the end of the reporting period it is essential that proper
cut-off procedures be implemented.
The following cut-off errors could arise:
• Goods have been received into inventory, but the purchase invoice has not been processed.
• Goods have been returned to a supplier, and deleted from inventory, but the credit note has not been
processed.
• Goods have been sold and dispatched to a customer, but the invoice has not been raised.
• Goods have been returned by a customer, but the credit note has not been issued.
If inventory movements have been processed before invoices and credit notes, adjusting entries are
needed to bring both sides of the transaction into the same accounting period.
9.5.3 Goods in transit

Accounting for goods in transit at the end of the reporting period will depend upon the terms of
trade. Where goods are purchased on an FOB shipping basis, the goods belong to the purchaser from
the time they are shipped, and should be included in inventory/accounts payable at the end of the
reporting period. All such purchases in transit will need to be identified and the following adjusting
journal entry posted:
Goods in Transit (Inventory) Dr 1 500

Accounts Payable Cr 1 500
(Recognition of inventory in transit at the end of the
reporting period)
If goods are purchased on FOB destination terms, no adjustment will be required because the goods still
legally belong to the supplier.
228 PART 2 Elements

If goods are sold on FOB destination terms, they belong to the entity until they arrive at the customer’s
premises. Because the sale will have been recorded in the current year, the following adjusting entries will
be required to remove that sale and reinstate the inventory:
Inventory Dr 3 000
Cost of Sales Cr 3 000
(Reversal of sale for goods in transit at the end of the
reporting period)
Sales Revenue Dr 4 500

Accounts Receivable Cr 4 500
(Reversal of sale for goods in transit at the end of the
reporting period)
9.5.4 Consignment inventory

Care must be taken in the treatment of consignment inventory. Under a consignment arrangement, an
agent (the consignee) agrees to sell goods on behalf of the consignor on a commission basis. The transfer
of goods to the consignee is not a legal sale/purchase transaction. Legal ownership remains with the con-
signor until the agent sells the goods to a third party. Steps must be taken to ensure that goods held on
consignment are not included in the physical count. Equally, goods owned by the entity that are held by
consignees must be added to the physical count.
9.5.5 Control account/subsidiary ledger reconciliation

This end-of-period procedure is required only under the perpetual method. The general ledger account
balance must be reconciled with the total of the subsidiary ledger (manual or computerised). Recording
errors and omissions will cause the reconciliation process to fail. Any material discrepancies should be
investigated and corrected. This process will identify only amounts that have not been posted to both
records; it cannot identify errors within the subsidiary records, such as posting a purchase to the wrong
inventory item code. However, the physical count/recorded figure reconciliation will isolate these errors.
ILLUSTRATIVE EXAMPLE 9.3 End-of-period adjustments
Bob Smith, trading as Honefoss Pty Ltd, completed his first year of trading as a toy wholesaler on 31
December 2014. He is worried about his end-of-year physical and cut-off procedures.
The inventory ledger account balance at 31 December 2014, under the perpetual inventory method,
was £78 700. His physical count, however, revealed the cost of inventory on hand at 31 December 2014
to be only £73 400. While Bob expected a small inventory shortfall due to breakage and petty theft, he
considered this shortfall to be excessive.
Upon investigating reasons for the inventory ‘shortfall’, Bob discovered the following:
• Goods costing £800 were sold on credit to R Finn for £1300 on 27 December 2014 on FOB
destination terms. The goods were still in transit at 31 December 2014. Honefoss Pty Ltd recorded
the sale on 27 December 2014 and did not include these goods in the physical count.
• Included in the physical count were £2200 of goods held on consignment.
• Goods costing £910 were purchased on credit from Lapua Ltd on 23 December 2014 and received on
28 December 2014. The purchase was unrecorded at 31 December 2014, but the goods were included
in the physical count.
• Goods costing £400 were purchased on credit from Kuovola Supplies on 22 December 2014 on
FOB shipping terms. The goods were delivered to the transport company on 27 December 2014. The
purchase was recorded on 27 December 2014, but, as the goods had not yet arrived, Honefoss Pty
Ltd did not include these goods in the physical count.
• At 31 December 2014 Honefoss Pty Ltd had unsold goods costing £3700 out on consignment. These
goods were not included in the physical count.
• Goods costing £2100 were sold on credit to Vetlonda Ltd for £3200 on 24 December 2014 on FOB
shipping terms. The goods were shipped on 28 December 2014. The sale was unrecorded at 31
December 2014 and Honefoss Pty Ltd did not include these goods in the physical count.
• Goods costing £1500 had been returned to Ruovesi Garments on 31 December 2014. A credit note
was received from the supplier on 5 January 2015. No payment had been made for the goods prior
to their return.

These transactions and events must be analysed to determine if adjustments are required to the ledger
accounts (general and subsidiary) and/or the physical count records as follows:
Workings
Recorded Physical
balance count
£ £
Balance prior to adjustment 78 700 73 400

Add: Goods sold, FOB destination and in transit at 31 December 800 800
Less: Goods held on consignment — (2 200)
Add: Unrecorded purchase 910 —
Add: Goods purchased, FOB shipping and in transit at 31 December — 400
Add: Goods out on consignment — 3 700
Less: Unrecorded sale (2 100) —
Less: Unrecorded purchase returns (1 500) —
£76 810 £76 100
If, after all adjustments are made, the recorded balance cannot be reconciled to the physical count, the
remaining discrepancy is presumed to represent inventory losses and a final adjustment is made as follows:
Adjusted balances 76 810 76 100

Inventory shortfall (710) —
£76 100 £76 100
The following journal entries are necessary on 31 December 2014 to correct errors and adjust the
inventory ledger accounts:
HONEFOSS PTY LTD

General Journal
2014
31 December
Accounts Receivable (R Finn) Cr 1 300
(Correction of sale recorded incorrectly)
Inventory (Item X) Dr 800

Cost of Sales Cr 800
(Correction of sale recorded incorrectly)
Inventory (Item Y) Dr 910

Accounts Payable (Lapua Ltd) Cr 910
(Correction of unrecorded purchase)
Accounts Receivable (Vetlonda Ltd) Dr 3 200

Sales Revenue Cr 3 200
(Correction of unrecorded sale)
Cost of Sales Dr 2 100

Inventory (Item Z) Cr 2 100
(Correction of unrecorded sale)
Accounts Payable (Ruovesi Garments) Dr 1 500

Inventory (Item W) Cr 1 500
(Correction of unrecorded purchase return)
Inventory Losses and Write-Downs Dr 710

Inventory Cr 710
(Unexplained variance (physical/records) written off)
230 PART 2 Elements

LO6 9.6 ASSIGNING COSTS TO INVENTORY ON SALE
The nature of inventory held by an entity does not affect its initial recognition at cost, but has a significant
impact when that inventory is sold. As shown in illustrative example 9.2, under the perpetual system the
cost of inventory items is transferred to a ‘Cost of Sales’ expense account on sale, and under the periodic
system a ‘Cost of Sales’ figure is calculated at the end of the reporting period. This is an easy task if the
nature of inventory is such that it is possible to clearly identify the exact inventory item that has been
sold and its cost, but what if it is not possible to identify exactly the cost of the item sold? How can you
measure the cost of a tonne of wheat when it is extracted from a stockpile consisting of millions of tonnes
acquired at different prices over the accounting period?
IAS 2 addresses this problem by mandating two different rules for the assigning of cost to inventory
items sold.
The rules differ depending on the nature of inventory held. Paragraph 23 of IAS 2 states that:
The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and
segregated for specific projects shall be assigned by using specific identification of their individual costs.
Thus, if the inventory held consists of items that can be individually identified because of their unique
nature or by some other means, or cannot be individually identified, but have been acquired for a specific
project, then the exact cost of the item sold must be recorded as cost of sales expense.
Paragraph 25 of IAS 2 states that:
The cost of inventories, other than those dealt with in paragraph 23, shall be assigned by using the first-in,
first-out (FIFO) or weighted average cost formula.
This means that, where a specific cost cannot be identified because of the nature of the item sold, then
some method has to be adopted to estimate that cost. This process is known as ‘assigning’ cost. Most
inventory items fall into this category; for example, identical items of food and clothing and bulk items
like oil and minerals. There are many methods of assigning a cost to inventory items sold, but IAS 2
restricts entities to a choice between two methods — FIFO and weighted average.
9.6.1 First-in, first-out (FIFO) cost formula

The FIFO formula assumes that items of inventory that were purchased or produced first are sold first, and
the items remaining in inventory at the end of the period are those most recently purchased or produced
(IAS 2 paragraph 27). Thus, more recent purchase costs are assigned to the inventory asset account, and
older costs are assigned to the cost of sales expense account.
Consider this example: there are 515 Blu-ray players on hand at 31 December 2014, and recent purchase
invoices showed the following costs:
28 December 180 players at €49.00
15 December 325 players at €48.50
30 November 200 players at €47.00
The value of ending inventory is found by starting with the most recent purchase and working back-
wards until all items on hand have been priced (on the assumption that it is not known when any par-
ticular Blu-ray player was sold). The value of ending inventory would be €25 052.50 (being 180 players at
€49 + 325 players at €48.50 + 10 players at €47).
Many proponents of the FIFO method argue that this method best reflects the physical movement of
inventory, particularly perishable goods or those subject to changes in fashion or rapid obsolescence (as
in the case of Blu-ray players). If the oldest goods are normally sold first, then the oldest costs should be
assigned to expense.
9.6.2 Weighted average cost formula

Under the weighted average cost formula, the cost of each item sold is determined from the cost of sim-
ilar items purchased or produced during the period. The average may be calculated on a periodic basis
(weighted average), or as each additional shipment is received (moving average).
Using a periodic basis, the cost of inventory on hand at the beginning of the period plus all inventory
purchased during the year is divided by the total number of items available for sale during the period
(opening quantity plus purchased quantity). This produces the cost per unit. For example: inventory on
hand at 1 January 2015 was valued at £3439.78, consisting of 134 units at an average of £25.67 each.
During the year the following purchases were made:
200 units at £27.50 = £5 500.00

175 units at £28.35 = £4 961.25
300 units at £29.10 = £8 730.00
120 units at £29.00 = £3 480.00

At the end of the year, the weighted average cost of inventory would be calculated as:
£3439.78 + £5500.00 + £4961.25 + £8730.00 + £3480.00 = £26 111.03 ÷ 929 units = £28.11 per unit
Using the moving weighted average method, the average unit cost is recalculated each time there is an
inventory purchase or purchase return. This is demonstrated in illustrative example 9.4.
ILLUSTRATIVE EXAMPLE 9.4 Application of cost formulas
The following information has been extracted from the records of Savonlinna Parts about one of its prod-
ucts. Savonlinna Parts uses the perpetual inventory method and its reporting period ends on 31 December.
Unit cost Total cost

No. of units $ $
2014
01/01 Beginning balance 800 7.00 5 600
06/01 Purchased 300 7.05 2 115
05/02 Sold @ $12.00 per unit 1 000
19/03 Purchased 1 100 7.35 8 085
24/03 Purchase returns 80 7.35 588
10/04 Sold @ $12.10 per unit 700
22/06 Purchased 8 400 7.50 63 000
31/07 Sold @ $13.25 per unit 1 800
04/08 Sales returns @ $13.25 per unit 20
04/09 Sold @ $13.50 per unit 3 500
06/10 Purchased 500 8.00 4 000
27/11 Sold @ $15.00 per unit 3 100
Required
1. Calculate the cost of inventory on hand at 31 December 2014 and the cost of sales for the year ended
31 December 2014, assuming:
(a) the FIFO cost flow assumption
(b) the moving average cost flow assumption (round the average unit costs to the nearest cent, and
round the total cost amounts to the nearest dollar).
2. Prepare the trading section of the statement of profit or loss and other comprehensive income for the
year ended 31 December 2014, assuming:
(a) the FIFO cost flow assumption
(b) the moving average cost flow assumption.
Part 1. (a) First-in, first-out cost formula
Purchases Cost of sales Balance1
No. Unit Total No. Unit Total No. Unit Total

Date Details units cost cost units cost cost units cost cost
01/01 Inventory balance 800 7.00 5 600
06/01 Purchases 300 7.05 2 115 800 7.00 5 600

300 7.05 2 115
05/02 Sales 800 7.00 5 600

200 7.05 1 410 100 7.05 705
232 PART 2 Elements

19/03 Purchases 1 100 7.35 8 085 100 7.05 705
1 100 7.35 8 085
24/03 Purchase returns (80) 7.35 (588) 100 7.05 705

1 020 7.35 7 497
10/04 Sales 100 7.05 705

600 7.35 4 410 420 7.35 3 087
22/06 Purchases 8 400 7.50 63 000 420 7.35 3 087

8 400 7.50 63 000
31/07 Sales 420 7.35 3 087

1 380 7.50 10 350 7 020 7.50 52 650
04/08 Sales returns2 (20) 7.50 (150) 7 040 7.50 52 800
04/09 Sales 3 500 7.50 26 250 3 540 7.50 26 550
06/10 Purchases 500 8.00 4 000 3 540 7.50 26 550

500 8.00 4 000
22/11 Sales 3 100 7.50 23 250 440 7.50 3 300

500 8.00 4 000
76 612 74 912
Notes:
1. As it is assumed the earliest purchases are sold first, a separate balance of each purchase at a different price must be maintained.
2. The principle of ‘last-out, first-in’ is applied to sales returns.
Part 1. (b) Moving average cost formula
Purchases Cost of sales1 Balance
No. Unit Total No. Unit Total No. Unit Total

Date Details units cost cost units cost cost units cost2 cost
01/01 Inventory balance 800 7.00 5 600
06/01 Purchases 300 7.05 2 115 1 100 7.01 7 715
05/02 Sales 1 000 7.01 7 010 100 7.01 705
19/03 Purchases 1 100 7.35 8 085 1 200 7.33 8 790
24/03 Purchase returns (80) 7.35 (588) 1 120 7.32 8 202
10/04 Sales 700 7.32 5 124 420 7.32 3 078

01/01 Inventory balance 8 400 7.50 63 000 8 820 7.49 66 078
06/01 Purchases 1 800 7.49 13 482 7 020 7.49 52 596
05/02 Sales (20) 7.49 (150) 7 040 7.49 52 746
19/03 Purchases 3 500 7.49 26 215 3 540 7.49 26 531
24/03 Purchase returns 500 8.00 4 000 4 040 7.56 30 531
10/04 Sales 3 100 7.56 23 436 940 7.56 7 095
76 612 75 117
Notes:
1. The ‘average’ cost on the date of sale is applied to calculate the ‘cost of sales’.
2. The average cost per unit is recalculated each time there is a purchase or a purchase return at a different cost.

Part 2
SAVONLINNA PARTS
Statement of Profit or Loss and Other Comprehensive Income (extract)
for the year ended 31 December 2014
Moving
FIFO average
$ $
Sales revenue 138 070 138 070
Less: Sales returns (265) (265)
Net sales 137 805 137 805
Less: Cost of sales (74 912) (75 117)
Gross profit $ 62 893 $ 62 688
Because the purchase price has been rising throughout the year, using the FIFO formula produces a
lower cost of sales (higher gross profit) and a higher inventory balance than the moving average formula.
9.6.3 Which cost formula to use?

The choice of method is a matter for management judgement and depends upon the nature of the inven-
tory, the information needs of management and financial statement users, and the cost of applying the
formulas. For example, the weighted average method is easy to apply and is particularly suited to inventory
where homogeneous products are mixed together, like iron ore or spring water. On the other hand, first-in,
first-out may be a better reflection of the actual physical movement of goods, such as those with use-by
dates where the first produced must be sold first to avoid loss due to obsolescence, spoilage or legislative
restrictions. Entities with diversified operations may use both methods because they carry different types of
inventory. Using diverse methods is acceptable under IAS 2, but paragraph 26 cautions that ‘a difference in
geographical location of inventories (or in the respective tax rules), by itself, is not sufficient to justify the
use of different cost formulas’. The nature of the inventory itself should determine the choice of formula.
9.6.4 Consistent application of costing methods

Once a cost formula has been selected, management cannot randomly switch from one formula to
another. Because the choice of method can have a significant impact on an entity’s reported profit and
asset figures, particularly in times of volatile prices, indiscriminate changes in formulas could result in
the reporting of financial information that is neither comparable nor reliable. Accordingly, paragraph 13
of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires that ‘accounting policies
be consistently applied to ensure comparability of financial information. Changes in accounting policies
are allowed (IAS 8 paragraph 14) only when required by an accounting standard or where the change
results in reporting more relevant and reliable financial information.’ Therefore, unless the nature of inven-
tory changes, it is unlikely that the cost formulas will change. Paragraph 19 of IAS 2 requires voluntary
changes in accounting policies to be applied retrospectively, i.e. the information is presented as if the new
accounting policy had always been applied. Hence, a change from one method to another would require
adjustments to the financial statements to show the information as if the new method had always been
applied. Adjustments can be taken through the opening balance of retained earnings. Comparative infor-
mation would also need to be restated.
LO7 9.7 NET REALISABLE VALUE

As the measurement rule mandated by IAS 2 for inventories is the ‘lower of cost and net realisable value’
(paragraph 9), an estimate of net realisable value must be made to determine if inventory must be written
down. Normally, this estimate is done at the end of the reporting period, but, where management become
aware during the reporting period that goods or services can no longer be sold at a price above cost,
inventory values should be written down to net realisable value. The rationale for this measurement rule,
according to paragraph 28 of IAS 2, is that ‘assets should not be carried in excess of amounts expected to
be realised from their sale or use’.
Net realisable value is the net amount that an entity expects to realise from the sale of inventory in the
ordinary course of business. It is defined in paragraph 6 of IAS 2 as ‘the estimated selling price in the ordi-
nary course of business less the estimated costs of completion and the estimated costs necessary to make
the sale’. Net realisable value is specific to an individual entity and is not necessarily equal to fair value less
selling costs. Fair value is defined as ‘the price that would be received to sell an asset or paid to transfer a
234 PART 2 Elements

liability in an orderly transaction between market participants at the measurement date. (See IFRS 13 Fair
Value Measurement.)’ (IAS 2 paragraph 6).
Net realisable value may fall below cost for a number of reasons including:
• a fall in selling price (e.g. fashion garments)
• physical deterioration of inventories (e.g. fruit and vegetables)
• product obsolescence (e.g. computers and electrical equipment)
• a decision, as part of an entity’s marketing strategy, to manufacture and sell products for the time being
at a loss (e.g. new products)
• miscalculations or other errors in purchasing or production (e.g. over-stocking)
• an increase in the estimated costs of completion or the estimated costs of making the sale (e.g. air-
conditioning plants).
9.7.1 Estimating net realisable value

Estimates of net realisable value must be based on the most reliable evidence available at the time the esti-
mate is made (normally the end of the reporting period) of the amount that the inventories are expected
to realise. Thus, estimates must be made of:
• expected selling price
• estimated costs of completion (if any)
• estimated selling costs.
These estimates take into consideration fluctuations of price or cost occurring after the end of the
reporting period to the extent that such events confirm conditions existing at the end of the reporting
period. The purpose for which inventory is held should be taken into account when reviewing net realis-
able values. For example, the net realisable value of inventory held to satisfy firm sales or service contracts
is based on the contract price. If the sales contracts are for less than the inventory quantities held, the net
realisable value of the excess is based on general selling prices. Estimated selling costs include all costs
likely to be incurred in securing and filling customer orders such as advertising costs, sales personnel sala-
ries and operating costs, and the costs of storing and shipping finished goods.
It is possible to use formulas based on predetermined criteria to initially estimate net realisable value.
These formulas normally take into account, as appropriate, the age, past movements, expected future
movements and estimated scrap values of the inventories. However, the results must be reviewed in the
light of any special circumstances not anticipated in the formulas, such as changes in the current demand
for inventories or unexpected obsolescence.
9.7.2 Materials and other supplies

IAS 2, paragraph 32, states that ‘materials and other supplies held for use in the production of inventories
are not written down below cost if the finished goods in which they will be incorporated are expected to
be sold at or above cost’. When the sale of finished goods is not expected to recover the costs, then mate-
rials are to be written down to net realisable value. IAS 2 suggests that the replacement cost of the mate-
rials or other supplies is probably the best measure of their net realisable value.
9.7.3 Write-down to net realisable value

Inventories are usually written down to net realisable value on an item-by-item basis. Paragraph 29 of
IAS 2 states that ‘it is not appropriate to write inventories down on the basis of a classification of inven-
tory, for example, finished goods, or all the inventories in a particular operating segment’. Where it is not
practical to separately evaluate the net realisable value of each item within a product line, the write-down
may be applied on a group basis provided that the products have similar purposes or end uses, and are
produced and marketed in the same geographical area. IAS 2 generally requires that service providers
apply the measurement rule only on an item-by-item basis, as each service ordinarily has a separate
selling price.
The journal entry to process the write-down would be:
Inventory Write-Down Expense Dr 800

Inventory Cr 800
(Write-down to net realisable value)
9.7.4 Reversal of prior write-down to net realisable value

If the circumstances that previously caused inventories to be written down below cost change, or if a new
assessment confirms that net realisable value has increased, the amount of a previous write-down can be
reversed (subject to an upper limit of the original write-down). This could occur if an item of inventory

written down to net realisable value because of falling sales prices is still on hand at the end of a subse-
quent period and its selling price has recovered.
The journal entry to process the reversal would be:
Inventory Dr 800
Inventory Write-Down Expense Cr 800
(Write-up to revised net realisable value)
ILLUSTRATIVE EXAMPLE 9.5 Application of measurement rule
Vastervick Pty Ltd retails gardening equipment and has four main product lines: mowers, vacuum
blowers, edgers and garden tools. At 31 December 2014, cost and net realisable values for each line were
as shown below.
Application of lower of cost and net realisable value measurement rule
Lower of cost
Cost per unit NRV per unit and NRV
Inventory item Quantity € € €
Mowers 16 215.80 256.00 3 452.80
Vacuum blowers 113 62.35 60.00 6 780.00
Edgers 78 27.40 36.00 2 137.20
Garden tools 129 12.89 11.00 1 419.00
Inventory at the lower of cost and net realisable value €13 789.00
The following journal entry would be required to adjust inventory values to net realisable value:
31 December 2014
Inventory Write-Down Expense Dr 509.36
Inventory Cr 509.36
(Write-down to net realisable value — vacuum blowers
€265.55 (113 × €2.35) and garden tools €243.81 (129 ×
€1.89))
LO8 9.8 RECOGNITION AS AN EXPENSE

Paragraph 34 of IAS 2 requires the following items to be recognised as expenses:
• carrying amount of inventories in the period in which the related revenue is recognised, in other
words, cost of sales
• write-down of inventories to net realisable value and all losses
• reversals of write-downs to net realisable value (reduction of the expense).
The only exception to this rule relates to inventory items allocated to other asset accounts, e.g. used by
an entity as components in self-constructed property, plant or equipment. The cost of these items would
be capitalised and recognised as an expense via depreciation.
LO9 9.9 DISCLOSURE

Paragraph 36 of IAS 2 contains the required disclosures relating to inventories. Before preparing the disclo-
sure note, inventories on hand will need to be classified into categories because paragraph 36(b) requires
‘the carrying amount in classifications appropriate to the entity’ to be disclosed. Common classifications
suggested in paragraph 37 are ‘merchandise, production supplies, materials, work in progress and finished
goods’. Figure 9.2 provides an illustration of the disclosures required by IAS 2.
236 PART 2 Elements

IAS 2
Paragraph
Note 1: Summary of accounting policies (extract)
Inventories
Inventories are valued at the lower of cost and net realisable value. 36(a)
Costs incurred in bringing each product to its present location and condition are 9–10
accounted for as follows:
• raw materials: purchase cost on a first-in, first-out basis 25
• finished goods and work in progress: cost of direct materials and labour and a proportion 12–13
of manufacturing overheads based on the normal operating capacity, but excluding
borrowing costs
• production supplies: purchase cost on a weighted average cost basis. 25
Net realisable value is the estimated selling price in the ordinary course of business, less 6
estimated costs of completion and the estimated costs necessary to make the sale.
Note 6: Inventories
2014 2013
€’000 €’000
36(b)
Raw materials 1 257 1 840
Work in progress 649 721
Finished goods 3 932 4 278
Production supplies 385 316
Total inventories at the lower of cost and net realisable value 6 223 7 155
In respect to inventory, the following items have been recognised as

expenses during the period:
Cost of sales 11 674 10 543 36(d)
Write-down to net realisable value 26 18 36(e)
Reversal of write-down(a) (3) — 36(f)
(a) A prior year write-down was reversed during the current period as a result of an increase in selling 36(g)
price for that inventory item.
Inventory with a carrying amount of €570 000 has been pledged as security for loans to the 36(h)
company.
FIGURE 9.2 An example of illustrative disclosures required by IAS 2
SUMMARY
The purpose of this chapter is to analyse the content of IAS 2 Inventories and provide guidance on its imple-
mentation. The principal issue in accounting for inventories is the determination of cost and its subsequent
recognition as an expense, including any write-down to net realisable value (IAS 2 paragraph 1). One key
decision in recognising inventory is the selection of an appropriate method for allocating costs between
individual items of inventory to determine the cost of sales and the cost of inventory on hand. Following the
initial recognition of the inventory, cost must be compared to net realisable value, and the value of inventory
written down where net realisable value falls below cost. IAS 2 requires disclosures to be made in relation to
the inventories held by an entity and the accounting policies adopted with respect to these assets.
1. Define ‘cost’ as applied to the valuation of inventory.
2. What is meant by the term ‘net realisable value’? Is this the same as fair value? If not, why not?
3. In what circumstances must assumptions be made in order to assign a cost to inventory items when
they are sold?
4. Compare and contrast the impact on the reported profit and asset value for an accounting period of
the first-in, first-out method and the weighted average method.
5. Why is the lower of cost and net realisable value rule used in the accounting standard? Is it permissible
to revalue inventory upwards? If so,when?
6. What impact do the terms of trade have on the determination of the quantity and value of inventory
on hand where goods are in transit at the end of the reporting period?

References
IASB 2004, IFRIC Update, November, www.ifrs.org.
Nokia 2015, Nokia in 2014, Nokia Corporation, Finland, www.nokia.com.
Exercise 9.1 CONSIGNMENT OF INVENTORY

★ Arend al Ltd reported in a recent financial statement that approximately $12 million of merchandise was
received on consignment. Should the company recognise this amount on its statement of financial posi-
tion? Explain.
Exercise 9.2 SELECTION OF COST ASSUMPTION

★ Under what circumstances would each of the following inventory cost methods be appropriate?
(a) Specific identification
(b) Last-in, first-out
(c) Average cost
(d) First-in, first-out
(e) Retail inventory
Exercise 9.3 DETERMINING INVENTORY COST AND COST OF SALES (PERIODIC)

★ Select the correct answer. Show any workings required and provide reasons to justify your choice.
1. The cost of inventory on hand at 1 January 2013 was $25 000 and at 31 December 2013 was $35 000.
Inventory purchases for the year amounted to $160 000, freight outwards expense was $500, and pur-
chase returns were $1400. What was the cost of sales for the year ended 31 December 2013?
(a) $148 100 (c) $149 100
(b) $148 600 (d) $150 000
The following inventory information relates to K Rauma, who uses a periodic inventory system and
rounds the average unit cost to the nearest dollar:
Beginning inventory 10 units @ average cost of $25 each = $250
January purchase 10 units @ $24 each
July purchase 39 units @ $26 each
October purchase 20 units @ $24 each
Ending inventory 25 units
What is the cost of ending inventory using the weighted average costing method?
(a) $625 (c) $618.75
(b) $620 (d) $610
Exercise 9.4 ASSIGNMENT OF COST (PERIODIC AND PERPETUAL)

★ Select the correct answer. Show any workings required and provide reasons to justify your choice.
Malmo Ltd’s inventory transactions for April 2014 are shown below.
Purchases Cost of sales Balance
Date No. units Unit cost Total cost No. units Unit cost Total cost No. units Unit cost Total cost
April 1 20 $8.00 $160.00
4 90 $8.40 $756.00
7 100 $8.60 $860.00
10 50
13 (20) $8.60 ($172.00)
18 70
21 (5)
29 40
238 PART 2 Elements

1. If Malmo Ltd uses the perpetual inventory system with the moving average cost flow method, the 18
April sale would be costed at what unit cost?
(a) $8.60 (c) $8.44
(b) $8.46 (d) $8.42
2. If Malmo Ltd uses the periodic inventory system with the FIFO cost flow method, what would be the
cost of sales for April?
(a) $1303.00 (c) $1310.00
(b) $1508.60 (d) $1324.00
3. If Malmo Ltd uses the perpetual inventory system with the FIFO cost flow method, the 21 April sale
return (relating to the 18 April sale) would be costed at what unit cost?
(a) $8.00 (c) $8.40
(b) $8.60 (d) $8.50
4. If Malmo Ltd uses the periodic method with the weighted average cost flow method, what would be the
value of closing inventory at 30 April 2011? (Round average cost to the nearest cent.)
(a) $295.40 (c) $253.20
(b) $301.00 (d) $297.50
Exercise 9.5 END-OF-PERIOD ADJUSTMENTS

★★ An extract from Uppsala Ltd’s unadjusted trial balance as at 30 June 2013 appears below. Uppsala Ltd’s
reporting period ends on 30 June and uses the perpetual method to record inventory transactions.
$ $
Inventory 194 400
Sales 631 770
Sales returns 6 410
Cost of sales 468 640
Inventory losses 12 678
• On 24 June 2013, Uppsala Ltd recorded a $1320 credit sale of goods costing $1200. These goods,
which were sold on FOB destination terms and were in transit at 30 June 2013, were included in the
physical count.
• Inventory on hand at 30 June 2013 (determined via physical count) had a cost of $195 600 and a net
realisable value of $194 740.
Required
1. Prepare any adjusting journal entries required on 30 June 2013.
2. Prepare the trading section of the statement of profit or loss and other comprehensive income for the
year ended 30 June 2013.
Exercise 9.6 APPLYING THE LOWER OF COST AND NRV RULE

★★ The following information relates to the inventory on hand at 30 June 2013 held by Vaasa Ltd.
Cost of
completion
Cost Cost to Estimated and
per unit replace selling price disposal
Item No. Quantity $ $ $ $
A1458 600 2.30 2.41 3.75 0.49
A1965 815 3.40 3.26 3.50 0.55
B6730 749 7.34 7.35 10.00 0.95
D0943 98 1.23 1.14 1.00 0.12
G8123 156 3.56 3.56 5.70 0.67
W2167 1 492 6.12 6.15 7.66 0.36

Required
Calculate the value of inventory on hand at 30 June 2013 in accordance with the requirements of IAS 2.
Exercise 9.7 END-OF-REPORTING-PERIOD ADJUSTMENTS

★★ Norway Outfitters sells outdoor adventure equipment. The entity uses the perpetual inventory method to
account for inventory transactions and assigns costs using the moving average method. All purchases and
sales are made on FOB destination, 30-day credit terms.
At 30 June 2014, the balance of the inventory control account in the general ledger was $248 265 after
the special journal totals were posted but before the balance-date adjusting entries were prepared and
posted.
A physical count showed goods worth $256 100 to be on hand. Investigations of the discrepancy between
the general ledger account balance and the count total revealed the following:
• Damaged ropes worth $1200 were returned to the supplier on 29 June, but this transaction has not yet
been recorded.
• During the stocktake, staff found that a box of leather gloves worth $595 had suffered water damage
during a recent storm. The gloves were damaged beyond repair and so were not included in the count,
but they are still recorded in the inventory records.
• Equipment worth $1500, which was sold for $2500 on 29 June, was still in transit to the customer on
30 June. The sale was recorded on 29 June and the equipment was not included in the physical count.
• An error occurred when posting the purchase journal totals for May 2014. The correct total of $25 100
was erroneously posted as $21 500.
• The physical count included goods worth $7600 that were being held on consignment for All Weather
Gear Pty Ltd.
• An all-terrain kit worth $1570 was returned by a customer on 28 June. The sales return transaction
was correctly journalised and posted to the ledgers, but the kit was not returned to the warehouse and
therefore was not included in the physical count.
Required
Adjust and reconcile the inventory control ledger account balance to the physical account (adjusted as
necessary).
Exercise 9.8 ALLOCATING COST (WEIGHTED AVERAGE), REPORTING GROSS PROFIT AND APPLYING THE NRV RULE
★★ Oslo Ltd wholesales bicycles. It uses the perpetual inventory method and allocates cost to inventory on
a moving average basis. The company’s reporting period ends on 31 March. At 1 March 2014, inventory
on hand consisted of 350 bicycles at $82 each and 43 bicycles at $85 each. During the month ended 31
March 2014, the following inventory transactions took place (all purchase and sales transactions are on
credit):
March 1 Sold 300 bicycles for $120 each.
3 Five bicycles were returned by a customer. They had originally cost $82 each and were sold
for $120 each.
9 Purchased 55 bicycles at $91 each.
15 Sold 86 bicycles for $135 each.
17 Returned one damaged bicycle to the supplier. This bicycle had been purchased on 9 March.
29 Two bicycles, sold on 22 March, were returned by a customer. The bicycles were badly
damaged so it was decided to write them off. They had originally cost $91 each.
Required
1. Calculate the cost of inventory on hand at 31 March 2014 and the cost of sales for the month of
March. (Round the average unit cost to the nearest cent, and round the total cost amounts to the
nearest dollar.)
240 PART 2 Elements

2. Show the Inventory general ledger control account (in T-format) as it would appear at 31 March 2014.
3. Calculate the gross profit on sales for the month of March 2014.
Exercise 9.9 ALLOCATING COST (FIFO), REPORTING GROSS PROFIT AND APPLYING THE NRV RULE
★★★ Stockholm Ltd wholesales bicycles. It uses the perpetual inventory method and allocates cost to inventory
on a first-in, first-out basis. The company’s reporting period ends on 31 March. At 1 March 2013, inven-
tory on hand consisted of 350 bicycles at $82 each and 43 bicycles at $85 each. During the month ended
31 March 2013, the following inventory transactions took place (all purchase and sales transactions are
on credit):
March 1 Sold 300 bicycles for $120 each.
3 Five bicycles were returned by a customer. They had originally cost $82 each and were sold
for $120 each.
17 Returned one damaged bicycle to the supplier. This bicycle had been purchased on 9 March.
29 Two bicycles, sold on 22 March, were returned by a customer. The bicycles were badly
damaged so it was decided to write them off. They had originally cost $91 each.
Required
1. Calculate the cost of inventory on hand at 31 March 2013 and the cost of sales for the month of March.
2. Show the Inventory general ledger control account (in T-format) as it would appear at 31 March 2013.
3. Calculate the gross profit on sales for the month of March 2013.
4. IAS 2 requires inventories to be measured at the lower of cost and net realisable value. Identify three
reasons why the net realisable value of the bicycles on hand at 31 March 2013 may be below their cost.
5. If the net realisable value is below cost, what action should Stockholm Ltd take?
Exercise 9.10 ASSIGNING COSTS AND END-OF-PERIOD ADJUSTMENTS

★★★ Lund Retailing Ltd is a food wholesaler that supplies independent grocery stores. The company operates
a perpetual inventory system, with the first-in, first-out method used to assign costs to inventory items.
Freight costs are not included in the calculation of unit costs. Transactions and other related information
regarding two of the items (baked beans and plain flour) carried by Lund Ltd are given below for June
2013, the last month of the company’s reporting period.
Baked beans Plain flour
Unit of packaging Case containing 25 × 410 g cans Box containing 12 × 4 kg bags
Inventory @ 1 June 2013 350 cases @ $19.60 625 boxes @ $38.40
Purchases 10 June: 200 cases @ $19.50 plus 3 June: 150 boxes @ $38.45
freight of $135 15 June: 200 boxes @ $38.45
19 June: 470 cases @ $19.70 per 29 June: 240 boxes @ $39.00
case plus freight of $210
Purchase terms 2/10, n/30, FOB shipping n/30, FOB destination
June sales 730 cases @ $28.50 950 boxes @ 40.00

Returns and allowances A customer returned 50 cases that As the June 15 purchase was
had been shipped in error. The unloaded, 10 boxes were
customer’s account was credited discovered damaged. A credit of
for $1425. $384.50 was received by Lund
Retailing Ltd.
Physical count at 30 June 2013 326 cases on hand 15 boxes on hand
Explanation of variance No explanation found — assumed Boxes purchased on 29 June still

stolen in transit on 30 June
Net realisable value at $29.00 per case $38.50 per box

30 June 2013
Required
1. Calculate the number of units in inventory and the FIFO unit cost for baked beans and plain flour as at
30 June 2013 (show all workings).
2. Calculate the total dollar amount of the inventory for baked beans and plain flour, applying the lower
of cost and net realisable rule on an item-by-item basis. Prepare any necessary journal entries (show all
workings).
242 PART 2 Elements

ACADEMIC PERSPECTIVE—CHAPTER 9
There is only scant literature on inventories and IAS 2, per- cost of sales, and hence improve reported profitability. Roy-
haps because the accounting treatment is not controversial. chowdhury (2006) estimates production costs as cost of
The main research interest therefore rests with the infor- goods sold plus the change in inventory. He focuses on firms
mation content of inventory and inventory changes. There is who report the smallest profit among available observations
also some research into earnings management through pro- during the 1987–2001 period. Based on past research these
duction costs. are firms suspected of using earnings management to avoid
Starting with the information role of inventory, Lev and losses (e.g., Burgstahler and Dichev, 1997). Consistent with
Thiagarajan (1993) postulate that increases in inventory his conjecture that real earnings management takes place
above the level of increases in sales serve as a fundamental in inventory production cost, he finds that suspect firms
signal to investors. Specifically, they argue that when inven- are characterised by high production costs, low operating
tory increases more than sales do, this is likely associated cash flows, and lower level of accruals than non-suspect
with unwarranted inventory buildup. One consequence of firms.
this is that future sales will decline as managers will have to Gunny (2010) extends this line of research to examine
offer discounts to customers. Alternatively, such an increase future operating performance of firms that engage in real
is likely to be followed by inventory write-offs. At the same earnings management to meet earnings benchmarks. She
time, over-production of inventory may entail a positive argues that engaging in real earnings management may serve
effect on current earnings in manufacturing firms. This is as a signal about future performance. She finds that firms
because overhead costs are allocated to a larger number of that overproduce to avoid reporting losses show higher
units, and hence reduces the per-unit cost of sales. Lev and return on equity and operating cash flows in the subsequent
Thiagarajan (1993) show that inventory buildup is nega- year than firms that report small losses while not engaging
tively associated with stock returns. This is consistent with in real earnings management. The conclusion therefore is
market participants regarding inventory buildup as a negative that real earnings management to meet earnings benchmarks
signal. Abarbanell and Bushee’s (1997) formally show that indicates better future performance.
Lev and Thiagarajan’s (1993) conjecture about the negative
association between inventory buildup and future earnings is
borne out in the data. However, they do not find that finan-
cial analysts revise their predictions in line with the empirical
References
evidence. This raises a concern that financial analysts do not Abarbanell, J., and Bushee. B. 1997. Fundamental analysis,
fully appreciate the consequences of inventory buildup. Abar- future earnings, and stock prices. Journal of Accounting
banell and Bushee’s (1998) subsequent analysis employs the Research, 35, 1–24.
same fundamental signal as Lev and Thiagarajan (1993), but Abarbanell, J., and Bushee. B. 1998. Abnormal returns to a
this time to show it can help form a profitable buy-and-hold fundamental analysis strategy. The Accounting Review, 73,
strategy. Specifically, a portfolio that takes a long (short) posi- 19–45.
tion in firms with increases in inventory below (above) the Burgstahler, D., and Dichev, I., 1997. Earnings management
levels of increase in sales generates positive returns. to avoid earnings decreases and losses. Journal of
Thomas and Zhang (2002) link inventory changes to Accounting and Economics 24, 99–126.
another important empirical finding that was previously Gunny, K. A. 2010. The relation between earnings
established by Sloan (1996). Sloan (1996) finds that accruals management using real activities manipulation and
are inversely related to future stock returns. This suggests future performance: Evidence from meeting earnings
that market participants do not fully understand the reversal benchmarks. Contemporary Accounting Research, 27(3),
property of accruals. Thomas and Zhang (2002) investigate if 855–888.
this is primarily caused by inventory changes. They find that Lev, B., and Thiagarajan, R. 1993. Fundamental information
both inventory and other components of accruals explain analysis. Journal of Accounting Research, 31, 190–215.
this phenomenon. However, the contribution of changes in Roychowdhury, S. 2006. Earnings management through
inventory is the largest. real activities manipulation. Journal of Accounting and
Roychowdhury (2006) examines real earnings manage- Economics, 42(3), 335–70.
ment, which he defines as ‘manipulating real activities to Sloan, R. G. 1996. Do stock prices fully reflect information
avoid reporting annual losses’. This contrasts with manip- in accruals and cash flows about future earnings? The
ulating accruals, which is the convention in accounting Accounting Review, 71, 289–315.
research for earnings management. One of the real activities Thomas, J. K., and Zhang, H., 2002. Inventory changes
subject to such manipulations is overproduction of inventory. and future returns. Review of Accounting Studies, 7(2–3),
As Lev and Thiagarajan (1993) note, this can help reduce 163–187.

10 Employee benefits
ACCOUNTING IAS 19 Employee Benefits
STANDARDS
IN FOCUS

OBJECTIVES
1 outline the principles applied in accounting for employee benefits
2 discuss the scope and purpose of IAS 19
3 discuss the definition of employee benefits
4 prepare journal entries to account for short-term liabilities for employee benefits, such as
wages and salaries, sick leave and annual leave
5 compare defined benefit and defined contribution post-employment benefit plans
6 prepare entries to account for expenses, assets and liabilities arising from defined contribution
post-employment plans
7 prepare entries to record expenses, assets and liabilities arising from defined benefit post-
employment plans
8 explain how to measure and record other long-term liabilities for employment benefits,
such as long service leave
9 explain when a liability should be recognised for termination benefits and how it should be
measured.
CHAPTER 10 Employee benefits 245

LO1 10.1 INTRODUCTION TO ACCOUNTING FOR
EMPLOYEE BENEFITS
Employee benefits typically constitute a significant component of an entity’s expenses, particularly
in the services sector. For example, HSBC Holdings plc reports in its 2014 financial statements that
‘total operating expenses’ of US$41 249 million include ‘employee compensation and benefits’ of
US$20 366 million. Employees are remunerated for the services they provide. Employee remuneration
is not limited to wages, which may be paid weekly, fortnightly or monthly, but often includes enti-
tlements to be paid, such as sick leave, annual leave, long service leave and post-employment ben-
efits, such as pension plans. The measurement of short-term liabilities for employee benefits, such as
sick leave and annual leave, is relatively straightforward. However, the measurement of other types
of employee benefits, including post-employment benefits, other long-term benefits, such as long
service leave, and termination benefits, is more complex because it requires estimation and present
value calculations.
LO2 10.2 SCOPE AND PURPOSE OF IAS 19

IAS 19 Employee Benefits applies to all employee benefits except those to which IFRS 2 Share-based
Payment applies. Employee benefits arise from formal employment contracts between an entity and its
individual employees. Employee benefits also include requirements specified by legislation or industry
arrangements for employers to contribute to an industry, state or national plan. Informal practices that
generate a constructive obligation, such as payment of annual bonuses, also fall within the scope of
employee benefits under IAS 19. Share-based employee benefits are beyond the scope of IAS 19. Chapter 8
considers share-based payments, including share-based employee remuneration.
The purpose of IAS 19 is to prescribe the recognition, measurement and disclosure requirements
for expenses, assets and liabilities arising from services provided by employees. Liabilities arise when
employees provide services in exchange for benefits to be provided later by the employer. Accounting for
employee benefits is complicated because some benefits may be provided many years after employees
have provided services. The measurement of liabilities for employee benefits is made more difficult
because the payment of some employee benefits for past services may be conditional upon the continu-
ation of employment.
LO3 10.3 DEFINING EMPLOYEE BENEFITS

Paragraph 8 of IAS 19 defines employee benefits as including all types of consideration that the employer
may give in exchange for services provided by employees or for the termination of employment. Employee
benefits are usually paid to employees but the term also includes amounts paid to their dependants or to
other parties.
Wages, salaries and other employee benefits are usually recognised as expenses. However, the costs
of employee benefits may be allocated to assets in accordance with other accounting standards. For
example, the cost of labour used in the manufacture of inventory is included in the cost of inventory
in accordance with IAS 2 Inventories. The cost of an internally generated intangible asset recognised
in accordance with IAS 38 Intangible Assets, such as the development of a new production process,
includes the cost of employee benefits for staff, such as engineers, employed in generating the new pro-
duction process.
LO4 10.4 SHORT-TERM EMPLOYEE BENEFITS

Short-term employee benefits are expected to be settled wholly within 1 year after the end of the
annual reporting period in which the employee renders the service. Examples of short-term employee
benefits include wages, salaries, bonuses and profit-sharing arrangements. They also include various
forms of paid leave entitlements for which employees may be eligible. Sick leave and annual leave are
common forms of paid leave entitlements. IAS 19 refers to various forms of leave entitlements as paid
absences.
Short-term employee benefits also include non-monetary benefits, which are often referred to as ‘fringe
benefits’. Non-monetary benefits include the provision of health insurance, housing and motor vehicles.
An entity may offer non-monetary benefits to attract staff. For example, a mining company may provide
housing to employees where there are no major towns located near its mining sites. Non-monetary ben-
efits may also arise from salary sacrifice arrangements, otherwise referred to as salary packaging. A salary
sacrifice arrangement involves the employee electing to forgo some of his or her salary or wages in return
for other benefits, such as a motor vehicle, provided by the employer.
246 PART 2 Elements

10.4.1 Payroll
The subsystem for regular recording and payment of employee benefits is referred to as the payroll. The
payroll involves:
• recording the amount of wages or salaries for the pay period
• updating personnel records for the appointment of new employees
• updating personnel records for the termination of employment contracts
• calculating the amount to be paid to each employee, net of deductions
• remitting payment of net wages or salaries to employees
• remitting payment of deductions to various external parties
• complying with regulatory requirements, such as reporting to taxation authorities.
Entities may process several payrolls. For example, an entity may process a payroll each fortnight for
employees who are paid on a fortnightly basis and process a separate monthly payroll for employees paid
on a monthly basis.
In return for providing services to the employer, employees regularly receive benefits, or remuneration,
in the form of wages or salaries. Employers are typically required to deduct income tax from employees’
wages and salaries. Thus the employee receives a payment that is net of tax, and the employer subse-
quently pays the amount of income tax to the taxation authority.
Employers may offer a service of deducting other amounts from employees’ wages and salaries and
paying other parties on their behalf. For example, the employer may deduct union membership fees from
employees’ wages and make payments to the various unions on behalf of the employees.
Payments made on behalf of an employee from amounts deducted from the employee’s wages or sal-
aries form part of the entity’s wages and salaries expense. As these amounts are typically remitted in the
month following the payment of wages and salaries, they represent a short-term liability for employee
benefits at the end of each month.
Paragraph 11(a) of IAS 19 requires short-term employee benefits for services rendered during the period
to be recognised as a liability after deducting any amounts already paid. Short-term liabilities for employee
benefits must be measured at the nominal (undiscounted) amount that the entity expects to pay.
10.4.2 Accounting for the payroll

Illustrative example 10.1 demonstrates accounting for the payroll, including deductions from employees’
remuneration, the remittance of payroll deductions and the measurement of resulting liabilities at the end
of the period.
ILLUSTRATIVE EXAMPLE 10.1 Accounting for the payroll
Pacific Inc. pays its managers on a monthly basis. All managerial salaries are recognised as expenses. Pacific
Inc.’s employees can elect to have their monthly health insurance premiums deducted from their salaries
and paid to their health insurance fund on their behalf. Pacific Inc. also operates a giving scheme under
which employees can elect to have donations to nominated charities deducted from their salaries and
wages and remitted on their behalf to the selected charities. Figure 10.1 summarises the managerial pay-
rolls for May and June 2016.
May 2016 June 2016

$ $ $ $
Gross payroll for the month 2 400 000 2 500 000

Deductions payable to:
Taxation authority 530 000 600 000
Total Care Health Fund 40 000 40 000
National Health Fund 32 000 32 500
UNICEF 7 000 7 000
Total deductions for the month 609 000 679 500
Net salaries paid 1 791 000 1 820 500
FIGURE 10.1 Summary of Pacific Inc.’s payroll.

Each time the monthly payroll is processed, the cost of the salaries is charged to expense
accounts and a liability is accrued for the gross wages payable. Payments of net wages and salaries
and remittance of payroll deductions to taxation authorities and other parties reduce the payroll
liability account.
The managerial payroll is processed on the second Monday of the month and net salaries are
paid to employees on the following Tuesday. During May, managers earned salaries of $2.4 million.
After deducting amounts for income tax, contributions to health funds and donations, Pacific Inc.
paid its managers a net amount of $1 791 000 during May. All of the deductions are paid to the
various external bodies in the following month. Health insurance deductions are remitted on the
first Friday of the following month. Thus, the deductions for health insurance and union sub-
scriptions for the May payroll are remitted on Friday 3 June. Income tax withheld is remitted on
the 20th of the following month. Deductions for donations are paid on the 21st of the following
month.
The balance of Pacific Inc.’s accrued managerial payroll account at 1 June 2016 is $609 000, being the
deductions from managers’ salaries for income tax, health insurance premiums and donations for May
2016. These amounts are paid during June 2016.
During June 2016, Pacific Inc.’s managers earned gross salaries of $2.5 million. The managers actually
received $1 820 500, being the net wages and salaries after deductions for income tax, health insurance
premiums and donations to charities. In total, $679 500 was deducted from managers’ salaries for June
2016. This amount is a liability at the end of June 2016. The amounts deducted from employees’ salaries
during June 2016 are remitted during July 2016.
The journal entries to record Pacific Inc.’s payroll and remittances for June 2016 are as follows:
June 3 Accrued Payroll Dr 40 000

Bank Cr 40 000
(Payment of May payroll deductions for
Total Health Care Fund)
Accrued Payroll Dr 32 000
Bank Cr 32 000
National Health Fund)
June 13 Salaries Expense Dr 2 500 000

Accrued Payroll Cr 2 500 000
(Managerial payroll for June)
June 14 Accrued Payroll Dr 1 820 500

Bank Cr 1 820 500
(Payment of net salaries for June)
June 20 Accrued Payroll Dr 530 000

Bank Cr 530 000
withheld income tax)
June 21 Accrued Payroll Dr 7000
Bank Cr 7000
UNICEF)
10.4.3 Accrual of wages and salaries

The end of the payroll period often differs from the end of the reporting period because payrolls are
usually determined on a weekly or fortnightly basis. Accordingly, it is usually necessary to recognise an
expense and a liability for employee benefits for the business days between the last payroll period and the
end of the reporting period. This is demonstrated in illustrative example 10.2.
248 PART 2 Elements

ILLUSTRATIVE EXAMPLE 10.2 Accrual of wages and salaries
Canterbury plc pays its employees on a fortnightly basis. The last payroll in the year ended 30 November
2016 was for the fortnight (10 working days) ended Friday 25 November 2016. There were three busi-
ness days between the end of the final payroll period and the end of the reporting period. Assuming the
cost of employee benefits for the remaining three days was £720 000, Canterbury plc would record the
following accrual:
Wages and Salaries Expense Dr 720 000

Accrued Wages and Salaries Cr 720 000
(Accrual of wages and salaries)
The accrued wages and salaries is a liability for short-term employee benefits. Paragraph 16 of IAS 19
requires accrued short-term employee benefits to be measured at nominal value; that is, the amount
expected to be paid to settle the obligation.
10.4.4 Short-term paid absences

Employees may be entitled to be paid during certain absences, such as annual recreational leave or short
periods of illness. Some entities also offer other forms of paid leave, including maternity leave, parental
leave, carers’ leave and bereavement leave. Entitlements to short-term paid absences are those entitlements
that are expected to be settled within 12 months after the end of the reporting period.
Short-term paid absences may be either accumulating or non-accumulating. Non-accumulating paid
absences are leave entitlements that the employee may not carry forward to a future period. For example,
an employment contract may provide for 5 days of paid, non-cumulative sick leave. If the employee does
not take sick leave during the year, the unused leave lapses; that is, it does not carry forward to an increased
entitlement in the following year.
Accumulating paid absences are leave entitlements that the employee may carry forward to a future
period if unused in the current period. For example, an employment contract may provide for 20 days of
paid annual leave. If the employee takes only 15 days of annual leave during the year, the remaining 5 days
may be carried forward and taken in the following year.
Accumulating paid absences may be vesting or non-vesting. If accumulating paid absences are vesting,
the employee is entitled, upon termination of employment, to cash settlement of unused leave. If accumu-
lating paid absences are non-vesting, the employee has no entitlement to cash settlement of unused leave.
For example, an employment contract may provide for cumulative annual leave of 20 days, vesting to a
maximum of 30 days, and non-vesting cumulative sick leave of 10 days per annum. After 2 years of service,
the employee would have been entitled to take 40 days of annual leave and 20 days of sick leave, but
if the employee resigned after 2 years of employment, during which no annual leave or sick leave had been
taken, the termination settlement would include payment for 30 days’ unused annual leave (the maximum
allowed by the employment contract). There would be no cash settlement of the unused sick leave because
it was non-vesting.
Paragraph 13(a) of IAS 19 requires expected short-term accumulating paid absences to be recog-
nised when the employee renders services that increase the entitlement. For example, if its employees
are entitled to 2 weeks of cumulative sick leave for every year of service, the entity is required to accrue
the sick leave throughout the year. The employee benefit — that is, the accumulated leave — is meas-
ured as the amount that the entity expects to pay to settle the obligation that has accumulated at the
end of the reporting period. If the leave is cumulative but non-vesting, it is possible that there will
not be a future settlement for some employees. The sick leave might remain unused when the employ-
ment contract is terminated. However, the sick leave must still be accrued throughout the period of
employment because an obligation arises when the employee provides services that give rise to the
leave entitlement. If the leave is non-vesting, it is necessary to estimate the amount of accumulated
paid absence that the entity expects to pay.
For non-accumulating short-term paid absences, paragraph 13(b) requires the entity to recognise the
employee benefit when the paid absence occurs. A liability is not recognised for unused non-accumulating
leave entitlements because the employee is not entitled to carry them forward to a future period. Hence
there is no obligation.
The alternative forms of short-term paid absences and the corresponding recognition and measurement
requirements are depicted in figure 10.2.

Accumulation Vesting/non-vesting Recognition Liability measurement
Accumulating — employee Vesting — employee Recognised as Nominal, amount

may carry forward unused is entitled to cash employee provides expected to be paid,
entitlement settlement of unused services giving rise to i.e. total vested
leave entitlement accumulated leave
Non-vesting — no cash Recognised as Nominal, amount

settlement of unused employee provides expected to be paid,
leave services giving rise to requires estimation
entitlement of amount that will
be used
Non-accumulating — unused Recognised when paid No liability is

entitlement lapses each period absences occur recognised
FIGURE 10.2 Short-term paid absences
The following illustrative examples demonstrate accounting for short-term paid absences. First, illustra-
tive example 10.3 demonstrates accounting for annual leave.
ILLUSTRATIVE EXAMPLE 10.3 Accounting for annual leave
Schnee AG has four employees in its Alpine branch. Each employee is entitled to 20 days of paid recrea-
tional leave per annum, referred to as annual leave (AL). At 1 January 2016, the balance of the provision
for annual leave was €4360. During the year employees took a total of 70 days of annual leave, which
cost Schnee AG €9160. After annual leave taken during the year had been recorded, the provision for
annual leave account had a debit balance of €4800 in the trial balance at 31 December 2016 before
end-of-period adjustments. All annual leave accumulated at 31 December 2016 is expected to be paid by
31 December 2017. The following information is obtained from the payroll records for the year ended
31 December 2016:
AL 1 January 2016 Increase in

Employee Wage per day in days entitlement in days AL taken in days
Bauer €120 9 20 16
Fiedler €160 7 20 16
Goetz €180 8 20 14
Wagner € 90 8 20 24
A liability must be recognised for accumulated annual leave at 31 December 2016. This is measured as
the amount that is expected to be paid. As annual leave is vesting, all accumulated leave is expected to
be paid. The first step in measuring the liability is to calculate the number of days of accumulated
annual leave for each employee at 31 December 2016. Although this calculation would normally be
performed by payroll software, we will manually calculate the number of days to enhance your under-
standing of the process. The next step is to multiply the number of days of accumulated annual leave by
each employee’s daily wage.
Increase in Accumulated AL Liability for AL

AL 1 January entitlement AL taken 31 December 2016 31 December 2016
Employee in days in days in days in days €
Bauer 9 20 16 13 1 560
Fiedler 7 20 16 11 1 760
Goetz 8 20 14 14 2 520
Wagner 8 20 24 4 360
6 200
250 PART 2 Elements

The calculation of accumulated annual leave in days and the resultant liability are as follows:
Bauer: 9 + 20 − 16 = 13 days × €120 per day = €1560

Fiedler: 7 + 20 − 16 = 11 days × €160 per day = €1760
Goetz: 8 + 20 − 14 = 14 days × €180 per day = €2520
Wagner: 8 + 20 − 24 = 4 days × €90 per day = €360
Thus Schnee AG should recognise a liability of €6200 for annual leave at 31 December 2016. After
recording annual leave taken during the year, the unadjusted trial balance shows a debit balance of €4800
for the provision for annual leave. Thus, a journal entry is required to record an increase of €11 000.

Provision for Annual Leave Cr 11 000
(Accrual of liability for annual leave)
In illustrative example 10.3, an annual adjustment was made to the provision for annual leave. Some
entities make accruals for annual leave more frequently to facilitate more comprehensive internal reporting
to management. This is easily achieved with electronic accounting systems or payroll software.
Accounting for accumulating sick leave is demonstrated in illustrative example 10.4. In this illustration,
the accumulating sick leave is non-vesting.
ILLUSTRATIVE EXAMPLE 10.4 Accounting for accumulating sick leave
Atlantic Inc. has 10 employees who are each paid $500 per week for a 5-day working week (i.e.
$100 per day). Employees are entitled to 5 days of accumulating non-vesting sick leave each year. At
1 January 2016 the accumulated sick leave brought forward from the previous year was 10 days in total.
During the year ended 31 December 2016 employees took 35 days of paid sick leave and 10 days of
unpaid sick leave. One employee resigned at the beginning of the year. At the time of her resignation
she had accumulated 5 days of sick leave. It is estimated that 60% of the unused sick leave will be taken
during the following year and that the remaining 40% will not be taken at all.
After recording sick leave taken during the year, the unadjusted trial balance shows that the provision
for sick leave had a debit balance of $3000 at 31 December 2016.
The following table presents information used to calculate the amount of the provision for sick leave
that Atlantic Inc. should recognise at 31 December 2016:
Sick leave Leave expected to be taken
Base Balance b/d Accumulated Taken or Within After

No. of pay/day 1 January in 2016 lapsed 12 months 1 year
employees $ 2016 Days Days Days % %
10 100 10 50 40 60 0
The 10 employees who were employed for all of the year ended 31 December 2016 each became
entitled to 5 days of sick leave during the year. Thus the total increase in entitlement during the year
is 50 days. During the year, 35 days of paid sick leave were taken and 5 days of sick leave entitlement
lapsed because an employee with 5 days’ accumulated sick leave resigned without having used her enti-
tlement. Thus, the aggregate sick leave entitlement reduced by 40 days during the year.
The first step in measuring the amount of the liability is to calculate the number of days of accumu-
lated sick leave entitlement at 31 December 2016.
Days
Brought forward 1 January 2016 10

Increase in entitlement for services provided in the current year 50
Sick leave entitlement taken or lapsed during the year (40)
Sick leave carried forward 31 December 2016 20

The number of days of accumulated sick leave at the end of the reporting period is multiplied by the
proportion of days expected to be taken, in this case, 60%. This amount, 12 days, is then multiplied by
the current rate of pay per day:
20 days × 60% × $100 per day = $1200
Thus the provision for sick leave should be $1200 Cr at 31 December 2016. The unadjusted balance
of the provision for sick leave is $3000 Dr. Accordingly, the provision must be increased by $4200 as
follows:

Provision for Sick Leave Cr 4 200
(Accrual of liability for sick leave)
For simplicity, the accrual adjustment to recognise sick leave is made at the end of the year in this
example. Many companies make such adjustments throughout the year to provide more complete
internal reporting to management. This is facilitated by payroll software that automates the calculation
of accumulated entitlements.
10.4.5 Profit-sharing and bonus plans

Employers may offer profit-sharing arrangements and bonuses to their employees. Bonuses may be deter-
mined as a lump-sum amount or based on accounting or market-based measures of performance. Many
large companies use bonuses in management incentive schemes. For example, the remuneration received
by the senior executives of BHP Billiton includes base salary, both cash-based and share-based bonuses
linked to performance (incentive-based remuneration) and pension benefits. The components of remuner-
ation for the chief executive officer (CEO) for 2014 are shown in figure 10.3. As can be seen, the majority
of a senior executive’s remuneration can be in forms other than base salary.
Name: Andrew Mackenzie 2015 2014

Position: Chief executive officer (CEO) U$’000 U$’000
Base salary 1 700 1 700
Benefits: tax return preparation in required countries; private 145 92
family health insurance; and spouse business-related travel
Short-term incentive awarded for 2014:50% in cash; and 50% 2 312 3 136
in deferred share-based awards, subject to shareholder approval
Long-term incentive: vesting of LTI awards on 20 August 2014 0 2 635
for performance for the five years ended 30 June 2014
Pension: BHP Billiton’s contribution to defined contribution pension plans 425 425
Total 4 582 7 988
FIGURE 10.3 BHP Billiton CEO Remuneration

Source: BHP Billiton (2015, p. 176).
Paragraph 19 of IAS 19 requires an entity to recognise a liability for profit-sharing and bonus payments
if it has a present obligation to make such payments and the amount can be estimated reliably. A present
obligation exists if the entity has no realistic opportunity to avoid making the payments. The employee’s
performance under an employment contract may give rise to a legal obligation to pay a bonus. Alterna-
tively, a constructive obligation may arise if the entity has a well-established practice of paying the bonus
and has no realistic alternative but to pay the bonus because non-payment may be harmful to the entity’s
relations with its employees.
Liabilities for short-term profit-sharing arrangements and bonuses are measured at the nominal (i.e.
undiscounted) amount that the entity expects to pay. Thus, if payment under a profit-sharing arrangement
is subject to the employee still being employed when the payment is due, the amount recognised as a lia-
bility is reduced by the amount that is expected to go unpaid due to staff turnover. For example, assume
an entity has a profit-sharing arrangement in which it is obligated to pay 1% of profit for the period to
employees and the amount becomes payable 3 months after the end of the reporting period. Based on
252 PART 2 Elements

staff turnover in prior years, the entity estimates that only 95% of employees will be eligible to receive a
share of profit 3 months after the end of the reporting period. Accordingly, the amount of the liability that
should be recognised for the profit-sharing scheme is equal to 0.95% of the entity’s profit for the period.
In this simple example it is assumed the bonus is distributed equally among employees.
LO5 10.5 POST-EMPLOYMENT BENEFITS

Post-employment benefits are benefits, other than termination benefits (which are considered in section 10.9),
that are payable after completion of employment, typically after the employee retires. Where post-
employment benefits involve significant obligations, it is common (and in some countries compulsory)
for employers to contribute to a post-employment benefit plan for employees.
Post-employment benefit plans are defined in paragraph 8 of IAS 19 as arrangements through which an
entity provides post-employment benefits. They are also referred to as pension plans, employee retirement
plans and pension plans. The employer makes payments to a fund. The fund, which is a separate entity,
typically a trust, invests the contributions and provides post-employment benefits to the employees, who
are the members of the fund. Figure 10.4 shows the relations between the employer, the pension fund
(plan) and the employees (members of the fund).
Employer
Pay contributions Render services
Remuneration
for services
Pay contributions (varies)
Employees
Pays benefits to member
Pension plan (members of
on/after retirement
the fund)
FIGURE 10.4 Relationships between the employer, pension plan and employees
The two types of post-employment benefit plans are:

• defined benefit plans and
• defined contribution plans, including multi-employer plans.
Paragraph 8 of IAS 19 refers to defined contribution plans as post-employment plans for which an
entity pays fixed contributions into a separate entity. The contributions are normally based on the wages
and salaries paid to employees. The contributing entity has no legal or constructive obligation to pay
further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to
employees’ services in the current and prior periods. The amount received by employees on retirement is
dependent upon the level of contributions and the return earned by the fund on its investments.
In paragraph 8 of IAS 19, defined benefit plans are defined as post-employment plans other than defined
contribution plans. If a post-employment plan is not classified as a defined contribution plan, by default, it
is a defined benefit plan. Critical to the definition of a defined contribution post-employment benefit plan is
the absence of an obligation for the employer to make further payments if the plan is unable to pay all the
benefits accruing to members for their past service. Thus, defined benefit post-employment plans are those
in which the employer has some obligation to pay further contributions to enable the plan to pay members’
benefits. In a defined benefit post-employment plan, the benefit received by members on retirement is deter-
mined by a formula reflecting their years of service and level of remuneration. It is not dependent upon the
performance of the plan. If the plan has insufficient funds to pay members’ post-employment benefits, the
trustee of the plan will require the employer, who is the sponsor of the plan, to make additional payments.
Similarly, if the plan achieves higher returns than are required to pay members’ post-employment benefits,
the employer may be able to take a ‘contribution holiday’. Employers often prefer defined contribution plans
because there is no risk of liability for further contributions if the plan fails to earn an adequate return.

IAS 19 prescribes accounting treatment for contributions to post-employment benefit plans and assets
and liabilities arising from post-employment benefit plans from the perspective of the employer. It does
not prescribe accounting requirements for the post-employment benefit plan.
LO6 10.6 ACCOUNTING FOR DEFINED CONTRIBUTION

POST-EMPLOYMENT PLANS
As described above, entities that participate in defined contribution post-employment plans make payments to
a post-employment benefit plan. The amount is determined as a percentage of remuneration paid to employees
who are members of the plan. Contributions payable to defined contribution funds are recognised in the
period the employee renders services. The contributions payable during the period are recognised as expenses
unless another standard permits the cost of employment benefits to be allocated to the carrying amount of an
asset, such as internally constructed plant in accordance with IAS 16 Property, Plant and Equipment.
If the amount paid to the defined contribution plan by the entity during the year is less than the amount
payable in relation to services rendered by employees, a liability for unpaid contributions must be recognised
at the end of the period. The liability is measured at the undiscounted amount payable to the extent that con-
tributions are due within 12 months after the reporting period. Paragraph 52 of IAS 19 requires discounting
of liabilities for contributions to defined contribution plans that are due more than 12 months after the
reporting period in which the employee provides the related services. The discount rate used to discount a
post-employment benefit obligation is determined by reference to market yields on high-quality corporate
bonds in accordance with IAS 19 paragraph 83. If the obligation is to be settled in a country that does not
have a deep market in high-quality corporate bonds, the market yield on government bonds must be used.
If the amount paid to the defined contribution plan by the entity during the year is greater than the
amount of contributions payable in relation to services rendered by employees, the entity recognises an
asset to the extent that it is entitled to a refund or reduction in future contributions. In this situation, the
asset would be a prepayment, or prepaid expenses.
ILLUSTRATIVE EXAMPLE 10.5 Accounting for defi ned contribution post-employment plans
Arctic Ltd provides a defined contribution pension plan for its employees. Arctic Ltd is required to con-
tribute 9% of gross wages, salaries and commissions payable for services rendered by employees. It
makes quarterly payments of $80 000 to the pension plan. If the amount paid to the pension plan
during the financial year is less than 9% of gross wages, salaries and commissions for that year, Arctic
Ltd must pay the outstanding contributions by 31 March of the following financial year. If the amount
paid during the financial year is more than 9% of the gross wages, salaries and bonuses for the year, the
excess contributions are deducted from amounts payable in the following year.
Arctic Ltd’s annual reporting period ends on 31 December.
Arctic Ltd’s employee benefits for the year ended 31 December 2016 comprise:
$
Gross wages and salaries 3 900 000
Gross commissions 100 000
4 000 000
The deficit in Arctic Ltd’s pension plan contributions for 2016 is determined as follows:
$
Contributions payable:
9% × gross wages, salaries and commissions 360 000
Contributions paid during 2014: $80 000 × 4 320 000
Pension contribution payable 40 000
Arctic Ltd must recognise a liability for the unpaid pension plan contributions. The liability is not
discounted because it is a short-term employee benefits liability. Arctic Ltd would record the following
entry for 31 December 2016:

Pension contributions payable Cr 40 000
(Accrual of liability for unpaid pension plan contributions)
254 PART 2 Elements

LO7 10.7 ACCOUNTING FOR DEFINED BENEFIT
POST-EMPLOYMENT PLANS
As described in section 10.5, the employer pays contributions to a plan, which is a separate entity from the
employer. The plan accumulates assets through contributions and returns on investments. The accumu-
lated assets are used to pay post-employment benefits to members (retired employees). The return on
investments held by the pension plan comprises dividend and interest income and changes in the fair
value of investments. The benefits paid to members are a function of their remuneration levels while
employed and the number of years of service. The trustee of the plan may require the employer to make
additional contributions if there is a shortfall. Thus, the employer effectively underwrites the actuarial
and investment risks of the plan. In other words, the entity bears the risk of the plan being unable to pay
benefits.
The assets of the pension plan, which are mostly investments, do not always equal its obligation to
pay post-employment benefits to members. The pension plan has a deficit to the extent that the present
value of the defined benefit obligation (i.e. post-employment benefits that are expected to be paid to
employees for their services up to the end of the reporting period) exceeds the fair value of the plan assets.
Conversely, a surplus arises when the fair value of the plan assets exceeds the present value of the defined
benefit obligation.
Whether the deficit (surplus) of the defined benefit pension plan is a liability (asset) of the sponsoring
employer is debatable. Some argue that the surplus in the pension plan does not satisfy all of the charac-
teristics of an asset. Arguably, the assets of the plan are not controlled by the employer because they cannot
be used for its benefit. For example, the employer may not use the surplus of the defined benefit pension
plan to pay its debts; the assets of the plan are only used to generate cash flows to pay post-employment
benefits to the members of the plan. Although the surplus is expected to result in future cash savings, such
as lower contributions in future, it could be argued that the employer has not obtained control over those
benefits through a past event where the reduction in contributions is at the discretion of the trustee of the
pension plan.
Similarly, it has been argued that a deficit in the defined benefit pension plan is not a liability of the
sponsoring employer because it does not have a present obligation to make good the shortfall. For instance,
the employer may modify the post-employment benefits payable so as to avoid some of the obligation.
The perspective adopted in IAS 19 is that the surplus or deficit of the defined benefit pension plan
is an asset, or liability, respectively, of the sponsoring employer. In some cases, the entity might not
have a legal obligation to make good any shortfall in the pension plan. For example, the terms of the
trust deed may allow the employer to change or terminate its obligation under the plan. Although
the employer might not have a legal obligation to make up any shortfall, it typically has a constructive
obligation because terminating its obligations under the plan may make it difficult to retain and
recruit staff. Accordingly, the accounting treatment prescribed by IAS 19 for an entity’s obligations
arising from sponsorship of a defined benefit plan assumes that the entity will continue to promise
the post-employment benefits over the remaining working lives of its employees. Similarly, the standard
reflects the view that any surplus of the fund represents expected future inflows, in the form of reduced
contributions, arising from having contributed more than is needed in the past. The standard and Basis
for Conclusions focus on how to measure the resulting asset rather than justifying whether it meets the
definition and recognition criteria.
If adopting the view that a deficit or surplus of the defined benefit pension plan is a liability or asset
of the sponsoring employer, the next conceptual issue is whether it should be recognised and, if so, how
it should be measured. Before looking at how the standard setters resolved these issues, we will consider
the possibilities, which are shown in figure 10.5. At one extreme, the deficit or surplus is not recognised in
the financial statements of the entity that sponsors the defined benefit pension plan. In other words, the
deficit or surplus is ‘off balance sheet’. At the other extreme, referred to as ‘net capitalisation’, the deficit
(surplus) of the fund is recognised as a liability (asset) on the statement of financial position of the entity
that sponsors the defined benefit pension plan. Under net capitalisation, the net pension liability or asset
is usually measured as the difference between the present value of post-employment benefits earned by
employees for services in the current and prior periods and the fair value of plan assets. Between these
two extremes are various partial capitalisation methods in which some amount of the surplus or deficit of
the fund remains off balance sheet. For example, an earlier version of IAS 19 permitted increments in the
defined benefit obligation resulting from prior periods (referred to as past service costs) to be recognised
progressively over the average remaining period until they became vested.
Partial recognition
Off balance sheet Recognised in full
Pension plan surplus or deficit
FIGURE 10.5 Alternative approaches to accounting for defined benefit pension plans

In the absence of accounting regulation, preparers were able to select different approaches to accounting
for defined benefit post-employment benefits, ranging from off balance sheet to net capitalisation. For
instance, many companies in the United States kept their obligations for defined benefit pension plans
off balance sheet prior to the introduction of FAS 158: Defined Benefit Pension and other Post-retirement
Pension Plans in 2006.
Obviously, the use of different methods of accounting for post-employment benefits reduces the com-
parability of financial statements. Concerns were also raised about delays in recognition of liabilities
perpetuated by partial capitalisation methods. Untimely recognition of assets or liabilities arising under
post-employment benefit plans results in misleading information in the statement of financial position
which is not adequately resolved by additional disclosures in the notes. The International Accounting
Standards Board (IASB®) and the US Financial Accounting Standards Board (FASB) jointly undertook a
project to enhance the comparability and transparency of accounting for post-employment benefits (IASB
2008), resulting in a revised version of IAS 19 Employee Benefits. We will now turn to the requirements of
IAS 19 for accounting for defined benefit post-employment benefits.
The net capitalisation approach is adopted by IAS 19. Thus, the sponsoring employer recognises a net
defined benefit liability or asset, representing its exposure to the defined benefit pension plan at the end of
the reporting period. Contributions paid into the plan by the employer increase the assets of the plan, and
thus increase a surplus or reduce any deficit of the plan. The employer accounts for its contributions to the
plan as a decrease in the net defined benefit liability, or an increase in the net defined benefit asset. The
employer recognises expenses in relation to its sponsorship of the defined benefit pension plan when ser-
vice costs and interest costs are incurred, rather than when contributions are paid. This will become clear
as we work through the revised requirements of IAS 19 for accounting for defined benefit pension plans.
The key steps involved in accounting by the employer for a defined benefit post-employment plan in
accordance with IAS 19 (paragraph 57) are:
1. determining the deficit or surplus of the plan
2. determining the amount of the net defined benefit liability (asset), which is the amount of the deficit
or the surplus, adjusted for any effect of limiting a net-defined benefit asset to the asset ceiling, which is
explained below
3. determining the amounts to be recognised in profit or loss for current service cost, any past service cost
and net interest expense (income) on the net defined benefit liability (asset)
4. determining the remeasurement of the net defined benefit liability (asset) to be recognised in other
comprehensive income, which comprises actuarial gains and losses, return on plan assets (other than
amounts included in net interest), and any change in the effect of the asset ceiling (other than amounts
included in net interest).
We will now take a closer look at each step.
10.7.1 Step 1: Determining the deficit or surplus of the plan

There are two elements to determining the deficit or surplus of the plan — the obligation to pay benefits
and any plan assets. Paragraph 67 of IAS 19 requires an entity to use the projected unit credit method to
determine the present value of post-employment benefits earned by employees for services in the current
and prior periods. Other names for the projected unit credit method include the accrued benefit method
pro-rated on service and the benefits/years of service method. The projected unit credit method, which
attributes a proportionate amount of additional benefit to each period of service, is shown in illustrative
example 10.6.
ILLUSTRATIVE EXAMPLE 10.6 Determining the present value of the defi ned benefi t obligation using the projected
unit credit method
Dickens plc provides a defined benefit pension plan in which employees receive post-employment benefits
determined as 1% of their final year salary, for every year of service. Salaries are expected to increase by
5% (compound) each year. The accountant has determined that the appropriate discount rate is 10% p.a.
Charles commenced working for Dickens plc on 2 January 2016 with an annual salary of £40 000 and is
expected to retire on 31 December 2018. For simplicity, this example ignores the additional adjustment
that would be necessary to reflect the probability that Charles will resign or retire at a different date.
To understand the table below, you will need to read the following explanation which commences
with the figure in the bottom right cell. At 31 December 2018 Charles will be entitled to 3% of his
final year salary for three years of service. If his salary increases by 5% p.a., his salary for the year ended
31 December 2018 will be £44 100. At 3% of final year salary, Charles’ post-employment benefit will
be £1323 (£44 100 × 3%). Note that this is the amount in the ‘Total current and prior years’ of the
column labelled ‘Year ended 31/12/18’. The benefit attributed to each year is 1/n of the total benefit pay-
able after n years. In this example, the amount attributed to each year is £441, being 1/3 of £1323. The
amount of £441 is the amount in the row labelled ‘Current year’ in the column for each year. The total
256 PART 2 Elements

current and prior year amount for each year is carried forward in the table as the prior year amount in
the next year.
Schedule of changes in the defined benefit obligation
Year ended 31/12/16 Year ended 31/12/17 Year ended 31/12/18

£ £ £
Prior year 0 441 882

Current year 441 441 441
Total current and prior years 441 882 1 323
The obligation is measured as the present value of the accumulated post-employment benefit at the
end of each period. In this example a discount rate of 10% is used. Each period the present value increases
partly as a result of current year benefits relating to service, and partly because the discounting period
is reduced as the time to settlement decreases. The present value of the accrued benefits increases as the
expected settlement time approaches because the expected settlement is discounted over a shorter period
of time. The difference in the present value attributable to discounting over a shorter period is accounted
for as interest expense. The interest component is calculated for each period by multiplying the opening
balance of the liability by the interest rate.
The following table illustrates the increase in the defined benefit obligation over the 3-year period,
differentiating between the service cost and interest elements. The opening obligation is the present
value of the benefit attributed to Charles’ prior years. The interest cost for the year ended 31 December
2016 is nil because the opening balance of the obligation is nil for that year. The current service cost is
the present value of the defined benefit attributed to the current year. For example, the benefit attributed
to current service is £441 for 2016, as per the table above. This is the increase in Charles’ defined benefit
entitlements attributable to his services during 2016. This amount is expected to be settled 2 years later,
on 31 December 2018. Accordingly, the current service cost for 2016 is measured as the present value of
the benefit attributed to that year, which is calculated as £441/(1 + 0.1)2 = £365. The closing obligation
is the present value of the benefit attributed to current and prior years. The closing balance of one year
forms the opening balance of the next year. Thus the opening balance for 2017 is £365 and the interest
cost for that year is £36, being £365 × 10%.
Schedule of current service cost, interest and present value of the defined benefit obligation

£ £ £
Opening obligation 0 365 802

Interest at 10% 0 36 80
Current service cost 365 401 441
Closing obligation 365 802 1 323
To complete the first step, it is necessary to determine the difference between the fair value of plan
assets and the present value of the defined benefit obligation. The excess of the defined benefit obli-
gation over the fair value of the plan assets is the deficit of the plan. Conversely, any excess of the fair
value of plan assets over the present value of the defined benefit obligation is a surplus of the plan. The
previous example is based on an individual to simplify the calculations of accrued benefits. However,
the plan would typically provide multiple members and the plan assets would generate cash inflows to
be used to settle obligations to all members.
ILLUSTRATIVE EXAMPLE 10.7 Determining the deficit or surplus of the defi ned benefi t pension plan
To illustrate the calculation of the deficit or surplus of the defined benefit pension plan, we will assume
the following information about the assets and obligations for post-employment benefits of Dickens
Employee Pension Plan:

31/12/16 31/12/17 31/12/18
£ £ £
Closing obligation 4 900 5 700 6 550

Fair value of plan assets 4 500 5 400 6 600
Deficit (surplus) of the plan 400 300 (50)
The closing obligation is the present value of the defined benefit obligation at the end of each
reporting period. The plan has a deficit of £400 at 31 December 2016. This amount is calculated as
‘£4900 – £4500’, which is the amount by which the present value of the defined benefit obligation exceeds
the fair value of plan assets. At 31 December 2017, the plan has a deficit of £300, being the excess of the
obligation of £5700 over the fair value of plan assets, £5400. At 31 December 2018, the fair value of plan
assets exceeds the defined benefit obligation. Accordingly, the defined benefit pension plan has a surplus
of £50, being the fair value of plan assets, £6600, less the defined benefit obligation, £6550.
Obligations to pay pensions during employees’ lives or that of their eligible dependants can further
complicate the measurement of accrued benefits because the total payment is dependent upon the mor-
tality rate of the employees and their eligible beneficiaries. Companies often rely on actuarial assess-
ments to estimate the defined benefit obligation and the level of investment required to enable the
plan to pay accumulated benefits as and when they fall due. Actuaries apply mathematical, statistical,
economic and financial analysis to assess risks associated with contracts, such as insurance policies and
pension plans. Actuarial estimates rely on assumptions, such as the employee retention rates and the
rate at which salaries are expected to increase. Actuaries also provide financial planning advice, on mat-
ters such as the level of investment needed to generate sufficient future cash flows to meet the expected
obligations as and when they fall due.
10.7.2 Step 2: Determining the amount of the net defined

benefit liability (asset)
A net defined benefit liability arises when the defined benefit pension plan has a deficit. The net defined
benefit liability is measured as the amount of the deficit of the defined benefit pension plan, which is cal-
culated following the procedure described in step 1. For example, in illustrative example 10.7 the amount
of the net defined benefit liability for the year ended 31 December 2017 is £300.
A net defined benefit asset arises when the defined benefit pension plan has a surplus. The net defined
benefit asset is measured as the amount of the surplus, adjusted for any effect of limiting a net defined
benefit asset to the asset ceiling. The asset ceiling is defined in paragraph 8 of IAS 19 as ‘the present
value of any economic benefits available in the form of refunds from the plan or reductions in future
contributions to the plan’. The net defined benefit asset is the lower of the surplus of the defined ben-
efit pension plan and the asset ceiling. For example, if we assume that the present value of reductions
in Dickens plc’s future contributions to the plan at 31 December 2018 were £60, the net defined benefit
asset of Dickens plc would be measured as £50, being the lower of the surplus of the defined benefit
plan and the asset ceiling. However, if the present value of reductions in Dickens plc’s future contribu-
tions to the plan at 31 December 2018 were only £40, its net defined benefit asset would be measured
as £40.
10.7.3 Step 3: Determining the amounts to be recognised

in profit or loss
The amount of the net defined benefit liability (asset) is affected by the present value of the defined benefit
obligation and the fair value of plan assets. The present value of the defined benefit obligation is affected
by the service cost, which comprises current service cost, past service cost and any gain or loss on settle-
ment of the defined benefit.
Current service cost is ‘the increase in the present value of defined benefit obligation resulting from
employee service in the current period’ (IAS 19 paragraph 8). The service cost for each year in illustrative
example 10.6 is a current service cost to Dickens plc because it is the increase in the present value of the
defined benefit obligation attributed to employment services rendered by Charles during each year.
Past service cost is defined in paragraph 8 of IAS 19 as the change in the present value of the defined
benefit obligation for employee service in prior periods. This occurs if the plan is amended or curtailed.
258 PART 2 Elements

Illustrative example 10.8 draws on the same information as used in illustrative example 10.6, with the
addition of an amendment to the terms of the pension plan.
Paragraph 8 of IAS 19 defines the net interest on the net defined benefit liability (asset) as the change
in the net defined benefit liability (asset) that arises from the passage of time. The net interest on net
defined benefit liability (asset) is measured by multiplying the discount rate that is used to measure the
defined benefit obligation at the beginning of the period by the net defined benefit liability (asset) (IAS
19 paragraph 123). Paragraph 83 requires the discount rate to be determined with reference to market
yields on high-quality corporate bonds. In the absence of a deep market in such bonds, the market yield
on government bonds should be used. The standard requires contributions received and benefits paid
by the plan to be taken into account when calculating interest. This involves recalculating interest for
part of the year each time the plan assets are increased by a contribution or where payment of benefits
resulted in settlement gains or losses, giving rise to change in the net defined benefit liability or asset.
Throughout this text, this process is simplified by applying the discount rate to the opening balance of
the net defined benefit liability (asset), effectively assuming contributions and benefits are paid at the
end of each year.
When the pension plan pays benefits to a member, both the plan assets and the defined benefit
obligation are reduced. If, at the time of settlement, the carrying amount of the obligation to the
member is equal to the amount actually payable, the settlement will have no effect on the surplus
or deficit of the plan. However, the carrying amount of the defined benefit obligation results from
numerous actuarial estimates which may differ from amounts actually due at settlement. Differences
between the carrying amount of the defined benefit obligation of the plan and the amount actually
paid to a member give rise to a gain or loss on settlement, which is a service cost recognised in profit
or loss.
ILLUSTRATIVE EXAMPLE 10.8 Modifications to a defi ned benefi t pension plan
At the beginning of 2018 Dickens plc modified the terms of the defined benefit pension plan from 1%
of final year salary per year of service to 0.9% of final year salary per year of service. The modification
applied retrospectively to services rendered before 2018. Accordingly, after the modification the defined
benefit payable at 31 December 2018 is expected to be 2.7% of final year salary instead of 3% of final
salary, which had been used in the measurement of the defined benefit obligation at 31 December 2017.
The revised defined benefit payable to Charles at 31 December 2018 is expected to be £1191. This is
calculated as 2.7% of Charles’ final year salary (2.7% × £44 100 = £1191). Applying the projected credit
method, the annual service cost is £397.
Schedule of changes in the defined benefit obligation
Benefit attributed to: Year ended 31/12/16 Year ended 31/12/17 Year ended 31/12/18
£ £ £
Prior year 0 397 794

Current year 397 397 397
Total current and prior years 397 794 1 191
The following schedule shows the current service cost, interest cost and present value of the defined
benefit obligation on the basis of the revised terms of the plan, under which the benefit payable is 0.9%
of salary for each year of service. The present value of the increase in the defined benefit obligation
attributed to current service cost is £328 and £361 in 2016 and 2017, respectively. These present values
are determined using the discount rate of 10%.
Schedule of current service cost, interest and present value of the defined benefit obligation

£ £ £
Opening obligation 0 328 722

Interest at 10% 0 33 72
Closing obligation 328 722 1 191

Workings:
2016 Current service cost = £397/(1 + 0.1)2 = £328

2017 Current service cost = £397/(1 + 0.1)1 = £361; Interest cost = £328 × 10% = £33
2018 Interest cost = £722 × 10% = £72
Recall that the terms of the defined benefit pension plan were modified at the beginning of 2018.
Until 31 December 2017, the measurement of the present value of the defined benefit obligation had
been based on a benefit of 1% of final salary for each year of service. This yielded a present value of £802
at 31 December 2017 as shown in illustrative example 10.6. From the beginning of 2018, the amount
of the present value of the defined benefit obligation should be remeasured based on a benefit of only
0.9% of final year salary for each year of service. This yields a present value of £722 as shown in the
immediately preceding schedule. Accordingly, the opening obligation for the year ended 31 December
2018 should be adjusted for a past service cost of (£80) as follows:
Year ended 31/12/17 Year ended 31/12/18

£ £
Opening obligation 365 802

Past service costs arising from — (80)
modifications to the plan
Adjusted obligation 722
Interest at 10% 36 72
Current service cost 401 397
Closing obligation 802 1 191
Current and past service cost, interest income or expense and settlement gains or losses are recognised
in profit or loss.
10.7.4 Step 4: Determining the remeasurements of the net

defined benefit liability (asset) to be recognised in other
Changes in the net defined benefit liability (asset) that result from remeasurements comprise actuarial
gains and losses, return on plan assets (other than amounts included in net interest), and any change in
the effect of the asset ceiling (excluding amounts included in net interest).
Actuarial gains and losses occur when changes in actuarial assumptions or experience adjustments
affect the present value of the defined benefit obligation. The measurement of the defined benefit
obligation is sensitive to assumptions such as employee turnover and the rate of increase in salaries.
For example, an increase in the rate of salary increase used in measuring the defined benefit obligation
would increase the expected future settlement and, hence, the present value of the defined benefit
obligation. An increase in the rate of salary increase results in an actuarial loss because it increases the
present value of the defined benefit obligation. Another example of a change in an actuarial assump-
tion is a change in the discount rate used to determine the present value of the obligation. An increase
in the discount rate results in an actuarial gain because it reduces the present value of the defined
benefit obligation.
Experience adjustments refer to differences between the actual results and previous actuarial estimates
used to measure the defined benefit obligation. An example is the difference between the estimated
employee turnover for the year and the actual employee turnover during the year. Experience adjustments
may also relate to early retirement, mortality rates and the rate of increase in salaries.
The return on plan assets is determined after deducting the costs of managing the plan assets and tax
payable by the pension plan on its income derived from plan assets. Other administration costs are not
deducted from the return on plan assets (IAS 19 paragraph 130).
The effects of remeasurements of the net defined benefit liability (asset) are recognised in other com-
prehensive income. Amounts recognised in other comprehensive income as a result of remeasurments of
260 PART 2 Elements

the net defined benefit liability are not able to be reclassified to profit or loss. (The reclassification of items of
other comprehensive income to profit or loss is considered in chapter 16.) The recognition of actuarial gains and
losses as items of other comprehensive income shields reported profit from the volatility that these items
can cause.
ILLUSTRATIVE EXAMPLE 10.9 Accounting for a defi ned benefi t pension plan
Gesundheit GmbH has a defined benefit pension plan for its senior managers. Members of the plan had
been entitled to 10% of their average salary for every year of service.
The following information is available about the Gesundheit Pension Plan:
€’000
31 December 2016
Present value of defined benefit obligation at 31 December 2016 26 000
Fair value of plan assets at 31 December 2016 30 000
Asset ceiling at 31 December 2016 4 200
Interest rate used to measure the defined benefit obligation 31 December 2016 7%
1 January 2017
Past service costs 5 000
Year ended 31 December 2017
Current service cost 4 000
Contributions received by the plan 4 500
Benefits paid by the plan Nil
Return on plan assets 800
Actuarial gain resulting from change in the discount rate, 31 December 2017 1 470
Present value of defined benefit obligation at 31 December 2017 35 700
Fair value of plan assets at 31 December 2017 37 400
Asset ceiling at 31 December 2017 2 500
Interest rate used to measure the defined benefit obligation 31 December 2017 8%
(a) The current service cost is given as €4 million. This estimation is based on actuarial advice provided
by the manager of the pension plan.
(b) Actuarial advice has been obtained for the present value of the defined benefit obligation at 31
December 2016 and 2017.
(c) On 1 January 2017 Gesundheit GmbH revised its defined benefits and increased the entitlement to
11% of average salary. The revision to the defined benefit plan resulted in an increase in the defined
benefit obligation of €5 million on 1 January 2017.
(d) During 2017, Gesundheit GmbH contributed €4 500 000 to the plan. All of the contributions to
the Gesundheit Pension Plan are paid by Gesundheit GmbH. The senior managers of Gesundheit
GmbH, who are the members of the plan, do not pay any contributions.
(e) The discount rate used to measure the defined benefit obligation was increased from 7% to 8% on
31 December 2017, resulting in a decrease of €1 470 000 in the present value of the defined benefit
obligation.
(f) The fair value of plan assets is derived from valuations performed by Helf & Gott Valuers each year.
The information shown above is used to prepare the journal entries to account for Gesundheit GmbH’s
pension liability (asset) for 2017 in accordance with IAS 19. But first we will determine the amount of
the net defined benefit liability (asset) at 31 December 2016.
Gesundheit Pension Plan had a surplus of €4 000 000, being the excess of the fair value of plan assets
over the present value of the defined benefit obligation, at 31 December 2016. Gesundheit GmbH recog-
nised a net defined benefit asset of €4 000 000, being the lesser of the surplus and the asset ceiling of
€4 200 000.
Next we will consider the four steps involved in accounting by the employer for a defined benefit
post-employment plan identified by IAS 19 (paragraph 57). The defined benefit worksheet, which is
shown below for the Gesundheit Pension Plan, incorporates the four steps and provides workings for
the summary journal entries to account for the defined benefit post-employment plan in the books of
the employer and provides a basis for the disclosure requirements required by IAS 19.

Gesundheit Defined Benefit Pension Plan Worksheet
Gesundheit Pension
Gesundheit GmbH Plan
Profit/loss OCI Bank Net DBL(A) DBO Plan Assets

€’000 €’000 €’000 €’000 €’000 €’000
Balance 31/12/16 4 000 Dr 26 000 Cr 30 000 Dr

Past service cost 5 000 Dr 5 000 Cr
Revised balance 1/1/17 1 000 Cr 31 000 Cr 30 000 Dr
Net interest at 7% 70 Dr 2 170 Cr 2 100 Dr
Current service cost 4 000 Dr 4 000 Cr
Contributions to the plan 4 500 Cr 4 500 Dr
Benefits paid by the plan 0 0
Return on plan assets 800 Cr 800 Dr
Actuarial gain: DBO 1 470 Cr 1 470 Dr
Journal entry 9 070 Dr 2 270 Cr 4 500 Cr 2 300 Cr
Balance 31/12/17 1 700 Dr 35 700 Cr 37 400 Dr
Adjustment for asset Not
ceiling if < deficit applicable
Balance 31/12/17 1 700 Dr 35 700 Cr 37 400 Dr
Step 1: Determining the deficit or surplus of the fund

The pension plan has a surplus of €1 700 000 at 31 December 2017. This is shown in the last row of the
defined benefit worksheet, and can be calculated as the excess of the fair value of plan assets (€37 400 000)
over the present value of the defined benefit obligation (DBO) (€35 700 000).
Step 2: Determining the amount of the net defined benefit liability (asset) — DBL(A)
The net defined benefit asset (DBA) is €1 700 000, being the lesser of the surplus of €1 700 000 and the
asset ceiling of €2 500 000 at 31 December 2017.
Step 3: Determining the amounts to be recognised in profit or loss

The increase in the DBO of €5 000 000 resulting from the past service cost is recognised as an
expense in profit or loss. The revised balance of the net defined benefit liability is €1 000 000, cal-
culated as the deficit of the plan, being the excess of the DBO over the fair value of plan assets after
accounting for the past service cost. The revised balance of the DBL(A) is used in the calculation of
the interest cost.
The net interest is €70 000 determined as 7% of the net DBL after taking into account the past service
cost, as shown in the defined benefit worksheet. The net interest is recognised in profit or loss. The interest
component of the increase in the DBO and the fair value of plan assets is €2 170 000 and €2 100 000,
respectively.
The current service cost of €4 000 000 increases the DBO. The current service cost is recognised in
profit or loss.
Thus the three items recognised in profit or loss, the past service cost, the net interest and the
current service cost, amount to €9 070 000 as shown in the journal entry line of the defined benefit
worksheet.
Step 4: Determining the amount of remeasurements to be recognised in other comprehensive income

There are two remeasurements of the net defined benefit asset during 2017. One remeasurement results
from the return on plan assets exceeding the interest income included in net interest recognised in profit
or loss. The return on plan assets affects the fair value of plan assets as shown in the defined benefit
worksheet. The other remeasurement results from the increase in the discount rate used to measure the
present value of the DBO, which reduces the DBO by €1 470 000, as shown in the defined benefit work-
sheet. The effects of the remeasurements are recognised in other comprehensive income (OCI) as shown
in the defined benefit worksheet.
The payment of contributions during 2017 increases the net defined benefit asset and increases the
plan assets.
Any benefits paid to members during the period would reduce both the plan assets and the DBO. It
appears in the pension plan columns only because it is a transaction of the plan, and not a transaction
of the sponsoring employer.
262 PART 2 Elements

The worksheet provides working papers for the journal entries to account for the defined benefit pen-
sion plan in the books of Gesundheit GmbH. The summary journal entries are shown below.
Summary entry Pension Expense (P/L) Dr 9 070 000

Pension Plan Gain (OCI) Cr 2 270 000
Bank Cr 4 500 000
Net Defined Benefit Pension Asset Cr 2 300 000
(Payment of pension contributions and
recognition of changes in net pension asset)
The defined benefit worksheet also provides a basis for preparation of notes to the financial state-
ments for some of the disclosures required by IAS 19 in respect of defined benefit post-employment
plans. Paragraph 140 includes a requirement for a reconciliation of the opening balance to the closing
balance of the net defined benefit liability (asset), showing separate reconciliations for plan assets, the
present value of the defined benefit obligation and the effect of the asset ceiling. Each reconciliation is
required to show the effect, if applicable, of past service cost and gains and losses arising on settlement,
current service cost, interest income or expense, and remeasurement of the net defined liability (asset),
showing separately return on plan assets excluding amounts included in interest, actuarial gains arising
from changes in demographic assumptions, actuarial gains and losses arising from changes in financial
assumptions and changes in the effect, if any, of the asset ceiling (IAS 19 paragraph 141). Paragraph 141
also requires disclosure of contributions, distinguishing between those paid by the employer and those
paid by the members of the plan, and benefits paid. Other reconciliation items include the effects of
changes in foreign exchange rates and the effects of business combinations and disposals.
The net capitalisation method can result in large gains and losses being recognised in profit or loss, or
other comprehensive income, due to changes in the surplus or deficit of the fair value of plan assets over
the present value of the defined benefit obligation. For instance, the present value of the defined benefit
obligation increases if employee retention is greater than the amount assumed in the previous actuarial
estimate. Similarly, an unexpected decline in the return on investment of plan assets may cause the plan
assets to grow at a slower rate than the present value of the defined benefit obligation, giving rise to an
increase in the pension liability recognised by the employer. The net capitalisation method is unpopular
with some preparers of financial statements who would prefer less volatility of earnings.
LO8 10.8 OTHER LONG-TERM EMPLOYEE BENEFITS

Long-term employee benefits are benefits for services provided in the current or prior periods that will not
be paid until more than 12 months after the end of the period. Post-employment benefits were considered in
section 10.5. This section considers long-term employee benefits that are provided to employees during the
period of their employment. A common form of long-term employee benefit is long service leave, which
is a paid absence after the employee has provided a long period of service, such as 3 months of paid leave
after 10 years of continuous employment.
Long service leave accrues to employees as they provide service to the entity. The principle adopted
by IAS 19 is that an obligation arises for long service leave when the employees provide services to the
employer, even though the employees may have no legal entitlement to the leave. Thus, a liability is recog-
nised for long service leave as it accrues. Long service leave payments reduce the long service leave liability.
Accounting for other long-term employee benefits is similar to accounting for defined benefit post-
employment plans except that the effects of remeasurements are not recognised in other comprehensive
income (IAS 19 paragraphs 154–55). Thus the net liability (asset) for long-term employee benefits is
measured as the net of the present value of the defined benefit obligation at the reporting date minus the
fair value at the reporting date of plan assets (if any) out of which the obligations are to be settled directly,
subject to adjustment of a net asset for the effects of an asset ceiling, if applicable.
In some countries it is extremely unusual to establish plan assets to provide for the payment of long
service leave benefits to employees. Thus, the accounting treatment for long service leave benefits is usually
confined to the recognition of the present value of the obligation measured in accordance with the pro-
jected unit credit method.
The projected unit credit method measures the obligation for long-term employee benefits by calculating
the present value of the expected future payments that will result from employee services provided to date. The
measurement of the present value of the obligation for long service leave payments is complicated by the need
to make several estimates. These include estimation of when the leave will be taken, projected salary levels, and
the proportion of employees who will continue in the entity’s employment long enough to become entitled to
long service leave. Actuarial advice is often used in the measurement of long service leave obligations.

The steps involved in the measurement of a liability for long service leave are as follows:
1. Estimate the number of employees who are expected to become eligible for long service leave. The probability
that employees will become eligible for long service leave generally increases with the period of employ-
ment. For example, if an entity provides long service leave after 10 years of employment, the probability
that employees who have already been working for the entity for 7 years will continue in employment
for another 3 years is very high, as the closer proximity to long service leave entitlement provides an
incentive to employees to stay with their current employer.
2. Estimate the projected wages and salaries at the time that long service leave is expected to be paid. This step
involves the application of expected inflation rates or other cost adjustment rates over the remaining
period before long service leave is paid. Applying an estimated inflation rate:
Projected salaries = current salaries × (1 + inflation rate)n

where n = number of years until long service leave is expected to be paid.
For example, for employees who have 3 years remaining before long service leave is expected to be
paid, current salaries are projected over a period of 3 years.
3. Determine the accumulated benefit. The projected unit credit is determined as the proportion of projected
long service leave attributable to services that have already been provided by the employee.
The accumulated benefit is calculated as:
Years of employment weeks of paid leave

× × projected salaries
Years required for LSL 52
4. Measure the present value of the accumulated benefit. The accumulated benefit is discounted at a rate deter-
mined by reference to market yields on high-quality corporate bonds, in accordance with paragraph 83.
If the country in which the long service leave entitlement will be paid does not have a deep market in
high-quality corporate bonds, the government bond rate is used.
accumulated benefit
Present value =
(1 + i)n
where i is the interest rate on high-quality corporate bonds maturing n years later.
The liability for long service leave is a provision. After determining the amount of the obligation for
long service leave at the end of the period, following steps 1 to 4 above, the provision is increased or
decreased as required.
Illustrative example 10.10 demonstrates the measurement of the obligation for long service leave,
applying the projected unit credit method in accordance with IAS 19, and the entries to account for
changes in the provision for long service leave.
ILLUSTRATIVE EXAMPLE 10.10 Accounting for long service leave
Green Ltd commenced operations on 2 January 2016 and had 150 employees. Average salaries were
$60 000 per annum for the year. Green Ltd accounts for all recognised employee costs as expenses.
Employees are entitled to 13 weeks of long service leave after 10 years of employment. The following
information is based on advice received from actuarial consultants at 31 December 2016:
Number of years unit credit 1 year

Number of years until long service leave is expected to be paid 9 years
Probability that long service leave will be taken (proportion of employees
expected to stay long enough to become entitled to long service leave) 50%
Expected increase in salaries (based on inflation) 2% p.a.
Yield on 9-year high-quality corporate bonds at 31/12/16 10%
The discount rate is determined using 9-year bonds because the long service leave is expected to be
paid 9 years after the end of the reporting period.
Step 1: Estimate the number of employees who are expected to become eligible for long service leave.
50% × 150 employees = 75 employees
264 PART 2 Elements

Step 2: Estimate the projected salaries.
= Salary × (1 + inflation rate)n

= $60 000 × 75 employees × (1 + 0.02)9 = $5 377 917
The current salary is inflated over 9 years because employees are expected to take long service leave
9 years after the end of the reporting period.
Step 3: Determine the accumulated benefit.

= × × projected salaries
1 13
= × × $5 377 917 = $134 448
10 52
Step 4: Measure the present value of the accumulated benefit.
Accumulated benefit
=
(1 + i)n
= $134 448 / (1 + 0.1)9 [or $134 448 × 0.4241 from present value tables]
= $57 019
The change in the provision for long service leave is recorded by the following journal entry:
2016
31 December Long Service Leave Expense Dr 57 019
Provision for Long Service Leave Cr 57 019
(Increase in provision for long service leave)
Note there was no beginning of period provision for long service leave as this is the first year.
During the following year, Green Ltd’s 150 employees continued to work for the company. Average
salaries increased to $68 000 per annum for the year. The following information is based on advice
received from actuarial consultants at 31 December 2017:
Number of years unit credit 2 years

Number of years until long service leave is expected to be paid 8 years
Probability that LSL will be taken (proportion of employees 55%
expected to stay long enough to be entitled)
Expected increase in salaries (based on inflation) 2% p.a.
Yield on 8-year high-quality corporate bonds 31/12/17 9%
The discount rate is determined using 8-year bonds because the long service leave is expected to be
paid 8 years after the end of the reporting period.
Step 1: Estimate the number of employees who are expected to become eligible for long service
leave.
55% × 150 employees = 82.5 employees
Step 2: Estimate the projected salaries.
= Salary × (1 + inflation rate)n

= $68 000 × 82.5 employees × (1 + 0.02)8 = $6 573 009
The current salary is inflated over 8 years because employees are expected to take long service leave
8 years after the end of the reporting period.

Step 3: Determine the accumulated benefit.

= × × projected salaries
2 13
= × × $6 573 009 = $328 650
10 52
Step 4: Measure the present value of the accumulated benefit.
Accumulated benefit
=
(1 + i)n
= $328 650/(1 + 0.09)8 [or $328 650 × 0.50187 from present value tables]
= $164 939
The increase in the long service leave is $107 920 (calculated as $164 939 less $57 019) because there
have been no long service leave payments during the year to reduce the provision from the amount
recognised at the end of the previous year. The change in the provision for long service leave is recorded
by the following journal entry:
2017
31 December Long Service Leave Expense Dr 107 920
Provision for Long Service Leave Cr 107 920
(Increase in provision for long service leave)
The increase in the provision for long service leave during 2017 can be attributed to several factors:
• an increase in unit credit accumulated by employees. In the first year, the employees’ accumulation
was 10% of the leave, but, by the end of the second year, 20% had been accumulated because the
employees had completed a second year of service.
• the interest cost, being the increase in the present value arising from discounting the future cash flows
over a shorter period.
• an increase in projected salaries resulting from an increase in remuneration. That is, salaries increased
beyond the projected 2% during 2017.
• a reduction in the interest rate used from 10% at 31 December 2016 to 9% at 31 December 2017.
LO9 10.9 TERMINATION BENEFITS

When an employee is retrenched or made redundant, the employer may be obliged to pay termination ben-
efits. For example, a downturn in the economy may cause a manufacturer to reduce the scale of its operations,
resulting in some portion of the entity’s workforce being made redundant. Termination benefits are typically
lump sum payments. Paragraph 8 of IAS 19 refers to termination benefits as employee benefits that are pay-
able as a result of either the employer deciding to terminate an employment contract, other than through
normal retirement, or an employee accepting an offer of benefits in return for termination of employment.
Thus, the obligation to pay termination benefits arises from the termination of an employment contract,
rather than from past services provided by the employee. Although the obligation arises from a decision to
terminate employment, the extent of past services provided by each employee is usually a factor in deter-
mining the amount of the payment.
The decision to undertake a redundancy program is not sufficient for the recognition of a liability for ter-
mination benefits. Merely deciding to undertake a redundancy programme does not create an obligation to a
third party and thus does not meet the definition of a liability in accordance with the Conceptual Framework.
As stated above, an obligation to pay termination benefits can result from a decision of the employee to
accept an offer, such as a redundancy arrangement, or a decision by the employer to terminate the employ-
ment contract. These alternative decisions are reflected in the requirement to recognise a liability and expense
for termination benefits at the earlier of the following dates in accordance with paragraph 165 of IAS 19:
(a) when the entity can no longer withdraw the offer of the benefits; and
(b) when the entity recognises costs for a restructuring that is within the scope of IAS 37 and that involves the
payment of termination benefits.
266 PART 2 Elements

Paragraph 166 elaborates on when the entity can no longer withdraw an offer for termination benefits
that become payable as a result of the employee’s acceptance of an offer. The entity is unable to withdraw
an offer after the employee accepts it. Further, the entity may be prevented from withdrawing an offer by
existing regulations, contracts or laws. The entity can no longer withdraw an offer once such restrictions
take effect.
Paragraph 167 is concerned with termination benefits that become payable as a result of the entity’s
decision to terminate employment. In this case, the offer can no longer be withdrawn when the entity has
communicated to affected employees a plan of termination that meets all the following criteria (IAS 19
paragraph 167):
(a) steps taken to complete the plan indicate that it is unlikely to change significantly;
(b) the plan identifies the location, function or job classification, the number of employees whose services
are to be terminated, and the expected completion date; and
(c) the plan is sufficiently detailed to enable employees to determine the type and amount of benefits they
will receive.
If at the time of initial recognition, termination benefits are expected to be settled wholly within 12 months
after the end of the annual reporting period, they are measured at the nominal (undiscounted) amount
that the entity expects to pay. However, if the termination benefits are not expected to be settled wholly
within 12 months after the end of the reporting period, they must be measured at present value. The
expected payments required to settle the obligation are discounted at a rate determined by reference to
market yields on high-quality corporate bonds, in accordance with paragraph 83. This is consistent with
the measurement of other long-term employee benefits.
ILLUSTRATIVE EXAMPLE 10.11 Termination benefi ts
During December 2016, the board of directors of Universal plc approved a plan to outsource its data
processing operations. The closure of the data processing operations is expected to result in the retrench-
ment of 180 employees in England and Wales. The chief financial officer provided an estimate of redun-
dancy costs of £1.2 million. The board expected that it would take at least 6 months to select a contractor
for outsourcing the data processing and a further 3 months for training before internal data processing
operations could be discontinued.
During November 2017, redundancy packages were negotiated with trade union representatives and
communicated to employees. Data processing operations were to be transferred to an external service
provider in India on 1 March 2018.
When should Universal plc recognise an expense and liability for the redundancy payments?
2016
The termination benefits become payable as a result of Universal plc’s decision to terminate employ-
ment, rather than as a result of an offer being accepted by employees. Accordingly, Universal plc must
recognise a liability for termination benefits when it can no longer withdraw from a plan of termin-
ation communicated to affected employees, and that plan meets the criteria specified in paragraph 167
of IAS 19.
At 31 December 2016, the termination plan meets some of the criteria. Management had specified the
location (England and Wales) and function (data processing) of the employees becoming redundant,
and estimated their number at 180. The termination benefit payable for each job specification is likely
to have formed the basis of the estimated redundancy costs of £1.2 million. However, until Universal
plc has identified an alternative source of data processing, it will not be able to decide on a time at
which the redundancy plan should be implemented. Further, although the decision to discontinue the
internal data processing operation had been made by Universal plc’s board of directors, it has not been
communicated to the employees. Therefore, Universal plc should not recognise an expense and liability
for termination benefits in association with the planned closure of its data processing operations at
31 December 2016 in accordance with IAS 19.
2017
By November 2017, the company had completed the formal detailed termination plan by specifying
when it is to be implemented. The negotiations with unions over the amount of redundancy pay-
ments and entering into a contract with an external provider demonstrate that it is unlikely that
significant changes will be made to the amount or timing of the redundancy plan. The termination
plan has been communicated to affected employees. Accordingly, Universal plc should recognise an
expense and a liability for termination benefits in association with the planned closure of its data
processing operations in its financial statements for the period ended 31 December 2017 in accord-
ance with IAS 19.

SUMMARY
Employee benefits are a significant expense for most reporting entities. Accounting for employee benefits
is complicated by the diversity of arrangements for remuneration for services provided by employees. This
area of accounting is further complicated by the different methods prescribed by IAS 19 to account for
various forms and categories of employee benefits. Liabilities for short-term employee benefits, such as
salaries, wages, sick leave, annual leave and bonuses payable within 12 months after the reporting period,
are measured at the undiscounted amount that the entity expects to pay. Long-term liabilities for defined
benefits, such as long service leave, are measured at the present value of the defined benefit obligations
less the fair value of plan assets, if any, out of which the obligation is to be settled. The obligation for
long service leave is measured using the projected unit credit method. IAS 19 also prescribes accounting
treatment for post-employment benefit plans. Accounting for defined contribution post-employment
plans is relatively straightforward: a liability is recognised by the entity for contributions payable for the
period in excess of contributions paid. Conversely, an asset is recognised if contributions paid exceed
the contributions payable to the extent that the entity expects the excess contributions to be refunded or
deducted from future contributions. An entity’s net exposure to a defined benefit post-employment plan
is measured at the present value of the defined benefit obligations less the fair value of plan assets. If the
defined benefit plan has a surplus, the net defined benefit asset recognised by the entity is subject to an
asset ceiling. In this chapter, we have also considered termination benefits. The measurement of a liability
for termination benefits depends on whether they are expected to be settled wholly within 12 months
of the annual reporting period in which they were first recognised. The principles for the measurement
of the termination benefits liability are consistent with those for short-term employee benefits and other
long-term employee benefits.
1. What is a paid absence? Provide an example.
2. What is the difference between accumulating and non-accumulating sick leave? How does the recogni-
tion of accumulating sick leave differ from the recognition of non-accumulating sick leave?
3. What is the difference between vesting and non-vesting sick leave? How does the recognition and measure-
ment of vesting sick leave differ from the recognition and measurement of non-vesting sick leave?
4. Explain how a defined contribution pension plan differs from a defined benefit pension plan.
5. During October 2008, there was a sudden global decline in the price of equity securities and credit
securities. Many pension funds made negative returns on investments during this period. How would
this event affect the wealth of employees and employers? Consider both defined benefit and defined
contribution pension funds in your answer to this question.
6. Explain how an entity should account for its contribution to a defined contribution pension plan in
accordance with IAS 19.
7. Compare the off-balance-sheet approach to accounting for a defined benefit post-employment plan
with the net capitalisation approach adopted by IAS 19. Can these approaches be explained by different
underlying views as to whether a deficit or surplus in the plan meets the definition of a liability or asset
of the sponsoring employer?
8. In relation to defined benefit post-employment plans, paragraph 56 of IAS 19 states, ‘the entity is, in
substance, underwriting the actuarial and investment risks associated with the plan’. Evaluate whether
the requirements for the recognition and measurement of the net defined benefit liability reflect the
underlying assumptions about the entity’s risks.
9. Identify and discuss the assumptions involved in the measurement of a provision for long service
leave. Assess the consistency of these requirements with the fundamental qualitative characteristics of
financial information prescribed by the Conceptual Framework.
10. Explain the projected unit credit method of measuring and recognising an obligation for long-term
employee benefits. Illustrate your answer with an example.
11. The board of directors of City Scooters GmbH met in December 2016 and decided to close down a
branch of the company’s operations when the lease expired in the following August. The chief finan-
cial officer advised that termination benefits of €2.0 million are likely to be paid. Should the company
recognise a liability for termination benefits in its financial statements for the year ended 31 December
2016? Justify your judgement with reference to the requirements of IAS 19.
References
BHP Billiton 2015, Annual Report, BHP Billiton, www.bhpbilliton.com.
HSBC Holdings plc 2014, Annual Report 2014, HSBC Holdings plc, London, www.hsbc.com.
IASB 2008, Discussion paper: Preliminary views on amendments to IAS 19 Employee Benefits,
www.ifrs.org.
268 PART 2 Elements

Exercise 10.1 ACCOUNTING FOR SICK LEAVE

★ Ontario Ltd has 200 employees who each earn a gross wage of $140 per day. Ontario Ltd provides 5 days
of paid non-accumulating sick leave for each employee per annum. During the year, 150 days of paid sick
leave and 20 days of unpaid sick leave were taken. Staff turnover is negligible.
Required
Calculate the employee benefits expense for sick leave during the year and the amount that should be rec-
ognised as a liability, if any, for sick leave at the end of the year.
Exercise 10.2 ACCOUNTING FOR ANNUAL LEAVE

★ Newcastle plc provides employees with 4 weeks (20 days) of annual leave for each year of service. The
annual leave is accumulating and vesting up to a maximum of 6 weeks. Thus, all employees take their
annual leave (AL) within 6 months after the end of each reporting period so that it does not lapse. Refer to
the following extract from Newcastle plc’s payroll records for the year ended 31 December 2016:
AL 1 January Increase in AL taken

Employee Wage/day 2016 Days entitlement Days Days
Chand £160 6 20 15
Kim £125 3 20 16
Smith £150 2 20 13
Zhou £100 4 20 17
Required
Calculate the amount of annual leave that should be accrued for each employee.
Exercise 10.3 ACCOUNTING FOR PROFIT-SHARING ARRANGEMENTS

★ Schwarzwald GmbH has a profit-sharing arrangement in which 1% of profit for the period is payable
to employees, paid 3 months after the end of the reporting period. Employees’ entitlements under the
profit-sharing arrangement are subject to their continued employment at the time the payment is made.
Based on past staff turnover levels, it is expected that 95% of the share of profit will be paid. Schwarzwald
GmbH’s profit for the period was €70 million.
Required
Prepare a journal entry to record Schwarzwald GmbH’s liability for employee benefits arising from the
profit-sharing arrangement at the end of the reporting period.
Exercise 10.4 ACCOUNTING FOR DEFINED CONTRIBUTION PENSION PLANS

★ Southern Inc. provides a defined contribution pension fund for its employees. The company pays con-
tributions equivalent to 10% of annual wages and salaries. Contributions of $50 000 per month were paid
for the year ended 31 December 2016. Actual wages and salaries were $7 million. Three months after the
reporting period, there is a settlement of the difference between the amount paid and the annual amount
payable determined with reference to Southern Inc.’s audited payroll information. The settlement at 31
March involves either an additional contribution payment by Southern Inc. or a refund of excess contribu-
tions paid.
Required
Prepare all journal entries required during 2016 for Southern Inc.’s payment of, and liability for, pension
plan contributions.

Exercise 10.5 ACCOUNTING FOR THE PAYROLL AND ACCRUAL OF WAGES AND SALARIES
★ Lavender plc pays its employees on a fortnightly basis. All employee benefits are recognised as expenses.
The following information is provided for its July and August payrolls:
July August
£ £ £ £
Fortnightly payroll 580 000 700 000
720 000 600 000
Gross payroll for the month 1 300 000 1 300 000
Deductions payable to:
Taxation authority 250 000 245 000
Health fund 20 000 20 000
Community charity 4 000 4 000
Union fees 6 500 6 500
Total deductions for the month 280 500 275 500
Net wages and salaries paid
14 July, 11 August 458 775 553 230
28 July, 25 August 560 725 1 019 500 471 270 1 024 500
1 300 000 1 300 000
The two fortnightly payrolls in August were for the fortnight ended Friday 7 August and Friday 21 August.
The payrolls were processed and paid on the following Monday and Tuesday respectively. Payroll deduc-
tions are remitted as follows:
Health fund deductions 3rd day of the following month
Union fees 3rd day of the following month
Taxation authority 15th day of the following month
Community charity 21st day of the following month
Required
1. Prepare all journal entries to account for the August payroll and all payments relating to employee benefits
during August.
2. Prepare a journal entry to accrue wages for the remaining days in August not included in the final August
payroll. Use the same level of remuneration as per the final payroll for August.
Exercise 10.6 ACCOUNTING FOR SICK LEAVE

★ Nagaland Ltd opened a call centre on 1 January 2016. The company provides 1 week (5 days) of sick leave
entitlement for the employees working at the call centre. The following information has been obtained
from Nagaland Ltd’s payroll records and actuarial assessments for the year ended 31 December 2016.
The column headed ‘Term. in 2016’ indicates the leave entitlement pertaining to service of employees
whose employment was terminated during the year. The actuary has estimated the percentage of unused
leave that would be taken within 12 months if Nagaland Ltd allowed leave to accumulate. Due to high
staff turnover, the remaining leave would lapse (or be settled in cash, if vesting) within 1 year after the
end of the reporting period.
Leave Estimated Estimated
Base Current taken in Term. in leave used termination
Employee category pay/day service 2016 2016 2016 2016
£ Days Days Days % %
Supervisors 100 30 20 3 90 10
Operators 80 500 400 60 70 30
Required
Calculate the employee benefits expense for sick leave for the year and the amount that should be recog-
nised as a liability for sick leave at 31 December 2016, assuming that sick leave entitlements are:
(a) non-accumulating
(b) accumulating and non-vesting
(c) accumulating and vesting.
270 PART 2 Elements

Exercise 10.7 ACCOUNTING FOR DEFINED BENEFIT PENSION PLANS
★★ Washington Inc. provides a defined benefit pension plan for its managers. The assistant accountant has
completed some sections of the defined benefit worksheet based on information provided in an actuary’s
report on the Washington DB Pension Plan for the year ended 31 December 2016:
WASHINGTON DB PENSION PLAN

Defined Benefit Worksheet for the year ended 31 December 2016
Washington DB Pension
Washington Inc. Plan
Profit/loss OCI Bank Net DBL(A) DBO Plan Assets

$’000 $’000 $’000 $’000 $’000 $’000
Balance 31/12/15 1 000 Cr 6 000 Cr 5 000 Dr

Net interest at 10%
Current service cost 400 Cr
Contributions to the plan 600 Cr 600 Dr
Benefits paid by the plan 100 Cr 100 Dr
Actuarial loss: DBO 300 Cr
Journal Entry
Balance 31/12/16 7 200 Cr 6 000 Dr
Adjustment for asset
ceiling if < deficit
Balance 31/12/16
The asset ceiling was $600 000 at 31 December 2016.
Required
1. Determine the surplus or deficit of the plan at 31 December 2016.
2. Determine the net defined benefit asset or liability at 31 December 2016.
3. Calculate the net interest and distinguish between the interest expense component of the defined
benefit obligation and the interest income component of the change in the fair value of plan assets
for 2016.
4. Determine the amount to be recognised in profit or loss in relation to the defined benefit pension plan
for 2016.
5. Determine the amount to be recognised in other comprehensive income in relation to the defined benefit
pension plan for the year ended 31 December 2016.

★★ For each of the following scenarios, determine (i) the surplus or deficit in the defined benefit pension plan
and (ii) the net defined benefit liability or asset that should be recognised by the sponsoring employer in
accordance with IAS 19:
Present value of DBO Fair value of plan assets Asset ceiling

$’000 $’000 $’000
(a) 1 300 1 000 $Nil

(b) 1 550 1 200 $Nil
(c) 2 000 2 200 100
(d) 2 400 2 500 250

Exercise 10.9 ACCOUNTING FOR LONG SERVICE LEAVE
★★ Geranium Ltd provides long service leave for its retail staff. Long service leave entitlement is determined
as 13 weeks of paid leave for 10 years of continued service. The following information is obtained from
Geranium Ltd’s payroll records and actuarial reports for its retail staff at 31 December 2016:
Unit credit No. of % expected to Annual salary No. of years Yield on HQ

(years) employees become entitled per employee until vesting corporate bonds
1 60 20% €27 000 9 10%

2 50 30% €27 000 8 9%
3 30 50% €27 000 7 9%
4 10 60% €27 000 6 9%
(a) The estimated annual increase in retail wages is 1% p.a. for the next 10 years, reflecting expected
inflation.
(b) The provision for long service leave for retail staff at 31 December 2015 was €22 000.
(c) No employees were eligible to take long service leave during 2016.
Required
Prepare the journal entry to account for Geranium Ltd’s provision for long service leave at 31 December
2016.

★★★ Lily Ltd provides a defined benefit pension plan for its managers. The following information is available
in relation to the plan.
2016
$
Present value of the defined benefit obligation 31 December 2015 10 000 000
Fair value of plan assets 31 December 2015 9 500 000
Contributions paid by Lily Ltd to the plan during the year 1 000 000
Benefits paid by the plan during the year 1 200 000
Present value of the defined benefit obligation 31 December 2016 10 750 000
Fair value of plan assets at 31 December 2016 10 047 500
(a) No past service costs were incurred during 2016.
(b) The interest rate used to measure the present value of defined benefits at 31 December 2015 was 9%.
(c) The interest rate used to measure the present value of defined benefits at 31 December 2016 was 10%.
(d) There was an actuarial gain pertaining to the present value of the defined benefit obligation as a result
of an increase in the interest rate.
(e) The only remeasurement affecting the fair value of plan assets is the return on plan assets.
(f) The asset ceiling was nil at 31 December 2015 and 31 December 2016.
(g) All contributions received by the plan were paid by Lily Ltd. Employees make no contributions.
Required
1. Determine the surplus or deficit of Lily Ltd’s defined benefit plan at 31 December 2016.
2. Determine the net defined benefit asset or liability that should be recognised by Lily Ltd at 31 December
2016.
3. Calculate the net interest for 2016.
4. Calculate the actuarial gain or loss for the defined benefit obligation for 2016.
5. Calculate the return on plan assets, excluding any amount recognised in net interest, for 2016.
6. Present a reconciliation of the opening balance to the closing balance of the net defined benefit liability
(asset), showing separate reconciliations for plan assets and the present value of the defined benefit
obligation.
7. Prepare a summary journal entry to account for the defined benefit pension plan in the books of Lily
Ltd for the year ended 31 December 2016.
272 PART 2 Elements

As discussed in the chapter a fundamental question arises ERR is a poorer predictor of future return on plan assets
whether the pension asset or liability should be included in than the percentage of investment in equities.
the sponsoring firm’s balance sheet. While recognising a lia- More broadly, assumptions underlying the calculation of
bility is consistent with future funding needs, it is not clear pension expense and liability could be used opportunisti-
that plan assets that are owned by the employees (through a cally by managers. Amir and Gordon (1996) find evidence
trust) should appear on the sponsoring firm’s balance sheet. consistent with this hypothesis. Specifically, they find that the
IAS 19 changed disclosure and recognition rules relative assumptions employed by managers worked to reduce reported
to what was domestically required in many countries that pension liability. Their evidence further suggests that this is
adopted IFRS® Standards. One issue that has been of interest more pronounced in highly leveraged firms. Bergstresser et al.
to accounting researchers is whether the new rules have influ- (2006) show that firms whose plan assets are large relative to
enced the trend observed in many countries to curtail defined operating income tend to select higher ERR than other firms.
benefit (DB) plans and replace them with defined contribu- Higher ERR is also observed in firms that meet certain earnings
tion (DC) plans. A possible explanation for this trend is that thresholds. Interestingly, in some circumstances, managers may
many employers find it hard to manage the various uncertain- prefer to increase reported pension expense and liability. Com-
ties embedded in DB plans (e.g., increasing life expectancy, prix and Muller (2011) examine cases where companies froze
inflation, interest rates). It is also possible that employers have the pension plans (i.e., stopped accruing pension obligations
found DC to be cheaper to run in that contribution rates are for existing and new members) to be able to make future sav-
lower than funding pension plan assets under DB programmes. ings. Since this decision could lead to labour disputes, man-
Kiosse and Peasnell (2009) review comment letters sent to the agers may be motivated to exaggerate the pension problem
UK’s Accounting Standard Board (ASB) when it deliberated FRS to reduce disagreement with employees. They find that the
17 (which is very similar to IAS 19). They observe that many number of employees affected and presence of labour union
commentators were concerned that rules to fully recognise the is negatively related to the likelihood of the freezing decision.
pension liability may lead sponsors to shut down DB plans. This is consistent with concerns about employee reaction influ-
The prime concern was the added volatility that new rules will encing managers against freezing. Furthermore, Comprix and
introduce to the income statement and balance sheet. Muller (2011) find that the ERR and discount rate selected by
Short of termination of the DB plans, the effect of IAS 19 freezing sponsor firms are lower than non-freezing firms in the
adoption may be seen in the effect on the strategy of invest- years preceding the freezing year. Because such lower estimates
ment in plan assets. Amir et al. (2010) provide evidence that work to increase pension expense and pension liability, the evi-
pertains to this effect. They find that UK companies shifted dence in Comprix and Muller (2011) is consistent with man-
to investment in bonds in and after 2005 — when IFRS agerial discretion to reduce the likelihood of labour disputes
Standards and IAS 19 were adopted. Moreover, they find that by worsening reported performance and financial position.
this shift was more pronounced in firms with larger pen-
sion plans. They argue that such firms were more exposed
to higher volatility in the financial statements post-adoption
References
and consequently had a greater incentive to reduce this vol- Amir, E., and Benartzi, S., 1998. The expected rate of return
atility through the less-risky strategy of investment in bonds on pension funds and asset allocation as predictors of
as opposed to investment in equities. portfolio performance. The Accounting Review, 73, 335–352.
Prior to SFAS 158 (FASB, 2006) in the US and the 2011 Amir, E., and Gordon, E. A., 1996. Firms’ choice of estimation
revision to IAS 19, sponsoring firms calculated pension parameters: Empirical evidence from SFAS No. 106. Journal
expense on a different basis. In particular, the income of Accounting, Auditing and Finance, 11, 427–448.
from plan assets was based on the notional expected rate Amir, E., Guan, Y., and Oswald, D., 2010. The effect of
of return (ERR) on plan assets. Importantly the selection of pension accounting on corporate pension asset allocation.
ERR was to a large extent subject to managerial discretion. Review of Accounting Studies, 15, 345–366.
Researchers have therefore been interested in understanding Bergstresser, D., Desai, M., and Rauh, J., 2006. Earnings
the degree to which this discretion was employed. Amir and manipulations, pension assumptions and managerial
Benartzi (1998) examine a sample of US firms that reported investment decisions. The Quarterly Journal of Economics,
under these previous rules. They take advantage of a pro- 121, 157–194.
prietary dataset that provides details of the composition of Comprix, J., and Muller, K. A., 2011. Pension plan accounting
plan assets and examine how ERR varies with this compo- estimates and the freezing of defined benefit pension
sition. Amir and Benartzi (1998) argue that firms that invest plans. Journal of Accounting and Economics, 51(1), 115–133.
a greater proportion of pension plan assets in equity invest- Financial Accounting Standards Board (FASB), 2006.
ments should employ a higher ERR to reflect the higher Statement of financial accounting standards (SFAS) No.
level of risk associated with equity investments. Thus, a high 158, employers’ accounting for defined benefit pension
correlation between the percentage of equities in plan assets and other postretirement plans — an amendment of FASB
and ERR should be observed. However, Amir and Benartzi statements No. 87, 88, 106 and 132(R). Norwalk, CT: FASB
(1998) find that this correlation is weak in that ERR changed Kiosse, P. V., and Peasnell, K., 2009. Have changes in
only slightly as the percentage of equities increased. This pension accounting changed pension provision?
suggests that managers were quite conservative in selecting A review of the evidence. Accounting and Business
ERR. This is further supported by the additional finding that Research, 39(3), 255–267.

11 Property,
equipment
plant and
ACCOUNTING IAS 16 Property, Plant and Equipment

STANDARDS
IN FOCUS

OBJECTIVES
1 describe the nature of property, plant and equipment
2 recall the recognition criteria for initial recognition of property, plant and equipment
3 demonstrate how to measure property, plant and equipment on initial recognition
4 explain the alternative ways in which property, plant and equipment can be measured
subsequent to initial recognition
5 explain the cost model of measurement and understand the nature and calculation of
depreciation
6 explain the revaluation model of measurement
7 discuss the factors to consider when choosing which measurement model to apply
8 account for derecognition
9 implement the disclosure requirements of IAS 16
10 explain the accounting issues relating to investment properties.
CHAPTER 11 Property, plant and equipment 275

LO1 11.1 THE NATURE OF PROPERTY, PLANT AND EQUIPMENT
The accounting standard analysed in this chapter is IAS 16 Property, Plant and Equipment. The standard
was first issued by the International Accounting Standards Board (IASB®) in March 1982, amended on
numerous occasions, exposed in May 2002 as part of the IASB project on improvements to IASs, and
issued in its present form in 2004. As a result of this process, the IASB has clarified selected matters and
provided additional guidance. It has not reconsidered the fundamental approach to the accounting for
property, plant and equipment contained in IAS 16.
According to paragraph 2 of IAS 16, the standard applies in accounting for property, plant and equip-
ment except where another standard requires or permits a different accounting treatment. IAS 16 does not
apply to property, plant and equipment classified as held for sale in accordance with IFRS 5 Non-current
Assets Held for Sale and Discontinued Operations; biological assets related to agricultural activity as these are
accounted for under IAS 41 Agriculture; or mineral rights and mineral reserves such as oil, gas and similar
non-regenerative resources. However, IAS 16 does apply to property, plant and equipment used to develop
or maintain biological assets and mineral rights and reserves.
Paragraph 6 of IAS 16 defines property, plant and equipment as follows:
Property, plant and equipment are tangible items that:
(a) are held for use in the production or supply of goods or services, for rental to others, or for administrative
purposes; and
(b) are expected to be used during more than one period.
Note the following:
• The assets are ‘tangible’ assets. The distinction between tangible and intangible assets is discussed in depth in
chapter 13. However, a key feature of tangible assets is that they are physical assets, such as land, rather
than non-physical, such as patents and trademarks.
• The assets have specific uses within an entity; namely, for use in production/supply, rental or
administration. Assets that are held for sale, including land, or held for investment are not included under
property, plant and equipment. Instead, assets held for sale are accounted for in accordance with IFRS 5.
• The assets are non-current assets, the expectation being that they will be used for more than one
accounting period.
Property, plant and equipment may be divided into classes for disclosure purposes, a class of assets
being a grouping of assets of a similar nature and use in an entity’s operations. Examples of classes of
property, plant and equipment are land, machinery, motor vehicles and office equipment. The notes to the
statement of financial position of Marks & Spencer plc, at 29 March 2014, as shown in figure 11.1, provide
an indication of what is contained in that category as well as the reasons for the movements in this cate-
gory of assets.
In this chapter, accounting for property, plant and equipment is considered as follows:
• recognition of the asset — the point at which the asset is brought into the accounting records
• initial measurement of the asset — determining the initial amount at which the asset is recorded in the
accounts
• measurement subsequent to initial recognition — determining the amount at which the asset is
reported subsequent to acquisition, including the recording of any depreciation of the asset
• derecognition of the asset.
FIGURE 11.1 Property, plant and equipment
Land Fixtures, Assets in the

and fittings and course of
buildings equipment construction Total
£m £m £m £m
At 31 March 2012
Cost 2 759.4 5 612.9 330.1 8 702.4
Accumulated depreciation and asset (270.6) (3 641.9) – (3 912.5)
write-offs
Net book value 2 488.8 1 971.0 330.1 4 789.9
Year ended 30 March 2013

Opening net book value 2 488.8 1 971.0 330.1 4 789.9
Additions 17.3 430.3 186.6 634.2
Transfers 16.1 189.8 (205.9) –
276 PART 2 Elements

Land Fixtures, Assets in the

and fittings and course of
buildings equipment construction Total
£m £m £m £m
Disposals (0.4) (4.6) – (5.0)

Asset write-offs (0.6) (16.2) – (16.8)
Depreciation charge (11.7) (362.4) – (374.1)
Exchange difference 2.1 1.8 1.6 5.5
Closing net book value 2 511.6 2 209.7 312.4 5 033.7
At 30 March 2013
Cost 2 817.1 6 198.1 312.4 9 327.6
Accumulated depreciation and asset (305.5) (3 988.4) – (4 293.9)
write-offs
Net book value 2 511.6 2 209.7 312.4 5 033.7
Year ended 29 March 2014

Opening net book value 2 511.6 2 209.7 312.4 5 033.7
Additions 34.6 362.7 155.8 553.1
Transfers 41.7 169.1 (210.8) –
Disposals (15.2) (5.3) – (20.5)
Asset write-offs (14.3) (14.9) (6.0) (35.2)
Depreciation charge (15.0) (364.7) – (379.7)
Exchange difference (3.7) (6.6) (1.2) (11.5)
Closing net book value 2 539.7 2 350.0 250.2 5 139.9
At 29 March 2014
Cost 2 871.7 6 686.8 256.2 9 814.7
Accumulated depreciation and asset (332.0) (4 336.8) (6.0) (4 674.8)
write-offs
Net book value 2 539.7 2 350.0 250.2 5 139.9
The net book value above includes land and buildings of £43.7m (last year £43.9m) and equipment of
£4.2m (last year £11.1m) where the Group is a lessee under a finance lease.
Additions to property, plant and equipment during the year amounting to £nil (last year £nil) were
financed by new finance leases.
Source: Marks & Spencer plc (Annual Report 2014, p. 110).
LO2 11.2 INITIAL RECOGNITION OF PROPERTY, PLANT

AND EQUIPMENT
Paragraph 7 of IAS 16 contains the principles for recognition of property, plant and equipment:
The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:
(a) it is probable that future economic benefits associated with the item will flow to the entity; and
(b) the cost of the item can be measured reliably.
This is a general recognition principle for property, plant and equipment. It applies to the initial recogni-
tion of an asset, when parts of that asset are replaced, and when costs are incurred in relation to that asset
during its useful life. To recognise a cost as an asset, the outlay must give rise to the expectation of future
economic benefits.
The criteria for recognition in paragraph 7 differ from the recognition criteria for the elements of finan-
cial statements in paragraph 4.38 of the Conceptual Framework. Under the Conceptual Framework, an asset
can be recognised when the cost or value can be measured with reliability; under IAS 16, recognition can
occur only if the cost can be measured reliably. Assets for which the cost cannot be reliably measured but
whose initial fair value can be measured reliably cannot be recognised in the entity’s records.

11.2.1 Asset versus expense
For most items of property, plant and equipment, the entity will incur some initial expenditure. One of
the key problems for the entity is determining whether the outlay should be expensed or capitalised as an
asset. As paragraph 7 of IAS 16 states, the elements of that decision relate to whether the entity expects
there to be future economic benefits, whether the receipt of those benefits is probable, and whether the
benefits will flow specifically to the entity. As noted in paragraph 4.45 of the Conceptual Framework, the
expensing of outlays:
does not imply either that the intention of management in incurring expenditure was other than to generate
future economic benefits for the entity or that management was misguided. The only implication is that the
degree of certainty that economic benefits will flow to the entity beyond the current accounting period is insuf-
ficient to warrant the recognition of an asset.
As property, plant and equipment consists of physical assets such as land and machinery, such assets
are normally traded in a market. One test of the existence of future benefits is then to determine whether
there exists a market for the item in question. A problem with some assets is that once items have been
acquired and installed, there is no normal market for them. However, in many cases, the expected eco-
nomic benefits arise because of the use of that asset in conjunction with other assets held by the entity.
At a minimum, the future benefits would be the scrap value of the item. Where the assets are intangible,
such as costs associated with the generation of software, the absence of a physical asset causes more prob-
lems in terms of asset recognition. Chapter 13 discusses in detail the problems associated with the recognition
of intangible assets.
11.2.2 Separate assets — significant parts

The total property, plant and equipment of an entity may be broken down into separate assets. This is
sometimes referred to as a ‘significant parts’ approach to asset recognition. An entity allocates the amount
initially recognised in respect of an asset to its significant parts and accounts for each part separately. Para-
graph 9 of IAS 16 notes that the identification of what constitutes a separate item of plant and equipment
requires the exercise of judgement, because the standard does not prescribe the unit of measure for recog-
nition. The key element in determining whether an asset should be further subdivided into its significant
parts is an analysis of what is going to happen in the future to that asset. Having identified an asset, the
entity wants to recognise the expected benefits as they are consumed by the entity, with the recognition
being in the period in which the benefits are received. Hence, if an asset has a number of significant parts
that have different useful lives then, in order for there to be an appropriate recognition of benefits con-
sumed, significant parts with different useful lives need to be identified and accounted for separately.
For example, consider an aircraft as an item of property, plant and equipment. Is it sufficient to recognise
the aircraft as a single asset? An analysis of the aircraft may reveal that there are various parts of the aircraft
that have different useful lives. Parts of the aircraft include the engines, the frame of the aircraft and the
fittings (seats, floor coverings and so on). It may be necessary to refit the aircraft every 5 years, whereas the
engines may last twice as long. Similarly, an entity that deals with the refining of metals may have a blast
furnace, the lining of which needs to be changed periodically. The lining of the blast furnace therefore
needs to be separated from the external structure in terms of asset recognition and subsequent accounting
for the asset. Further, as noted in paragraph 9 of IAS 16, it may be appropriate to aggregate individually
insignificant items (such as moulds, tools and dies) and apply the criteria to the aggregate value.
11.2.3 Generation of future benefits

Paragraph 11 of IAS 16 notes that certain assets may not of themselves generate future benefits, but instead
it may be necessary for the entity itself to generate future benefits. For example, some items of property,
plant and equipment may be acquired for safety or environmental reasons, such as equipment associated
with the safe storage of dangerous chemicals. The entity’s generation of the benefits from use of the chem-
icals can occur only if the safety equipment exists. Hence, even if the safety equipment does not of itself
generate cash flows, its existence is necessary for the entity to be able to use chemicals within the business.
LO3 11.3 INITIAL MEASUREMENT OF PROPERTY, PLANT

AND EQUIPMENT
Having established that an asset can be recognised, the entity must then assign to it a monetary amount.
Paragraph 15 of IAS 16 contains the principles for initial measurement of property, plant and equipment:
‘An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its
cost.’ Paragraph 16 specifies three elements of cost, namely:
• purchase price
• directly attributable costs
278 PART 2 Elements

• initial estimate of the costs of dismantling and removing the item or restoring the site on which it is
located.
These elements are considered separately in the following sections.
11.3.1 Purchase price

‘Purchase price’ is not defined in IAS 16, but paragraph 16(a) states that the purchase price includes
import duties and non-refundable purchase taxes, and is calculated after deducting any trade discounts
and rebates. The essence of what constitutes purchase price is found in the definition of cost in paragraph
6 of the standard, which states: ‘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.’
Where an item of property, plant and equipment is acquired for cash, determination of the purchase
price is relatively straightforward. One variation that may arise is that some or all of the cash payment is
deferred. In this case, as noted in paragraph 23 of IAS 16, the cost is the cash price equivalent at the rec-
ognition date, determined by measuring the cash payments on a present value basis (done by discounting
the cash flows). Interest is then recognised as the payments are made.
More difficulties arise where the exchange involves assets other than cash. In a non-cash exchange, the
acquiring entity receives a non-cash asset and in return provides a non-cash asset to the seller. In meas-
uring the cost of the asset acquired, the question is whether the measurement should be based on the
value of the asset given up by the acquirer, or by reference to the value of the asset acquired from the seller.
In relation to the application of the cost principle of measurement, note the following:
1. Cost is determined by reference to the fair value of what is given up by the acquirer rather than by the
fair value of the item acquired. The cost represents the sacrifice made by the acquirer. This principle is
inherent in the definition of cost in paragraph 6 of IAS 16. Further, paragraph 26 states that where both
the fair value of what is given up by the acquirer and the asset received are reliably measurable, then
the fair value of the asset given up is used to measure the cost of the asset received, unless the fair value
of the asset received is more clearly evident. ‘More clearly evident’ presumably relates to the cost and
difficulty of determining the fair value as, in the paragraph 26 example, the fair values of both the asset
received and the asset given up can be measured reliably.
2. Cost is measured by reference to fair value (paragraph 24). The term fair value is defined in paragraph 6
of IAS 16 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 an exit price. The process of determining fair value necessarily involves judgement and
estimation. The acquiring company is not actually trading the items given up in the marketplace for
cash, but is trying to estimate what it would get for those items if it did so. Hence, the determination of
fair value is only an estimation. A further practical problem in determining fair value is that the nature
of the market in which the goods given up are normally traded may make estimation difficult. The mar-
ket may be highly volatile with prices changing daily, or the market may be relatively inactive. Chapter 3
contains detailed information on the measurement of fair value.
If the acquirer gives up an asset at fair value, and the carrying amount of the asset is different from the
fair value, then the entity will recognise a gain or a loss. According to paragraph 34 of IAS 1 Presentation
of Financial Statements, gains and losses on the disposal of non-current assets are reported by deducting
from the proceeds on disposal the carrying amount of the asset and related selling expenses.
Assume then that an entity acquires a piece of machinery and gives in exchange a block of land. The
land is carried by the entity at original cost of £100 000 and has a fair value of £150 000. The journal
entry to record the acquisition of the machinery is:
Machinery Dr 150 000

Gain on Sale of Land Cr 50 000
Land Cr 100 000
The entity then reports a gain on sale of land of £50 000.

If, instead of giving land in exchange, the entity issued shares having a fair value of £150 000, the
journal entry is:
Machinery Dr 150 000

(Acquisition of machinery by issue of shares)
Further discussion on the measurement of the fair value of equity instruments issued by the acquirer in ex-
change for assets is found in chapter 14.
3. Paragraph 24 of IAS 16 requires the use of fair value to measure the cost of an asset received unless the
exchange transaction lacks commercial substance. Commercial substance is concerned with whether the

transaction has a discernible effect on the economics of an entity. Paragraph 25 states that an exchange
transaction has commercial substance if:
(a) the configuration (risk, timing and amount) of the cash flows of the asset received differs from the configu-
ration of the cash flows of the asset transferred. This would not occur if similar assets (e.g. an exchange
of commodities such as oil or milk) were exchanged as would occur where, for example, suppliers
exchanged inventories in various locations to fulfil demand on a timely basis in a particular loca-
tion; or
(b) the entity-specific value of the portion of the entity’s operations affected by the transaction changes as a result
of the exchange. Paragraph 6 defines entity-specific value as ‘the present value of the cash flows an
entity expects to arise from the continuing use of an asset and from its disposal at the end of its
useful life or expects to incur when settling a liability’. If there is no change in the expected cash
flows to the entity as a result of the exchange, as in the case of the exchange of similar items, then
the transaction lacks commercial substance; and
(c) the difference in (a) or (b) is significant relative to the fair value of the assets exchanged. In both (a) and
(b), the change in cash flows or configuration must be material, with materiality being measured in
relation to the fair value of the assets exchanged.
Where the transaction lacks commercial substance, the asset acquired is measured at the carrying
amount of the asset given up.
4. Paragraph 24 of IAS 16 also covers the situation where, in an exchange of assets, neither the fair value
of the assets given up nor the fair value of the assets acquired can be measured reliably. Such situations
could occur where the assets exchanged are both traded in weak markets where market transactions are
infrequent. In this situation, the acquirer measures the cost of the asset acquired at the carrying amount
of the asset given up.
Acquisition date
One of the problems in recording the acquisition of an item of property, plant and equipment relates to
the determination of the fair values of the assets involved in the exchange. As noted above, accounting for
the asset exchange requires that potentially both the fair values of the assets acquired and assets given up
must be determined. However, where the markets for these assets are volatile, choosing the appropriate
fair value may be difficult. This can be seen where an entity issues shares in exchange for an asset. The fair
value of the shares issued may change on a daily basis. At what point in time should the fair values be
measured?
Some likely dates that may be considered are:
• the date the contract to exchange the assets is signed
• the date the consideration is paid
• the date on which the assets acquired are received by the acquirer
• the date on which an offer becomes unconditional.
The advantage of these dates is that they relate to a point of time that can be determined objectively,
such as the date the item of property, plant and equipment arrives at the acquirer’s premises. A problem
is that there may be a number of dates involved if, for example, an item of equipment arrives in stages or
payment for the equipment is to be made in instalments over time.
The date on which the fair values should be measured is the date on which the acquirer obtains control
of the asset or assets acquired — hereafter referred to as the ‘acquisition date’. The definition of cost in para-
graph 6 of IAS 16 refers to the ‘time of its [the asset’s] acquisition’. There is no specific date defined in the
standard. In IFRS 3 Business Combinations, acquisition date is defined as ‘the date on which the acquirer
obtains control of the acquiree’.
The measurement of the fair value relates to the date the assets acquired are recognised in the records of
the acquirer. At this date, the acquirer must be able to reliably measure the cost of the asset. Recognition
of an asset requires the acquirer to have control of expected future benefits. Hence, when the item acquired
becomes the asset of the acquirer (i.e. when the expected benefits come under the control of the acquirer),
this is the point in time when the measurements of the fair values of assets acquired and given up are
made. Paragraph 23 of IAS 16 states that the cost of an item of property, plant and equipment is the cash
price equivalent at the ‘recognition date’. Recognition date is normally the same as acquisition date.
Acquisition of multiple assets

The above principles as stated in IAS 16 apply to the acquisition of individual items of property, plant and
equipment. However, an acquisition may consist of more than one asset, such as a block of land and a
number of items of machinery. The acquirer may acquire the assets as a group, paying one total amount
for the bundle of assets. The cost of acquiring the bundle of assets is determined as per IAS 16, namely by
measuring the fair value of what is given up by the acquirer to determine the purchase price, and adding to
this any directly attributable costs. However, even if the total cost of the bundle of assets can be determined,
for accounting purposes it is necessary to determine the cost of each of the separate assets as they may be
in different classes, or some may be depreciable and others not. No guidance is given in this standard for
determining the costs of each of the assets. However, IFRS 3 Business Combinations paragraph 2(b) states:
280 PART 2 Elements

The cost of the group shall be allocated to the individual identifiable assets and liabilities on the basis of their
relative fair values at the date of purchase. Such a transaction or event does not give rise to goodwill.
In this situation, the cost of each asset to be recorded separately is calculated by allocating the cost of
the bundle of assets over the assets acquired in proportion to the fair values of the assets acquired. To
illustrate this allocation procedure, assume an entity acquired land, buildings and furniture at a total cost
of £300 000 cash. In order to separately record each asset acquired at cost, the entity determines the fair
value of each asset, for example:
Land £ 40 000
Buildings 200 000
Furniture 80 000
£ 320 000
The total cost of £300 000 is then allocated to each asset on the basis of these fair values as follows:
Land £40 000/£320 000 × £300 000 = £ 37 500

Buildings £200 000/£320 000 × £300 000 = 187 500
Furniture £80 000/£320 000 × £300 000 = 75 000
£300 000
The acquisition of the three assets is recorded by the entity as follows:
Land Dr 37 500
Buildings Dr 187 500
Furniture Dr 75 000
Cash Cr 300 000
(Acquisition of assets for cash)
Under IAS 16, the basic principle of recording assets acquired is to record at cost. Where a bundle
of assets is acquired, the cost of the separate assets must be estimated, and the fair values of the assets
acquired can be used in this process. Where the cost of the assets in total is less than the sum of the fair
values of the assets acquired, a bargain purchase has been made. However, as the assets are to be recog-
nised initially at cost, no gain is recognised on acquisition.
11.3.2 Directly attributable costs

The key feature of those costs included in the cost of acquisition is that they are directly attributable to
bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended
by management (IAS 16 paragraph 16(b)).
Costs to be included
Paragraph 17 of IAS 16 provides examples of directly attributable costs:
• costs of employee benefits arising directly from the construction or acquisition of the item of property,
plant and equipment
• costs of site preparation
• initial delivery and handling costs
• installation and assembly costs — where buildings are acquired, associated costs could be the costs of
renovation
• costs of testing whether the asset is functioning properly
• professional fees.
It can be seen that all these costs are incurred before the asset is used, and are necessary in order for
the asset to be usable by the entity. Note, however, the use of the word ‘necessary’. There may be costs
incurred that were not necessary; for example, the entity may have incurred fines, or a concrete platform
may have been placed in the wrong position and had to be destroyed and a new one put in the right
place. These costs should be written off to an expense rather than being capitalised as part of the cost of
the acquired asset.
A further cost that may be capitalised into the cost of an item of property, plant and equipment is that
of borrowing costs. Borrowing costs (i.e. interest and other costs associated with the borrowing of funds)
are accounted for under IAS 23 Borrowing Costs. Paragraph 8 of IAS 23 states that borrowing costs that are
directly attributable to the acquisition, construction or production of a qualifying asset must be capitalised

as part of the cost of the asset. (A qualifying asset is one that necessarily takes a substantial period of time
to get ready for its intended use or sale, such as a building.)
Costs not to be included
Paragraphs 19 and 20 of IAS 16 contain examples of costs that should not be included in directly attrib-
utable costs:
• costs of opening a new facility. These costs are incurred after the item of property, plant and equipment is
capable of being used; the opening ceremony, for example, does not enhance the operating ability of
the asset.
• costs of introducing a new product or service, including costs of advertising and promotional activities. These
costs do not change the location or working condition of the asset.
• costs of conducting business in a new location or with a new class of customer (including costs of staff
training). Unless the asset is relocated, there is no change in the asset’s ability to operate.
• administration and other general overhead costs. These costs are not directly attributable to the asset, but
are associated generally with the operations of the entity.
• costs incurred while an item capable of operating in the manner intended by management has yet to be
brought into use or is operated at less than full capacity. These costs are incurred because of management’s
decisions regarding the timing of operations rather than being attributable to getting the asset in a
position for operation.
• initial operating losses, such as those incurred while demand for the item’s output builds up. These are not
incurred before the asset is ready for use.
• costs of relocating or reorganising part or all of the entity’s operations. If a number of currently operating
assets are relocated to another site, then the costs of relocation are general, and not directly attributable
to the item of property, plant and equipment.
Income earned
Paragraph 17(e) of IAS 16 notes that the cost of the asset should be determined after deducting the net
proceeds from selling any items produced when bringing the asset to that location and condition, such
as proceeds from the sale of samples produced during the testing process. The principle here is that any
flows, whether in or out, that occur before the asset is in a position to operate as management intends
must be taken into account in determining the cost of the asset. The testing process is a necessary part of
readying the asset for its ultimate use. Paragraph 21 provides an example of where income may be earned
before the asset is ready for use but should not be included in the calculation of the cost of the asset. The
example given is of income earned from the use of the construction site as a car park while there is a delay
before the construction of a building. These revenues have nothing to do with the creation of the asset.
They are incidental to the development activity, and should be separately recognised.
Acquisition for zero or nominal cost

An entity may acquire an asset for zero cost, or be required to pay an amount substantially different from
the fair value of the asset. For example, an entity may be given a computer for no charge, or be required to
pay only half price for a block of land or a building. Applying IAS 16, where there is zero cost, the entity
receiving the asset would not record the asset. In the case of a heavily discounted asset, the asset would be
recorded at the cost, namely the purchase price paid plus the directly attributable costs.
11.3.3 Costs of dismantling, removal or restoration

At the date an asset is initially recognised, an entity is required to estimate any costs necessary to eventu-
ally dismantle and remove the asset and restore its site. For example, when an asset such as an offshore oil
platform is constructed, an entity knows that in the future it is required by law to dismantle and remove
the platform in such a manner that the environment is cared for. The construction of the platform gives
rise to a liability for restoration under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The
expected costs, measured on a present value basis, are capitalised into the cost of the platform as the con-
struction of the platform brings with it the responsibility of disposing of it. Acceptance of the liability for
dismantling and removal is an essential part of bringing the asset to a position of intended use. As with
directly attributable costs, the dismantling and removal costs are depreciated over the life of the asset.
There may be restoration costs associated with the use of land, such as where the land is used for mining
or farming. These costs are capitalised into the cost of the land at the acquisition date and, although the
land is not depreciated, the restoration costs are depreciated over the period in which the benefits from use
of the land are received.
As explained in paragraphs BC14–BC15 of the Basis for Conclusions on IAS 16, because of the limited
scope of the revisions undertaken during the Improvements project, the IASB concentrated on the initial
estimate of the costs of dismantling, removal and restoration. Issues relating to changes in that estimate,
changes in interest rates, and the emergence of obligations subsequent to the asset’s acquisition are not
covered in IAS 16. However, the IASB did note that, regardless of whether the obligation is incurred when
282 PART 2 Elements

the item is acquired or when it is being used, the obligation’s underlying nature and its association with
the asset are the same. Hence, where obligations arise because of the use of an asset, these should be
included in the cost of the asset.
LO4 11.4 MEASUREMENT SUBSEQUENT TO INITIAL

RECOGNITION
As previously mentioned, at the point of initial recognition of an item of property, plant and equipment,
the asset is measured at cost. After this initial recognition, an entity has a choice on the measurement basis
to be adopted. IAS 16 paragraph 29 recognises two possible measurement models:
• the cost model
• the revaluation model.
The choice of model is an accounting policy decision. That policy is not applied to individual assets but
to an entire class of property, plant and equipment. Hence, for each class of assets, an entity must decide
the measurement model to be used. Having chosen a particular measurement model for a specific class
of assets, the entity may later change to the alternative basis. For example, an entity that initially chose
the revaluation model may at a later date change to the cost model. In order to change from one basis
to another, the principles of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors must be
applied. Paragraph 14 of IAS 8 states:
An entity shall change an accounting policy only if the change:
(a) is required by an IFRS; or
(b) results in the financial statements providing reliable and more relevant information about the effects of
transactions, other events or conditions on the entity’s financial position, financial performance or cash
flows.
It is part (b) that establishes the principle for change. The key is whether the change in measurement
basis will make the financial statements more useful to users; in particular, will the information be more
relevant and/or more reliable? In general, a change from the cost model to the revaluation model would
be expected to increase the relevance of information provided because more current information is being
made available. However, the change may make the information less reliable, as the determination of fair
value requires estimation to occur. The entity would need to assess the overall benefit of the change in
order to justify the change. In contrast, changing from the revaluation model would generally lead to a
decrease in the relevance of the information. However, it may be that the determination of fair value has
become so unreliable that the fair values determined have little meaning. Again, a judgement of the rela-
tive trade-offs between relevance and reliability needs to be made.
Paragraph 17 of IAS 8 notes that the accounting for a change from the cost model to the revaluation
model constitutes a change in accounting policy, but the accounting for such a change is done in accord-
ance with the principles in IAS 16 rather than those in IAS 8, namely by applying the principles of the
revaluation model. No such statement is made about a change from fair value back to cost. It would
appear that the accounting for this is based on IAS 8, paragraph 22 in particular. This paragraph requires
the change to be applied retrospectively, and the information disclosed as if the new accounting policy
had always been applied. Hence, a change from the revaluation model to the cost model would require
adjustments to the accounting records to show the information as if the cost model had always been
applied. Adjustments can be taken through the opening balance of retained earnings. Comparative infor-
mation would also need to be restated.
LO5 11.5 THE COST MODEL

After recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accu-
定义 mulated depreciation and any accumulated impairment losses.
The cost is as described in section 11.3, and includes outlays incurred up to the point where the asset is
at the location and in the working condition to be capable of operating in the manner intended by man-
agement. Note that this entails management determining a level of operations, a capacity of production
or a use for the item of property, plant and equipment. In getting a machine to an appropriate working
condition, management may need to undertake certain outlays to keep the machine running efficiently
at that level. In relation to a vehicle that is needed to take a driver from point A to point B, the car needs
to run efficiently and at a required safety level, without breaking down. In order for this to occur, the
car needs to be regularly serviced, have tune-ups and incur any other routine checks. Costs associated
with keeping the item of property, plant and equipment at the required working condition are expensed,
and not added to the depreciable cost of the asset. These costs are generally referred to as repairs and
maintenance.

Similar examples can be seen with other assets, such as escalators that need to be regularly maintained
to ensure they achieve the basic task of moving passengers from one level to another. Most items of plant
with moving parts require some form of regular maintenance. Paragraph 12 of IAS 16 notes the existence
of these ‘repairs and maintenance’ costs, stating that these costs should not be capitalised into the cost of
the asset. These costs relate to the day-to-day servicing of the asset and consist mainly of labour and con-
sumables, but may also include the cost of small parts. Costs of repairs and maintenance are expensed as
incurred.
After acquisition, management may also outlay funds refining the ability of the asset to operate. These
are not outlays associated with repairs, maintenance or replacement. Examples of such expenditures relate
to outlays designed to increase the remaining useful life of the asset, increase its capacity, improve the
quality of the output, and adjust the asset to reduce operating costs.
A decision to capitalise these outlays requires the application of the recognition principle in paragraph 7
of IAS 16. Capitalisation requires there to be an increase in probable future economic benefits associated
with the asset; that is, it should be probable that the expenditure increases the future economic benefits
embodied in the asset in excess of its standard of performance assessed at the time the expenditure is
made. Note the timing of the assessment process: at the time the expenditure is incurred. The comparison
is not with the original capacity to operate or the expected future benefits at acquisition, but with the
capacity existing at the time the subsequent expenditure is incurred. Hence, if the capacity of the asset
had reduced over time, expenditure to revive the asset to its original capacity would be capitalised. The
assessment of capacity requires judgement, and needs to take into account matters such as the level of
maintenance performed before the incurrence of the subsequent expenditure. The latter could not include
the costs of any as yet unperformed maintenance work.
11.5.1 Depreciation
Under the cost model, after initial recognition, an asset continues to be recorded at its original cost. The
subsequent carrying amount is determined after adjustments are made only for depreciation and impair-
ment losses. (Impairment losses are discussed in chapter 15.) The main point of the following discussion is to
determine the depreciation in relation to an item of property, plant and equipment.
In order to understand the accounting principles for depreciation, it is necessary to consider the definitions
of depreciation, depreciable amount, useful life and residual value contained in paragraph 6 of IAS 16:
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value.
The residual value of an asset 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.
Useful life is:
(a) the period over which an asset is expected to be available for use by an entity; or
(b) the number of production or similar units expected to be obtained from the asset by an entity.
Process of allocation
Depreciation is a process of allocation. Assets by definition are expected future benefits and, as noted in
section 11.2, the initial recognition of an item of property, plant and equipment requires that it is probable
that the future benefits will flow to the entity. On acquiring these benefits, an entity will have expectations
as to the period over which these benefits are to be received and the pattern of these benefits (e.g. they
could be received evenly over the life of the asset). The purpose of determining the depreciation charge for
the period is to measure the consumption of benefits allocable to the current period, ensuring that, over
the useful life of the asset, each period will be allocated its fair share of the cost of the asset acquired. This
principle is found in paragraphs 50 and 60 of IAS 16:
50 The depreciable amount of an asset shall be allocated on a systematic basis over its useful life.
60 The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are
expected to be consumed by the entity.
By describing depreciation as a process of allocation, the IASB is effectively arguing that an increase in
value is not sufficient justification for not depreciating an asset. The IASB wants to consider separately the
consumption of benefits and the changes in value over a period. In its 1996 discussion paper, ‘Measure-
ment of tangible fixed assets’, the Accounting Standards Board in the United Kingdom provided the fol-
lowing example (paragraph 5.15) to illustrate the difference between consumption and changes in value:
Even where there are no general price changes, a change in the value of a tangible asset might still not reflect
the consumption of economic benefits of the asset. For example, the drop in value of a new car during its first
year would be unlikely to equate to the consumption of economic benefits of the car during the same period
resulting from the use of the car. This difference occurs because the price change reflects the market’s evaluation
of the decline in economic benefits, which may differ from that made by a business. In this example the price
change reflects the market’s evaluation of the additional economic benefits a new car has over a second-hand car
284 PART 2 Elements

(e.g. the purchaser of a new car can specify exactly what features he wants while the purchaser of a second-hand
car cannot, a new car has a known history etc.), but does not reflect the business’s evaluation of the remaining
economic benefits.
Under IAS 16, the depreciation charge for the period reflects the consumption of the economic benefits
over the period and ignores the fall in the asset’s fair value. As paragraph 52 of the standard states, deprecia-
tion is recognised even if the fair value of an asset is greater than its carrying amount (which is the amount
at which an asset is recognised after deducting any accumulated depreciation and accumulated impairment
losses). However, depreciation is not recognised if the asset’s residual value exceeds the carrying amount.
As noted later in this chapter, where a revalued amount is used rather than cost, the depreciation charge
affects current period income, and an increase in the value of the asset affects revaluation surplus. If both
amounts affected income, then it would be important to determine whether it is useful to try to measure
separately the two components of the change in value of the asset. If depreciation is capitalised into the
cost of production, it may be argued that only the amount relating to the consumption of benefits should
affect the cost of inventory produced.
Methods of depreciation
The accounting policy that an entity must adopt for depreciation is specified in paragraphs 50 and 60 of
IAS 16, namely the systematic allocation of the cost or other revalued amount of an asset over its useful
life in a manner that reflects the pattern in which the asset’s future economic benefits are expected to be
consumed. There are many methods of allocation, depending on the pattern of benefits. Paragraph 62 of
the standard notes three methods:
• Straight-line method. This is used where the benefits are expected to be received evenly over the useful
life of the asset. The depreciation charge for the period is calculated as:
Depreciable amount Cost less residual value

=
Useful life Useful life
If an item of plant had an original cost of £100 000, a residual value of £10 000, and a useful life of
4 years, the depreciation charge each year is:
Depreciation expense p.a. = ¼(£100 000 – £10 000)

= £22 500
• The journal entry is:
Depreciation Expense – Plant Dr 22 500

Accumulated Depreciation – Plant Cr 22 500
(Depreciation on plant per annum)
Note that both the residual value and the useful life may change during the life of the asset as
expectations change.
• Diminishing-balance method. This method is used where the pattern of benefits is such that more
benefits are received in the earlier years in the life of the asset. As the asset increases in age, the benefits
each year are expected to reduce.
It is possible to calculate a rate of depreciation that would result in the depreciable amount being
written off over the useful life, with the depreciation charge each year being calculated by multiplying
the rate by the carrying amount at the beginning of the year. The formula is:
r
Depreciation rate = 1– n
c
where n = useful life
r = residual value
c = cost or other revalued amount
Using the same information as in the example for the straight-line method, the depreciation rate under
the diminishing-balance method is:
10 000
Depreciation rate = 1– 4
100 000
= 44% approximately

The depreciation expense each year following acquisition of the item of plant at the beginning of the
first year is:
Year 1 depreciation expense = 44% × £100 000 = £ 44 000

Year 4 depreciation expense = £13 798 − £10 000 = £ 3 798
The depreciation charge then reflects a decreasing pattern of benefits over the asset’s useful life.
• Units-of-production method. This method is based on the expected use or output of the asset. Variables
used could be production hours or production output.
Using the above example again, assume that over the 4-year life of the asset the expected output of
the asset is as follows:
Year 1 17 000 units

Year 2 15 000 units
Year 3 12 000 units
Year 4 6 000 units
50 000 units
The depreciation expense in each of the 4 years is:
Year 1 depreciation expense = 17/50 × £90 000 = £ 30 600

£ 90 000
IAS 16 does not specify the use of any specific method of depreciation. The method chosen by an entity
should be based on which method most closely reflects the expected pattern of consumption of the future
economic benefits embodied in the asset.
Paragraph 61 of IAS 16 requires an entity to review the depreciation method chosen to ensure that it
is providing the appropriate systematic allocation of benefits. The review process should occur at least at
the end of each financial year. If there has been a change in the pattern of benefits such that the current
method is inappropriate, the method should be changed to one that reflects the changed pattern of bene-
fits. This change is not a change in an accounting policy, simply a change in accounting method. As such it
is accounted for as a change in an accounting estimate, with the application of IAS 8. Under paragraph 36
of IAS 8, the change is recognised prospectively with adjustments being made to the amounts recognised
in the current period and future periods as appropriate.
The depreciation method is applied from the date the asset is available for use; that is, when it is in the
location and condition necessary for it to perform as intended by management. As noted in paragraph
55 of IAS 16, depreciation continues even if the asset is temporarily idle, dependent on movements in
residual value and expected useful life. However, under methods such as the units-of-production method,
no depreciation is recognised where production ceases.
Useful life
Determination of useful life requires estimation on the part of management, because the way in which an
item of property, plant and equipment is used and the potential for changes in the market for that item
affect estimates of useful life. Paragraph 56 of IAS 16 provides the following list of factors to consider in
determining useful life:
(a) the expected usage of the asset by the entity; this is assessed by reference to the asset’s expected capacity
or physical output
(b) the expected physical wear and tear, which depends on operational factors such as the number of work
shifts for which the asset will be used and the repair and maintenance programme of the entity, and
the care and the maintenance of the asset while it is idle
(c) technical or commercial obsolescence arising from changes or improvements in production, or from a
change in the market demand for the product or service output of the asset. For example, computers
may be regarded as having a relatively short useful life. The actual period over which they may be
expected to work is probably considerably longer than the period over which they may be considered
to be technologically efficient. The useful life for depreciation purposes is related to the period over
286 PART 2 Elements

which the entity intends to use them, which is probably closer to their technological life than the
period over which they would be capable of being used
(d) legal or similar limits on the use of the asset, such as expiry dates of related leases.
There is no necessary relationship between useful life to the entity and the economic life of the asset.
Management may want to hold only relatively new assets, and a policy of replacement after specified
periods of time may mean that assets are held for only a proportion of their economic lives. In other
words, useful life for the purpose of calculating depreciation is defined in terms of the asset’s expected use-
fulness to the entity. As noted earlier, the useful life of an asset covers the entire time the asset is available
for use, including the time the asset is idle but available for use.
As noted in paragraph 58 of IAS 16, land is a special type of asset. Unless the land is being used for
a purpose where there is a limited life imposed on the land, such as a quarry, it is assumed to have an
unlimited life. Such land is not subject to depreciation. Hence, when accounting for land and buildings,
these assets are dealt with separately so that buildings are subject to depreciation. If, however, the cost of
land includes the expected costs of dismantling, removal or restoration, then these costs are depreciated
over the period in which the benefits from use of the land are received.
Just as the depreciation method requires a periodic review, so the useful life of an asset is subject to
review. According to paragraph 51 of IAS 16, the review should occur at least at each financial year-end.
A change in the assessment of the useful life will result in a change in the depreciation rate used.
As this is a change in accounting estimate, changes are made prospectively in accordance with IAS 8
paragraph 36.
ILLUSTRATIVE EXAMPLE 11.1 Assessment of useful life
Future View is in the business of making camera lenses. The machine used in this process is very well
made, and could be expected to provide a service in making the lenses currently demanded for another
20 years. As the machine is computer-driven, the efficiency of making lenses is affected by the sophisti-
cation of the computer program to define what is required in a lens. Technological advances are being
made all the time, and it is thought that a new machine with advanced technology will be available
within the next 5 years. The type of lens required is also a function of what cameras are considered to be
in demand by consumers. Even if there is a change in technology, it is thought that cameras with the old
style lens could still be marketable for another 7 years.
Required
What useful life should management use in calculating depreciation on the machine?
Solution
Three specific time periods are mentioned:
• physical life: 20 years
• technical life: 5 years
• commercial life: 7 years.
A key element in determining the appropriate life is assessing the strategy used by management in mar-
keting its products. If management believes that to retain market share and reputation it needs to be at
the cutting edge of technology, 5 years will be appropriate. If, however, the marketing strategy is aimed
at the general consumer, 7 years will be appropriate. In essence, management needs to consider at what
point it expects to replace the machine.
Residual value
Note again the definition of residual value in paragraph 6 of IAS 16:
The residual value of an asset is the estimated amount that the 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.
Residual value is an estimate based on what the entity would currently obtain from the asset’s disposal;
that is, what could be obtained at the time of the estimate — not at the expected date of disposal at the
end of the useful life. The estimate is based on what could be obtained from disposal of similar assets that
are currently, at the date of the estimate, at the end of their useful lives, and which have been used in a
similar fashion to the asset being investigated. Where assets are unique, this estimation process is much
more difficult than for assets that are constantly being replaced. For an asset such as a vehicle, which may
have a useful life of 10 years, the residual value of a new vehicle is the net amount that could be obtained
now for a 10-year-old vehicle of the same type as the one being depreciated. In many cases, the residual
value will be negligible or scrap value.

This form of assessment means that the residual value will not be adjusted for expected changes in
prices. Basing the residual value calculation on current prices relates to the adoption in IAS 16 of depre-
ciation as a process of allocating economic benefits. If the residual value were adjusted for future prices,
then there may be no measure of benefits consumed during the period as the residual value may exceed
the carrying amount at the beginning of the period. It is also debatable whether the residual value
should take into account possible technological developments. In relation to computers it may reason-
ably be expected that there will be such changes within a relatively short period of time, whereas with
motor vehicles, trying to predict cars being powered with something other than oil is more difficult.
Management is not required to be a predictor of future inventions. Expectations of technological change
are already built into current second-hand asset prices. Management should then take into account
reasonable changes in technological development and the effect on prices. Where assets are expected to
be used for the whole or the majority of their useful lives, the residual values are zero or immaterial in
amount.
In paragraphs BC28–BC29 of the Basis for Conclusions on IAS 16, the IASB raises the issue of why an
entity deducts an asset’s residual value from the cost of the asset for measurement of depreciation. Two
reasons are proposed. First, the objective is one of precision; that is, reducing the amount of depreciation
so that it reflects the item’s net cost. The second is one of economics; that is, stopping depreciation if
the entity expects the asset to increase in value by an amount greater than that by which it will diminish.
The IASB did not adopt either the net cost or the economic objective completely. Expected increases in
value do not override the need to depreciate an asset. An increase in the expected residual value of an asset
because of past events affects the depreciable amount; expectations of future changes in residual value
other than the effects of expected wear and tear will not.
Where residual values are material, an entity must, under paragraph 51 of IAS 16, review the residual
value at each financial year-end. If a change is required, again the change is a change in estimate and is
accounted for prospectively as an adjustment to future depreciation.
Significant parts depreciation
It has been mentioned previously in this chapter that a significant parts approach requires an entity to
allocate the cost of an asset to its significant parts and account for each part separately; for example, the
cost of an aeroplane is allocated to such parts as the frame, the engines and the fittings. According to par-
agraph 43 of IAS 16, each part of an item of property, plant and equipment with a cost that is significant in
relation to the total cost of the item must be depreciated separately. In other words, an entity is required to
separate each item of property, plant and equipment into its significant parts, with each part being sepa-
rately depreciated. Any remainder is also depreciated separately.
Paragraph 13 of the standard discusses the replacement or renewal of the parts of an asset:
Under the recognition principle in paragraph 7, an entity recognises in the carrying amount of an item of prop-
erty, plant and equipment the cost of replacing part of such an item when that cost is incurred if the recognition
criteria are met. The carrying amount of those parts that are replaced is derecognised in accordance with the
derecognition provisions of this Standard (see paragraphs 67–72).
As is consistent with accounting for all separate items of property, plant and equipment, once an
acquired asset is separated into the relevant significant parts, if one of those parts needs regular replacing
or renewing, the part is generally accounted for as a separate asset. The replaced asset is depreciated over
its useful life, and derecognised on replacement.
To illustrate the accounting for parts, consider the case of a building with a roof that periodically
needs replacing. If the roof is accounted for as a separate part, then the roof is accounted for as a sep-
arate asset and is depreciated separately. On replacement, paragraph 13 of IAS 16 is applied, and the
carrying amount (if any) of the old roof is written off. In order for this derecognition to occur, it is
necessary to know the original cost of the roof and the depreciation charged to date. The new roof is
accounted for as the acquisition of a new asset, assessed under paragraph 7 and, if capitalised as an
asset, subsequently depreciated. If, however, the roof is not treated as a separate part from the acquisi-
tion date of the building, then on replacement of the roof, calculation of the amount to be derecognised
is more difficult. An estimation may need to be made of the cost of the roof at acquisition date in order
to derecognise the roof.
Another example of dealing with a part of an asset arises where assets are subject to regular major
inspections to ensure that they reach the requisite safety and quality requirements. Under paragraph
14 of IAS 16, such major inspections may be capitalised as a replacement part. In order for the cost of
the inspection to be capitalised, the recognition criteria in paragraph 7 of the standard must be met. In
particular, it must be probable that future economic benefits associated with the outlay will flow to the
entity. For example, if there is a 5-year inspection of aircraft by a specific party, and this is required every
5 years in order for the plane not to be grounded, then the cost of the inspection provides benefits to
the owner of the aircraft for that period of time by effectively providing a licence to continue flying. The
capitalised amount is then depreciated over the relevant useful life, most probably the time until the
next inspection.
288 PART 2 Elements

LO6 11.6 THE REVALUATION MODEL
Use of the revaluation model of measurement is the alternative treatment to the cost model. Paragraph 31
of IAS 16 states:
After recognition as an asset, an item of property, plant and equipment whose fair value can be measured reli-
ably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent
accumulated depreciation and subsequent accumulated impairment losses. Revaluations shall be made with
sufficient regularity to ensure that the carrying amount does not differ materially from that which would be
determined using fair value at the end of the reporting period.
In relation to this paragraph, note the following points:
1. The measurement basis is fair value, defined in Appendix A of IFRS 13 Fair Value Measurement 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 an exit price and is measured in
accordance with IFRS 13. Under this standard, there are a number of methods that may be used to
measure fair value such as the market approach, the cost approach and the income approach. There
are also a variety of inputs to these valuation techniques which are prioritised into three levels — Level
1, Level 2 and Level 3. This fair value hierarchy gives highest priority to observable inputs rather than
unobservable inputs. See chapter 3 for more information on fair value measurement.
2. IAS 16 does not specify how often revaluations must take place. The principle established is that the
revaluations must be of sufficient regularity such that the carrying amount of the asset does not ma-
terially differ from fair value. The frequency of revaluations depends on the nature of the assets them-
selves. For some assets, frequent revaluations are necessary because of continual change in the fair
values owing to a volatile market. For other assets, revaluation every 3 or 5 years may be appropriate
(paragraph 34). Paragraph 38 notes that assets may be revalued on a rolling basis provided that the
total revaluation is completed within a short period of time, and that at no time is the total carrying
amount of the class of assets materially different from fair value.
3. To understand the type of information that might be observed in determining whether there is a need
to revalue an asset, it is useful to note the inputs into the valuation techniques. For example, in para-
graph B35(g) of IFRS 13, in relation to buildings held and used, it is noted that a Level 2 input would
be the price per square metre for the building derived from observable market data; for example,
multiples derived from process in observed transactions involving comparable or similar buildings in
similar locations.
Paragraph 36 of IAS 16 notes that the revaluation model is not applied to individual items of property,
plant and equipment; instead, the accounting policy is applied to a class of assets. Hence, for each class of
assets, management must choose whether to apply the cost model or the revaluation model.
A class of property, plant and equipment ‘is a grouping of assets of a similar nature and use in an entity’s
operations’ (IAS 16 paragraph 37). Examples of separate classes are:
• land
• land and buildings
• machinery
• ships
• aircraft
• motor vehicles
• furniture and fixtures
• office equipment.
There are two purposes for requiring revaluation to be done on a class rather than on an individual
asset basis. First, this limits the ability of management to selectively choose which assets to revalue. Thus
in order to be able to adopt the revaluation model, the fair values need to be capable of being reliably
measured for all assets within the class. Second, the requirement to have all assets within the class meas-
ured on a fair value basis means that there is consistent measurement for the same type of assets in the
entity.
According to paragraph 31 of IAS 16, where an asset is carried at a revalued amount, recognition of the
asset should occur only when the fair value can be measured reliably. One question arising here is that, if
a class of assets is being carried at fair value but there are assets within that class for which the fair value
cannot be reliably measured, should those assets be written off because the recognition criteria cannot
be met? The problem is that writing off these assets provides less relevant information than including the
assets at cost.
11.6.1 Applying the revaluation model: revaluation increases

Paragraphs 39 and 40 of IAS 16 contain the principles for applying the fair value method to revaluation
increases. These paragraphs apply to individual items of property, plant and equipment. In other words, even
though revaluations are done on a class-by-class basis, the accounting is done on an asset-by-asset basis.

The first part of paragraph 39 states:
If an asset’s carrying amount is increased as a result of a revaluation, the increase shall be recognised in other
comprehensive income and accumulated in equity under the heading of revaluation surplus.
Note two points here:
1. The increase is recognised in comprehensive income. In the statement of profit or loss and other comprehensive
income, the comprehensive income for a period is divided into profit or loss (P/L) for the period and
other comprehensive income (OCI). Revaluation increases are recognised in other comprehensive
income, not profit or loss. An example of a statement of profit or loss and other comprehensive income
showing the disclosure of profit for the year separately from the other comprehensive income items is
given in figure 11.2.
XYZ GROUP
Statement of Profit or Loss and Other Comprehensive Income
for the year ended 31 December 20X7
(illustrating the presentation of profit or loss and other comprehensive income
in one statement and the classification of expenses within profit by function)
(in thousands of currency units)
20X7 20X6
Revenue 390 000 355 000
Cost of sales (245 000) (230 000)
Gross profit 145 000 125 000
Other income 20 667 11 300
Distribution costs (9 000) (8 700)
Administrative expenses (20 000) (21 000)
Other expenses (2 100) (1 200)
Finance costs (8 000) (7 500)
Share of profit of associates 35 100 30 100
Profit before tax 161 667 128 000
Income tax expense (40 417) (32 000)
Profit for the year from continuing operations 121 250 96 000
Loss for the year from discontinued operations (30 500)
Profit for the year 121 250 65 500
Other comprehensive income
Items that will not be reclassified to profit or loss
Gains on property revaluation 933 3 367
Actuarial gains (losses) on defined benefit pension plans (667) 1 333
Share of gain (loss) on property revaluation of associates 400 (700)
Income tax relating to items that will not be reclassified (166) (1 000)
500 3 000
20X7 20X6
Items that may be reclassified subsequently to profit or loss
Exchange differences on translating foreign operations 5 334 10 667
Available-for-sale financial assets (24 000) 26 667
Cash flow hedges (667) (4 000)
Income tax relating to items that may be reclassified 4 833 (8 334)
(14 500) 25 000
Other comprehensive income for the year, net of tax (14 000) 28 000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 107 250 93 500
FIGURE 11.2 Statement of profit or loss and other comprehensive income

Source: International Accounting Standards Board (2011, p. B1026).
Hence the initial journal entry for a revaluation increase is:
Asset Dr xxx
Gain on Revaluation of Non-Current Asset (OCI) Cr xxx
(Revaluation of asset)
290 PART 2 Elements

In accordance with paragraph 42 of IAS 16, the effects of any taxes on income need to be accounted
for in accordance with IAS 12 Income Taxes. A revaluation of an asset causes a change between the tax
base and the carrying amount of the asset, giving rise to a temporary difference, and a deferred tax
liability needs to be raised (see paragraph 20 of IAS 1). Paragraph 90 of IAS 1 Presentation of Financial
Statements requires the disclosure of ‘the amount of income tax relating to each item of other compre-
hensive income’. To reflect the tax effect of the gain, the required entry is:
Gain on Revaluation of Asset (OCI) Dr xxx

Deferred Tax Liability Cr xxx
(Recognition of tax effect of revaluation increase)
The reason for the immediate recognition of the deferred tax effect is because, as explained below, the
gain on revaluation of non-current assets is accumulated in equity.
2. Having recognised the gain in other comprehensive income, the gain, net of tax, is transferred to equity
under the heading of revaluation surplus. The required entry is:
Gain on Revaluation of Non-Current Asset (OCI) Dr xxx

Asset Revaluation Surplus Cr xxx
(Accumulation of net revaluation gain in equity)
The asset revaluation surplus is disclosed in the reserve section of the statement of financial position.
ILLUSTRATIVE EXAMPLE 11.2 Revaluation increases and tax effect
On 1 January 2014, XYZ Group carries an item of land at a cost of £100 000, this amount also being the
tax base of the asset. The land is revalued to £120 000. The tax rate is 30%.
The tax base of the asset is £100 000 and the new carrying amount is £120 000, giving rise to a tax-
able temporary difference of £20 000. A deferred tax liability of £6000 must be raised to account for the
expected tax to be paid in relation to the increase in expected benefits from the asset. The asset reval-
uation surplus raised will be the net after-tax increase in the asset (£20 000 − £6000 = £14 000). The
appropriate accounting entries on revaluation of the asset are shown in figure 11.3.
Land Dr 20 000
Gain on Revaluation of Land (OCI) Cr 20 000
(Recognition of revaluation increase: £120 000 – £100 000)
Gain on Revaluation of Land (OCI) Dr 6 000


Asset Revaluation Surplus Cr 14 000
FIGURE 11.3 Journal entries for revaluation with associated tax effect
Where the item of property, plant and equipment is depreciable, there are two possible accounting
treatments under paragraph 35 of IAS 16:
1. restate proportionately with the change in the gross carrying amount of the asset so that the carrying
amount of the asset after revaluation equals its revalued amount; or
2. eliminate the accumulated depreciation balance against the gross carrying amount of the asset and
then restate the net amount to the fair value of the asset. This method is applied in this chapter.
ILLUSTRATIVE EXAMPLE 11.3 Revaluation increases and depreciable assets
On 30 June 2014, an item of plant has a carrying amount of £42 000, being the original cost of £70 000
less accumulated depreciation of £28 000. The fair value of the asset is £50 000. The tax rate is 30%. The
entries are shown in figure 11.4.

The revaluation is done in two steps:
The first step is to write off the accumulated depreciation of the plant, reducing the asset to its carrying
amount of £42 000.
Accumulated Depreciation Plant Dr 28 000

Plant Cr 28 000
(Write down asset to its carrying amount)
The second step is to adjust the carrying amount of £42 000 to the fair value of the asset, £50 000, being
an increase of £8000. This increase is tax-effected, and the net gain accumulated to equity.
Plant Dr 8 000
Gain on Revaluation of Plant (OCI) Cr 8 000
(Revaluation of asset to fair value)
Gain on Revaluation of Plant (OCI) Dr 2 400

(Tax effect of revaluation increase)

FIGURE 11.4 Revaluation increase and depreciable assets
ILLUSTRATIVE EXAMPLE 11.4 Revaluation increase and the tax-effect worksheet
Assume that the depreciable asset in illustrative example 11.3 was acquired for £70 000 on 1 July 2012.
Depreciation rates are on a straight-line basis at 20% p.a. for accounting and 35% for tax. The tax rate is 30%.
On 30 June 2013, the carrying amount and the tax base of the asset are as follows:
Accounting Tax
Original cost £ 70 000 £ 70 000
Net amount 56 000 45 500
Hence, the taxable temporary difference at 30 June 2013 is £10 500 (£56 000 − £45 500), with a deferred
tax liability of £3150 being recognised.
On 30 June 2014, the asset has a carrying amount and tax base as follows:
Accounting Tax
Original cost £ 70 000 £ 70 000
Net amount 42 000 21 000
Assume that on this date the asset is revalued to £50 000. The appropriate entries are:
2014
June 30 Accumulated Depreciation Dr 28 000
Plant Cr 28 000
Plant Dr 8 000

292 PART 2 Elements

For the purpose of determining required entries for tax-effect accounting at the end of the year,
the carrying amount of the asset on 30 June 2014 in the accounting records is now £50 000, but its
tax base is unchanged at £21 000. This gives a taxable temporary difference of £29 000, and a total
deferred tax liability of £8700 at a 30% tax rate. As the beginning deferred tax liability for the year
is £3150 and £2400 of the deferred tax liability is already recognised in the revaluation entry above,
the adjustment required in the current year ending 30 June 2014 is £3150 (8700 − 3150 − 2400) or
(£6300 − £3150). In order to recognise the adjustment to the deferred tax liability, the appropriate
entry is as follows:
2014
June 30 Income Tax Expense Dr 3 150
(Recognition of deferred tax liability)
The tax-effect worksheet is shown in figure 11.5.
Taxable Deductible
Carrying Taxable Deductible Tax temporary temporary
amount amount amount base differences differences
Plant £50 000 £(50 000) £21 000 £21 000 £29 000
Temporary difference 29 000
Deferred tax liability — closing balance 8 700 Cr
Beginning balance 3 150 Cr
5 550
Movement during the year 2 400 Cr
Adjustment 3 150 Cr
FIGURE 11.5 Tax-effect worksheet on revaluation of assets
Revaluation increase reversing previous revaluation decrease

The full text of paragraph 39 of IAS 16 is as follows:
If an asset’s carrying amount is increased as a result of a revaluation, the increase shall be recognised in other
comprehensive income and accumulated in equity under the heading of revaluation surplus. However, the
increase shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset
previously recognised in profit or loss.
Hence, a revaluation increase is credited to an asset revaluation surplus unless the increase reverses a
revaluation decrease previously recognised as an expense in which case it is recognised as income. The
accounting treatment for revaluation decreases is discussed in the next section.
11.6.2 Applying the revaluation model: revaluation decreases

If an asset’s carrying amount is decreased as a result of a revaluation, the decrease shall be recognised in profit
or loss. However, the decrease shall be recognised in other comprehensive income to the extent of any credit
balance existing in the revaluation surplus in respect of that asset.
As with revaluation increases, this paragraph covers two situations: a revaluation decrease, and a revalu-
ation decrease following a previous revaluation increase.
The accounting for a revaluation decrease involves an immediate recognition of a loss in the period of
the revaluation. As the change in the carrying amount of the asset directly affects income, the tax effect is
dealt with in the normal workings of tax-effect accounting. Hence, no extra tax-effect entries outside those
generated via the tax-effect worksheet are necessary in accounting for revaluation decrease.

ILLUSTRATIVE EXAMPLE 11.5 Revaluation decrease
Assume an item of plant has a carrying amount of £50 000, being original cost of £60 000 less accumu-
lated depreciation of £10 000. If the asset is revalued downwards to £24 000, the appropriate journal
entries are:
Accumulated Depreciation Dr 10 000

Plant Cr 10 000
(Write down asset to its carrying amount of £50 000)
Loss – Downward Revaluation of Plant (P/L) Dr 26 000

Plant Cr 26 000
(Revaluation of asset from carrying amount of £50 000 to fair
value of £24 000)
In relation to the tax-effect worksheet, if the carrying amount and the tax base in this example were
the same immediately before the revaluation, then there would be a deductible temporary difference
of £26 000. A deferred tax asset of £7800 would be raised via the tax-effect worksheet analysis at the end
of the reporting period.
Decrease reversing previous revaluation increase

Where an asset revaluation surplus has been raised via a previous revaluation increase, in accounting for a
subsequent revaluation decrease for the same asset, the surplus must be eliminated before any expense is
recognised. In adjusting for the previous revaluation increase, both the asset revaluation surplus and the
related deferred tax liability must be reversed.
ILLUSTRATIVE EXAMPLE 11.6 Decrease reversing previous increase
Assume XYZ Group has a block of land with a carrying amount of £200 000. When the land was revalued
upwards from £100 000, the following entries were passed:
Land Dr 100 000

Gain on Revaluation of Land (OCI) Cr 100 000
Gain on revaluation of land (OCI) Dr 30 000


If the asset is revalued downwards to £160 000, the £40 000 write-down is a partial reversal of the pre-
vious upward revaluation. The accounting entries then reflect:
• a recognition of the decrease on other comprehensive income, and
• a decrease in accumulated equity, namely, asset revaluation surplus.
Loss on Revaluation of Land (OCI) Dr 40 000

Land Cr 40 000
(Revaluation downwards of land)

Loss on Revaluation of Land (OCI) Cr 12 000
(Tax effect of revaluation decrease)
Asset Revaluation Surplus Dr 28 000

(Reduction in accumulated equity due to revaluation decrease
on land)
294 PART 2 Elements

If the asset is revalued downwards to £80 000, which is a reduction of £120 000, the asset is written down
to an amount £20 000 less than the original cost of the asset.
In accordance with paragraph 40, the downward revaluation requires a loss to be recognised in profit
or loss, as well as a decrease to be recognised in other comprehensive income. Effectively this will result
in the elimination of the deferred tax liability and the asset revaluation surplus previously raised. The
appropriate entries are:
Loss on Revaluation of Land (P/L) Dr 20 000

Loss on Revaluation of Land (OCI) Dr 100 000
Land Cr 120 000
(Revaluation downwards of land)

(Tax effect of loss on revaluation of land)

(Reduction in accumulated equity due to revaluation decrease
on land)
The tax-effect worksheet, assuming the original revaluation increase occurred in a previous period, is
Taxable Deductible
Carrying Taxable Deductible temporary temporary
amount amount amount Tax base differences differences
Land £80 000 £(80 000) £100 000 £100 000 £20 000
Temporary difference 20 000
Deferred tax liability — closing balance —
Deferred tax asset — closing balance 6 000 Cr
Beginning balance £30 000 Cr
Movement during the year 30 000 Dr
Adjustment 6 000 Dr
FIGURE 11.6 Tax-effect worksheet on revaluation of assets
The tax-effect worksheet shows that XYZ Group would recognise a deferred tax asset of £6000,
reflecting the fact that the carrying amount of the asset is £20 000 less than the tax base.
Net revaluation increase reversing previous revaluation decrease

Where an asset is revalued upwards, an asset revaluation surplus is credited except where the increase
reverses a revaluation decrease previously recognised as a loss. In this case, the revaluation increase must
be recognised as a gain.
ILLUSTRATIVE EXAMPLE 11.7 Revaluation increase reversing previous decrease
Assume XYZ Group has an item of plant whose current carrying amount is £200 000 (accumulated
depreciation being £20 000). The asset had cost £300 000. It was revalued downwards from a carrying
amount of £270 000 to £220 000, with the following accounting entries being passed:

Plant Cr 30 000

Loss – Downward Revaluation of Plant (P/L) Dr 50 000
Plant Cr 50 000
(Revaluation of asset from carrying amount of £270 000 to
fair value of £220 000)
If the asset is assessed as having a fair value of £230 000, there is a revaluation increase of £30 000.
However as there was a previous decrease of £50 000, the appropriate revaluation entry must reverse
part of this previously recognised revaluation loss. The entries are:

Plant Cr 20 000
Plant Dr 30 000
Gain on Revaluation of Plant (P/L) Cr 30 000
(Revaluation of asset from carrying amount of £200 000 to
fair value of £230 000, subsequent to prior write-down of
the asset)
If the asset is assessed as having a fair value of £280 000, the accounting entries recognise the increase
of £80 000 as consisting of two parts:
1. the reversal of the previously recognised write-down loss of £50 000; the reversal is recognised as a
gain, and disclosed in profit or loss
2. the £30 000 increase recognised in other comprehensive income and accumulated in asset revalua-
tion surplus.
The entries are:

Plant Cr 20 000
Plant Dr 80 000
(Revaluation of plant from carrying amount of £200 000 to

(Tax effect of revaluation gain)

(Accumulation of revaluation gain in equity)
11.6.3 Effects of accounting on an asset-by-asset basis

If the fair value basis of measurement is chosen, IAS 16 requires it to be applied to items of property, plant
and equipment on a class-by-class basis. However, in accounting for revaluation increases and decreases,
the accounting is done on an individual asset basis within the class. Practising accountants and standard
setters have often argued that a better accounting treatment would be to account for revaluation increases
and decreases on a class-by-class basis. The rationale for this is that under IAS 16 revaluation increases
(gains) are recognised in other comprehensive income and accumulated in equity while revaluation
decreases (losses) are recognised in profit or loss in the period the revaluation occurs. If revaluation was
done on a class-by-class basis, then it would be the net increase that would be accounted for, providing a
netting of the gains and losses. Figure 11.7 illustrates this.
296 PART 2 Elements

Carrying amount Fair value Increase/(decrease)
Assets £ £ £
Plant A 1 500 000 2 000 000 500 000

Plant B 1 500 000 1 200 000 (300 000)
Total 3 000 000 3 200 000 200 000
FIGURE 11.7 Revaluation by asset or class of asset?
Applying IAS 16, both Plant A and Plant B, being in the one class of assets, have to be revalued to fair value
if the revaluation model is applied to plant. However, in accounting for the movements in fair value, each
asset is dealt with separately. With Plant A, as there is a revaluation increase of £500 000, the increase results in
a £500 000 gain being recognised in other comprehensive income and £350 000 (assuming a tax rate of 30%)
being accumulated in equity affecting an asset revaluation surplus. With Plant B, the revaluation decrease of
£300 000 is recognised as an expense affecting current period profit or loss. For those who argue that revaluations
should be accounted for on a class-by-class basis, the net revaluation increase on plant is £200 000. Accounting
on a class basis would result in recognising a £200 000 gain in other comprehensive income and then accumu-
lating £140 000 in an asset revaluation surplus with no effect on current period profit or loss. The argument for
the class method of accounting is that it reduces the biased effect that the IAS 16 method has on current period
profit or loss. However the two methods produce the same total comprehensive income for the period.
11.6.4 Applying the revaluation model: transfers from asset

revaluation surplus
Paragraph 41 of IAS 16 covers the accounting for the asset revaluation surplus subsequent to its creation.
There are two circumstances where the asset revaluation surplus may be transferred to retained earnings.
Note that there is no requirement that the asset revaluation surplus must be transferred, only a specification
of situations where it may be transferred. The first situation is where the asset is derecognised (i.e. removed
from the statement of financial position, for example, by sale of the asset). In this case, the whole or part of
the surplus may be transferred. The second situation is where an asset is being used up over its useful life, a
proportion of the revaluation surplus may be transferred to retained earnings, the proportion being in rela-
tion to the depreciation on the asset. In this case, the amount of the surplus transferred would be equal to the
difference between depreciation based on the original cost, and depreciation based on the revalued amount,
adjusted for the tax effect relating to the surplus. This second situation is shown in illustrative example 11.8.
ILLUSTRATIVE EXAMPLE 11.8 Transferring revaluation surplus to retained earning
Assume an item of plant is acquired for £100 000. The plant is immediately revalued to £120 000. The
asset has a useful life of 10 years and the tax rate is 30%.
The revaluation entries are:
Plant Dr 20 000
(Revaluation of plant from £100 000 to £120 000)

(Tax effect of revaluation of plant)

(Accumulation of revaluation gain in equity)
At the end of the year, depreciation expense of £12 000 is recorded. As the remaining useful life of the
asset is 10 years (revaluation took place at acquisition), XYZ Group may transfer 10% of the asset reval-
uation surplus to retained earnings. The entry is:

Retained earnings Cr 1 400
(Transfer from asset revaluation surplus to retained earnings)

11.6.5 Applying the revaluation model: depreciation
of revalued assets
Section 11.5.1 discusses the accounting treatment for depreciation under IAS 16. As noted, the term ‘depreciable
amount’ includes ‘other amount substituted for cost’. This includes fair value. Paragraph 50 of IAS 16 notes
that depreciation is a process of allocation. Hence, even though an asset is measured at fair value, depre-
ciation is not determined simply as the change in fair value of the asset over a period. As with the cost
method, depreciation for a period is calculated after considering the pattern of economic benefits relating
to the asset and the residual value of the asset.
ILLUSTRATIVE EXAMPLE 11.9 Depreciation of revalued assets
Assume XYZ Group has an item of plant that was revalued to £1000 at 30 June 2014. The asset is
expected to have a remaining useful life of 5 years, with benefits being received evenly over that period.
The residual value is calculated to be £100. Consider two situations.
Situation 1
At 30 June 2015, no formal revaluation occurs and the management of XYZ Group assess that the car-
rying amount of the plant is not materially different from fair value.
The appropriate journal entry for the 2014–15 period is:
2015
June 30 Depreciation Expense Dr 180
Accumulated Depreciation Cr 180
(Depreciation on plant 1/5[£1000 − £100])
The asset is reported in the statement of financial position at a carrying amount of £820, equal to a gross
amount of £1000 less accumulated depreciation of £180, the carrying amount being equal to fair value.
Situation 2
At 30 June 2015, a formal revaluation occurs and the external valuers assess the fair value of the plant to
be £890. Tax rate is 30%.
The appropriate journal entries for the 2014–15 period are:
2015
June 30 Depreciation Expense Dr 180
Accumulated Depreciation Dr 180

Plant Cr 180
Plant Dr 70
Gain on Revaluation of Plant (OCI) Cr 70
(Revaluation of plant from £820 to £890)
Gain on Revaluation of Plant (OCI) Dr 21

(Tax effect of revaluation of plant)

Asset Revaluation Surplus Cr 49
In other words, there is a two-step process. Depreciation is allocated in accordance with normal depre-
ciation principles. Then, as a formal revaluation occurs, the accumulated depreciation is written off and
the asset revalued to fair value. The asset is reported in the statement of financial position at fair value of
£890 with no associated accumulated depreciation.
It may be argued that the accounting in situation 2 is inappropriate. Whereas the depreciation charge
affects profit or loss, the gain on the revaluation of the asset affects other comprehensive income. The
economic benefits in relation to the asset for the period are not only those achieved by consumption
298 PART 2 Elements

of the asset, but also those obtained by changes in the market value of the asset. However, these are
accounted for differently under IAS 16. It could then be argued that the appropriate depreciation in
situation 2 should be the change in fair value over the period, namely £110 (£1000 − £890), with the
journal entry being:
Depreciation Expense Dr 110

(Depreciation on plant)
No revaluation entry is then necessary. Note, however, that this entry is not allowed under IAS 16.
Subsequent to revaluation, XYZ Group should reassess the useful life and residual value of the
revalued asset because these may change as a result of economic changes affecting XYZ Group and its
use of assets. Using the example in scenario 2, following the revaluation at 30 June 2015, assume XYZ
Group determines that the residual value is £110 and the remaining useful life is 4 years. In the 2015–16
period, the depreciation entry is:

LO7 11.7 CHOOSING BETWEEN THE COST MODEL

AND THE REVALUATION MODEL
Given that IAS 16 allows entities a choice between the cost model and the revaluation model, it is of
interest to consider what motivates entities to choose between the two measurement models.
Arguments relating to the choice of models generally claim that a current price (a fair value) will provide
more relevant information than a past price (the original cost). However, the requirement under IAS 16 to
continuously adjust the carrying amounts of assets measured at fair value so that they are not materially dif-
ferent from current fair values provides a cost disincentive to management to adopt the revaluation model.
Costs associated with adopting the revaluation model include the cost of employing valuers, annual costs
associated with reviewing the carrying amounts to assess whether a revaluation is necessary, extra record-
keeping costs associated with the revaluations, including accounting for the associated revaluation increases
and decreases, and increased audit costs relating to the review of changing revalued amounts.
A further factor that influences some entities’ measurement choice in favour of the cost model is harmo-
nisation with US GAAP, which does not allow the revaluation of non-current assets.
Another factor that entities have to consider when choosing their measurement bases for classes of prop-
erty, plant and equipment is the effect of the model on the statement of profit or loss and other compre-
hensive income. Where assets are measured on a fair value basis, the depreciation per annum is expected
to be higher as the depreciable amount is higher.
Besides the effect of lower depreciation, there will be the effect on the disposal of the asset. Where an
asset is measured at fair value, there is expected to be an immaterial amount of profit or loss on sale as,
at the time of sale, the recorded amount of the asset should be close to that of the market price. For an
asset measured at cost, any gain or loss on sale will be reported in the statement of profit or loss and other
comprehensive income.
What, apart from increased relevance and reliability arguments, are the incentives for management to
use the revaluation model? The effect of adopting the revaluation model is to increase the entity’s assets
and equities (via the revaluation surplus). Hence, entities that need to report higher amounts in these
areas would consider adoption of the revaluation model. The incentives for entities to adopt fair value
measures then tend to be entity-specific because the entities face pressures relating to external circum-
stances. Examples of such pressures are:
• Entities with debt covenants generally have constraints relating to their debt–asset ratios, such as the
requirement that the debt–asset ratio must not exceed 50%. Hence, for an entity with increasing debt,
adoption of the revaluation model for a class of assets that is increasing in value will ease pressures
on the debt–asset ratio by increasing the asset base of the entity. This assumes that the debt covenant
allows revaluations to be taken into account in measuring assets.
• An entity’s reported profit figure may be under scrutiny from a specific source, such as a trade union
seeking reasons to support claims for higher pay, or regulators looking at monopoly control within an
industry.

Where there are pressures to report lower profits, adoption of the revaluation model provides scope
for higher depreciation charges. These are reflected in the profit or loss for the period. The increases in
the values of the non-current assets do not affect profit or loss but are reported in other comprehensive
income. If ratios such as rates of return on assets or equity are based on profit rather than comprehensive
income, lower reported profits and higher asset/equity bases will result in an entity being seen in a less
favourable light.
However, as noted above, the incentives relating to playing with profit and asset numbers tend to rely
on users of the information having no knowledge of accounting rules or movements in prices within
industries or sectors, or being unable to make comparisons across entities within an industry segment.
One of the key elements of analysing entities within an industry is comparability of information. If all
entities in the sector are applying the cost model, analysts can make their judgements by comparing the
information between the entities and applying information from sources other than accounting reports,
such as movements in price indexes. The entity then has less reason to incur the costs of adopting the
revaluation model of measurement.
LO8 11.8 DERECOGNITION

As noted in paragraph 3 of IAS 16, the standard does not apply to non-current assets classified as held for
sale and accounted for under IFRS 5. IAS 16 then deals with the disposal of non-current assets that have
not previously been classified as held for sale.
Paragraph 67 of IAS 16 identifies two occasions where derecognition of an item of property, plant and
equipment should occur:
• on disposal, such as the sale of the asset
• when no future economic benefits are expected, either from future use or from disposal.
When items of property, plant and equipment are sold, regardless of whether there are many or few
remaining economic benefits, the selling entity will recognise a gain or loss on the asset, this being deter-
mined as the difference between the net proceeds from sale and the carrying amount of the asset at the
time of sale (IAS 16 paragraph 71). In calculating the net proceeds from sale, any deferred consideration
must be discounted, and the proceeds calculated at the cash price equivalent (IAS 16 paragraph 72). As
the carrying amount is net of depreciation and impairment losses, it is necessary to calculate the deprecia-
tion from the beginning of the reporting period to the point of sale. Failing to do this, whether under the
cost model or the revaluation model, would be out of step with the key principle established in IAS 16
that depreciation is a process of allocation and each period must bear its fair share of the cost or revalued
amount of the asset.
The gain or loss on sale is included in the profit or loss for the period. Note paragraph 34 of IAS 1 Pres-
entation of Financial Statements:
IFRS 15 Revenue from Contracts with Customers requires an entity to measure revenue from contracts with
customers at the amount of consideration to which the entity expects to be entitled in exchange for trans-
ferring promised goods or services. For example, the amount of revenue recognised reflects the amount of
any trade discounts and volume rebates the entity allows. An entity undertakes, in the course of its ordinary
activities, other transactions that do not generate revenue but are incidental to the main revenue-generating
activities. An entity presents the results of such transactions, when this presentation reflects the substance of
the transaction or other event, by netting any income with related expenses arising on the same transaction.
For example:
(a) an entity presents gains and losses on the disposal of non-current assets, including investments and oper-
ating assets, by deducting from the proceeds on disposal the carrying amount of the asset and related selling
expenses; . . .
Paragraph 34 requires only the disclosure of the gain or loss on sale, as opposed to separate dis-
closure of the income and the carrying amount of the asset (see also paragraph 98(c) of IAS 1). The
argument for the netting of the income and expense is that gains/losses on the disposal of property,
plant and equipment result from activities that are not considered to be the main revenue-generating
activities of an entity.
In paragraph BC35 of the Basis of Conclusions on IAS 16, the IASB argued:
users of financial statements would consider these gains and the proceeds from an entity’s sale of goods in
the course of its ordinary activities differently in their evaluation of an entity’s past results and their projec-
tions of future cash flows. This is because revenue from the sale of goods is typically more likely to recur in
comparable amounts than are gains from sales of items of property, plant and equipment. Accordingly, the
Board concluded that an entity should not classify as revenue gains on disposals of items of property, plant
and equipment.
However, in preparing a cash flow statement, proceeds from the sale of property, plant and equipment
are normally shown as a cash flow from investing activities.
300 PART 2 Elements

ILLUSTRATIVE EXAMPLE 11.10 Disposals of assets
XYZ Group acquired an item of plant on 1 July 2013 for £100 000. The asset had an expected useful life
of 10 years and a residual value of £20 000. On 1 January 2016, XYZ Group sold the asset for £81 000.
Required
Prepare the journal entries relating to this asset in the year of sale.
Solution
At the point of sale, the depreciation on the asset must be calculated for that part of the year for which
the asset was held before the sale. Hence, for the half-year before the sale, under the straight-line method,
depreciation of £4000 (i.e. 0.5 × 1/10[£100 000 − £20 000]) must be charged as an expense. The entry is:
Depreciation Expense Dr 4 000

Accumulated Depreciation Cr 4 000
(Depreciation charge up to point of sale)
The gain or loss on sale is the difference between the proceeds on sale of £81 000 and the carrying
amount at time of sale of £80 000 (i.e. £100 000 − 2.5[1/10 × £80 000]), which is £1000. The required
journal entry is:
Cash Dr 81 000
Plant Cr 100 000
Gain on Sale of Plant Cr 1 000
(Gain on sale of asset)
In this example, the asset was sold for £81 000. Assume that the asset, now referred to as Plant A, was
traded in for another asset, Plant B. Plant B had a fair value of £280 000, with XYZ Group making a cash
payment of £202 000 as well as giving up Plant A. The trade-in amount is then £78 000. The journal
entries to record this transaction are:
Plant B Dr 280 000

Loss on Sale of Plant A (P/L) Dr 2 000
Accumulated Depreciation – Plant A Dr 20 000
Plant A Cr 100 000
Cash Cr 202 000
(Acquisition of Plant B and trade-in of Plant A)
LO9 11.9 DISCLOSURE

Paragraphs 73–79 of IAS 16 contain the required disclosures relating to property, plant and equipment.
Information in paragraph 73 is required on a class-by-class basis, and paragraph 77 relates only to assets
stated at revalued amounts. Paragraph 79 contains information that entities are encouraged to disclose,
but are not required to do so. Figure 11.8 provides an illustration of the disclosures required by IAS 16.
FIGURE 11.8 Illustrative disclosures required by IAS 16
IAS 16
paragraph

Property, plant and equipment
Freehold land and buildings on freehold land are measured on a fair value basis. At the end 73(a)
of each reporting period, the value of each asset in these classes is reviewed to ensure that it
does not differ materially from the asset’s fair value at that date. Where necessary, the asset is 77(a)
revalued to reflect its fair value. In June 2014, revaluations were carried out by an independent
(continued)

valuer; since then valuations have been made internally. The basis for the assessment of fair 77(b)
value has been by reference to observable transactions in the property market, including an
analysis of prices paid in recent market transactions for similar properties. No other valuation
techniques were used. 77(a)
All other classes of property, plant and equipment are measured at cost. 73(a)
Depreciation
Depreciation is provided on a straight-line basis for all property, plant and equipment, other 73(b)
than freehold land.
The useful lives of the assets are: 73(c)
2016 2015
Freehold buildings 40 years 40 years
Plant and equipment 5 to 15 years 5 to 15 years
Note 10: Property, plant and equipment
Land and Plant and
buildings equipment
2016 2015 2016 2015
£’000 £’000 £’000 £’000
Balance at beginning of year 1 861 1 765 2 840 2 640 73(d)
Accumulated depreciation (400) (364) (732) (520)
Carrying amount 1 461 1 401 2 108 2 120
Additions — 123 755 372 73(e)(i)
Disposals (466) (18) (181) (158) 73(e)(ii)
Acquisitions via business combinations 739 — 412 — 73(e)(iii)
Impairment losses — — (100) — 73(e)(v)
Depreciation (20) (36) (161) (212) 73(e)(vii)
Transfer to assets held for sale (438) — (890) — 73(e)(ix)
Net exchange differences 11 (9) 8 (14) 73(e)(viii)
Carrying amount at end of year 1 287 1 461 1 951 2 108 73(d)
Property, plant and equipment:

At cost 1 707 1 861 2 944 2 840
Accumulated depreciation and
impairment losses (420) (400) (993) (732)
Carrying amount at end of year 1 287 1 461 1 951 2 108 73(d)
For the freehold land and buildings measured at fair value, the carrying amount 77(e)
that would have been recognised if they had been carried at cost is:
2016 2015
£’000 £’000
Carrying amount at end of year 942 824
Plant and equipment of £420 000 have been pledged as security for loans to the company. 74(a)
The company has entered into a contract to acquire £640 000 of plant equipment 74(c)
over the next 2 years.
Activity in the revaluation surplus for land and buildings is as follows: 77(f)
2016 2015
£’000 £’000
Balance at beginning of year 309 303
Revaluation of gains on land and buildings 42 9
Deferred tax liability (13) (3)
Balance at end of year 338 309
There are no restrictions on the distribution of the balance of the surplus to shareholders.
302 PART 2 Elements

LO10 11.10 INVESTMENT PROPERTIES
IAS 40 Investment Properties requires that an entity differentiate between investment properties and other
properties, such as owner-occupied property.
For an item to be classified as investment property, it must meet the definition of investment property.
Investment property is essentially property from which the entity intends to earn capital appreciation or
rental income or both.
11.10.1 Definition and classification

Investment property is defined in paragraph 5 of IAS 40 as land or buildings (or both, or part of a
building), held by an owner or leased by a lessee under a finance lease:
• to earn rentals or for capital appreciation or both;
• rather than for use in the production or supply of goods or services or for administrative purposes or
sale in the ordinary course of business.
In addition, a property held under an operating lease may be classified as an investment property (see
below).
The following are examples of properties that are classified as investment property:
• property held for long-term capital appreciation;
• a building that is leased out to a third party under an operating lease; or a vacant building that is held
with the intention to lease it out under an operating lease;
• a property being constructed or developed for future use as an investment property; and
• land whose use is undecided (the standard assumes that the land is held for capital appreciation).
The following are examples of properties that are not classified as investment property:
• property that is owner-occupied (it is classified as property, plant and equipment in terms of IAS 16
Property, Plant and Equipment);
• property that is leased out to a third party under a finance lease (it is treated in terms of IAS 17 Leases); and
• property held for sale in the ordinary course of business (it is classified as inventory in terms of IAS 2
Inventory).
11.10.2 Transfers in and out of investment property

Transfers in and out of investment property take place when and only when there is a change in use.
Examples of such a change in use where a property that was classified as investment property would cease
to be classified as an investment property include:
• when the investment property becomes owner-occupied — in which case it must be transferred to
property, plant and equipment;
• when there is commencement of development of the investment property with the view to resale — in
which case it must be transferred to inventory.
Conversely, examples of such a change in use where a property that was not classified as investment
property would become classified as an investment property would include:
• when a property that was owner-occupied ceases to be occupied by the owners — in which case it is
immediately transferred from property, plant and equipment to investment property; and
• when a property that was held for sale in the ordinary course of business is rented out under an
operating lease — in which case it is immediately transferred from inventories to investment property.
Note that if the rental agreement is structured as a finance lease instead of an operating lease, the prop-
erty would not become classified as investment property but would instead be classified as a finance lease,
in terms of IAS 17 Leases.
11.10.3 Joint use properties

It is common for land and buildings to be used for a variety of purposes, for example, a portion of the
property is used to earn rental income and a portion of the property is used in the production or supply
of goods or services.
The result is that a portion of the property meets the definition of investment property (the part used to earn
rental income) and a portion of the property meets the definition of property, plant and equipment (the part
used in the production or supply of goods or services). These properties are referred to as joint use properties.
Paragraph 10 of IAS 40 provides guidance on how to classify joint use properties. If each portion can
be sold or leased out separately (under a finance lease), then each portion is classified separately (one as
an investment property and the other as an owner-occupied property). On the other hand, if each portion
cannot be sold or leased out separately, then the entire property is classified as property, plant and equip-
ment, unless the owner-occupied portion is an insignificant portion, in which case the entire property is
classified as investment property.

Professional judgement is required to determine whether the owner-occupied portion is insignificant
and the resultant classification of the property.
11.10.4 Ancillary services

An entity may provide ancillary services to the occupants of its property, for example, maintenance of the
building or security. In such circumstances, the property may only be classified as an investment property
if these services are insignificant or incidental.
If the ancillary services provided are considered to be significant, then the entity can no longer be con-
sidered to be an inactive investor and classification as investment property may not be appropriate.
11.10.5 Measurement of investment properties

On acquisition, an investment property is initially measured at cost. Subsequent measurement permits a
choice between the cost model and the fair value model, which must then be applied to all investment
property, although the fair value model is encouraged by the standard.
Note, however, that the cost model is compulsory if the fair value is not reliably measurable on a continuing
basis. This scenario then forces the property to be measured under the cost model and it may not be measured
under the fair value model at a later stage, but this does not prevent the entity from using the fair value model
for its other investment properties. In addition, the fair value model is compulsory for a property held by a
lessee under an operating lease, where the lessee has chosen to classify it as investment property.
It is important to note that if the fair value model is chosen, it is almost impossible to subsequently
change to the cost model. Paragraph 55 of IAS 40 does not permit a change from the fair value model to
the cost model if the fair value becomes difficult to measure. Rather, the property is then measured at the
last known fair value until such time that a revised fair value becomes available.
Further, IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, only allows a change in
policy if the new accounting policy results in reliable and more relevant information, which is unlikely to
be the case when considering a change in policy from the fair value model to the cost model.
Use of the cost model
The cost model used for investment properties is the same as the cost model used for property, plant and
equipment.
An investment property held under the cost model is measured at cost and depreciated annually (in
terms of IAS 16 Property, Plant and Equipment); it is also tested for impairments (in terms of IAS 36 Impair-
ment of Assets).
Use of the fair value model
The fair value model requires that the investment property be initially measured at cost and at the end
of the reporting period it is remeasured to its fair value. Any subsequent gains or losses resulting from a
change in the fair value of the investment property are recognised in profit or loss for the period in which
they arise in terms of paragraph 35 of IAS 40.
It is important to note that the fair value model used to measure investment properties differs from the
revaluation model used for property, plant and equipment. Revalued property, plant and equipment is depre-
ciated and tested for impairment; revaluations are recognised in other comprehensive income. However,
investment property measured at fair value is not depreciated or tested for impairment; and fair value changes
are recognised in profit or loss.
Fair value is a market-based value measured in terms of IFRS 13, which must reflect, inter alia, rental
incomes from current leases, and other assumptions that market participants would use when pricing
investment property under current market conditions.
11.10.6 Disclosure
Paragraph 75(a)–(c) of IAS 40 requires that the accounting policy note should disclose:
• whether the fair value model or cost model is used;
• the criteria used to classify property leased by the entity under an operating lease as investment
property;
• where it was difficult to decide, the criteria that the entity used to determine whether a property is
classified as investment property, owner-occupied property or inventory.
Paragraphs 75(d), (e) and (g) of IAS 40 requires that the investment property note should disclose:
• whether the fair value was measured by an independent, suitably qualified valuer with relevant
experience in the location and type of property;
• any restrictions on the property;
• a reconciliation of the opening balance to the closing balance.
304 PART 2 Elements

Paragraph 75(f) of IAS 40 requires the profit before tax note to disclose:
• rental income earned from investment property;
• direct operating expenses related to all investment property, split into:
• those that earned rental income, and
• those that did not earn rental income (IAS 40 paragraph 75(f)).
There are additional disclosure requirements specific to the fair value model or cost model. Paragraphs
76–78 of IAS 40 require the following disclosure if the fair value model was used:
• a reconciliation between the opening balance and closing balance of investment property;
• if a specific property is measured using the cost model because the fair value could not be reliably
measured then the following must be disclosed in relation to that property:
• a description of the property;
• a separate reconciliation from opening balance to closing balance;
• an explanation as to why the fair value could not be measured reliably;
• the range of estimates within which the fair value is highly likely to lie;
• if such a property is disposed of, a statement to this effect including the carrying amount at the time
of sale and the resulting gain or loss on disposal.
Paragraph 79(c)–(d) of IAS 40 requires the following disclosure if the cost model had been used:
• a reconciliation between the opening balance and closing balance of investment property must show all:
• the gross carrying amount and accumulated depreciation (at the beginning and end of the year);
• depreciation for the current year (and in the profit before tax note);
• impairments (and reversals) for the current year (and in the profit before tax note);
• additions (either through acquisition or a business combination);
• subsequent expenditure that was capitalised;
• transfers to and from inventories and property, plant and equipment;
• exchange differences;
• other changes.
SUMMARY
‘Property, plant and equipment’ covers a wide range of assets such as vehicles, aircraft, all types of build-
ings, and specific structures such as oil and gas offshore platforms. These assets have a variety of useful
lives, expected benefits, risk of receipt of benefits, movements in value over time, and expected value at
point of derecognition. In some cases at derecognition, assets such as oil platforms require entities to
incur costs rather than receive a residual value on sale. IAS 16, although recognising this variety, provides
common principles to be applied to all items of property, plant and equipment.
Initial recognition occurs when the recognition criteria are met and assets are then recorded at cost.
Subsequent to initial recognition, entities have a choice of measurement model, namely the cost model
and the revaluation model. Under both measurement models, assets are subject to depreciation, this being
a process of allocation and not a process of change in value. The measurement of depreciation requires
judgements to be made by the accountant, including useful lives, residual values and pattern of receipt of
benefits. Use of the revaluation model has additional accounting complications with revaluation increases
and decreases potentially affecting asset revaluation surplus accounts, and having tax-effect consequences.
Because of the judgements having to be made, IAS 16 requires extensive disclosures to be made.
DEMONSTRATION PROBLEM 11.1 Movements in assets, depreciation
Munich Manufacturing Ltd’s post-closing trial balance at 30 June 2015 included the following balances:
Machinery Control (at cost) £244 480

Accumulated Depreciation – Machinery Control 113 800
Fixtures (at cost; purchased 2 December 2012) 308 600
Accumulated Depreciation – Fixtures 134 138
The Machinery Control and Accumulated Depreciation — Machinery Control accounts are supported
by subsidiary ledgers. Details of machines owned at 30 June 2015 are as follows:
Estimated Estimated
Machine Acquisition date Cost useful life residual value
1 28 April 2011 £74 600 5 years £3800

2 4 February 2013 82 400 5 years 4400
3 26 March 2014 87 480 6 years 5400

(a) Munich Manufacturing Ltd uses the general journal for all journal entries, records depreciation to
the nearest month, balances its books every 6 months, and records amounts to the nearest pound.
(b) The company uses straight-line depreciation for machinery and diminishing-balance depreciation at
20% per annum for fixtures.
The following transactions and events occurred from 1 July 2015 onwards:
2015
July 3 Exchanged items of fixtures (having a cost of £100 600; a carrying amount at exchange date
of £56 872; and a fair value at exchange date of £57 140) for a used machine (Machine 4).
Machine 4’s fair value at exchange date was £58 000. Machine 4 originally cost £92 660
and had been depreciated by £31 790 to exchange date in the previous owner’s accounts.
Munich Manufacturing Ltd estimated Machine 4’s useful life and residual value to be 3 years
and £4580 respectively.
Oct. 10 Traded in Machine 2 for a new machine (Machine 5) that cost £90 740. A trade-in allowance
of £40 200 was received and the balance was paid in cash. Freight charges of £280 and
installation costs of £1600 were also paid in cash. Munich Manufacturing Ltd estimated
Machine 5’s useful life and residual value to be 6 years and £5500 respectively.
2016
April 24 Overhauled Machine 3 at a cash cost of £16 910, after which Munich Manufacturing Ltd
revised its residual value to £5600 and extended its useful life by 2 years.
May 16 Paid for scheduled repairs and maintenance on the machines of £2370.
June 30 Recorded depreciation and scrapped Machine 1.
Required
1. Prepare journal entries to record the above transactions and events.
2. Prepare the Accumulated Depreciation — Machinery Control and Accumulated Depreciation — Fixtures
ledger accounts for the period 30 June 2015 to 30 June 2016.
Solution
1. Journal entries
Calculate the depreciation on each of the depreciable assets so that when events such as a sale occur,
depreciation up to the date of the transaction can be calculated. Depreciation is calculated as:
(Cost – residual value)/expected useful life
For the three items of machinery, the depreciation per month is calculated as follows:
Machine 1 depreciation = (£74 600 – £3800)/60 months = £1180 per month

On 3 July, the company exchanges items of fixtures for a machine. After assessing that the transaction
has commercial substance, the fixtures are derecognised by eliminating both the asset account and the
accumulated depreciation.
The acquired machine (Machine 4) is recognised at cost. Cost is measured using the fair value of the
consideration given by the acquirer. As cost is the measurement used, the fair value of the machine is
not relevant. Similarly, the carrying amount of the asset in the seller’s records is also not relevant. The
entry also records the profit on sale.
2015
July 3 Machinery (M4) Dr 57 140
Accumulated Depreciation – Fixtures* Dr 43 728
Fixtures Cr 100 600
Profit on sale of fixtures (P/L) Cr 268
*£100 600 − £56 872
The depreciation per month for M4 is then calculated:
Machine 4 depreciation = (£57 140 − £4580)/36 months = £1460 per month
306 PART 2 Elements

On 10 October, Machine 2 is traded in for Machine 5. Depreciation up to point of sale on Machine 2
is determined, being £1300 per month for the 3 months from July to September.
Oct. 10 Depreciation − Machinery (M2)* Dr 3 900

Accumulated Depreciation − Machinery (M2) Cr 3 900
*£1300 × 3 months
Machine 2 is derecognised with the machine and related accumulated depreciation being written out
of the records. Machine 5 is recorded at cost. Cost is determined as the sum of the purchase price and
directly attributable costs. Purchase price is the fair value of consideration given up by the acquirer.
In the absence of a fair value for Machine 2, the consideration is based on the fair value of Machine
5, namely £90 740. The directly attributable costs are the freight charges of £280 and installation
costs of £1600, both being necessarily incurred to get the asset into the condition for management’s
intended use. The cash outlay is then the sum of the balance paid to the seller of Machine 5 and the
directly attributable costs.
Machinery (M5)* Dr 92 620

Accumulated Depreciation – Machinery (M2)** Dr 41 600
Loss on sale of Machinery (P/L) Dr 600
Machinery (M2) Cr 82 400
Cash Cr 52 420
*£90 740 + £280 + £1 600
**£1300 × 32 months
The depreciation per month for Machine 5 is then calculated:
Machine 5 depreciation = (£92 620 − £5500)/72 months = £1210 per month
On 24 April 2016, Machine 3 received an overhaul. This resulted in a change in the capacity of the
machine, which increased the residual value and extended its useful life. Because this results in a change
in the depreciation per month, depreciation based on the rate before the overhaul for the period up to
the date of the overhaul is recorded.
2016
April 24 Depreciation – Machinery (M3)* Dr 11 400
Accumulated Depreciation − Machinery (M3). Cr 11 400
*£1140 × 10 months
Because the overhaul increases the expected benefits from the asset — that is, the outlay for the over-
haul results in probable future benefits, the cost of the overhaul is capitalised, increasing the overall cost
of the asset.
Machinery (M3) Dr 16 910

Cash Cr 16 910
The overhaul results in a change in expectations, so it is necessary to calculate a revised depreciation

per month:
M3: New depreciable amount = £87 480 + £16 910 – £5600 = £98 790
Accumulated depreciation balance = £1140 × 25 months = £28 500
Carrying amount to be depreciated = £98 790 − £28 500 = £70 290
New useful life = 72 months – 25 months + 24 months = 71 months
Revised depreciation = £70 290/71 months = £990 per month
Because outlays on repairs and maintenance do not lead to increased future benefits, these outlays are
expensed.

May 16 Repairs and Maintenance Expense Dr 2 370
Cash Cr 2 370
At the end of the reporting period, depreciation is accrued on all depreciable assets:
Machinery: M1 1180 × 10 months £ 11 800

M3 £990 × 2 months 1 980
M4 £1460 × 12 months 17 520
M5 £1210 × 9 months 10 890
£ 42 190*
Fixtures: £308 600 − £100 600 £208 000
Less: £134 138 − £43 728 (90 410)
£117 590
20% × £117 590 £ 23 518**
June 30 Depreciation – Machinery* Dr 42 190

Depreciation – Fixtures** Dr 23 518
Accumulated Depreciation − Machinery Cr 42 190
Accumulated Depreciation − Fixtures Cr 23 518
Machine 1 is scrapped, so the asset is derecognised by writing off the asset and related accumulated
depreciation. The undepreciated amount is recognised as an expense. A residual value of £3800 was
expected but not received, so the company incurs a loss of £3800.
Accumulated Depreciation – Machinery (M1)* Dr 70 800

Loss on scrapping (P/L) (M1)** Dr 3 800
Machinery (M1) Cr 74 600
*£1180 × 60 months
**£74 600 − $70 800
2. Ledger accounts
Accumulated Depreciation – Machinery Control
10/10/15 Machinery 41 600 30/6/15 Balance b/d 113 800

31/12/15 Balance c/d 76 100 10/10/15 Depreciation 3 900
117 700 117 700
30/6/16 Machinery 70 800 31/12/15 Balance b/d 76 100
Balance c/d 58 890 24/4/16 Depreciation 11 400
30/6/16 Depreciation 42 190
129 690 129 690
30/6/16 Balance b/d 58 890
Accumulated Depreciation – Fixtures
3/7/15 Fixtures 43 728 30/6/15 Balance b/d 134 138

31/12/15 Balance c/d 90 410
134 138 134 138
31/12/15 Balance b/d 90 410
30/6/16 Balance c/d 113 928 30/6/16 Depreciation 23 518
113 928 113 928
30/6/16 Balance b/d 113 928
308 PART 2 Elements

DEMONSTRATION PROBLEM 11.2 Cost and revaluation models of measurement
On 1 July 2014, Weinheim Ltd acquired a number of assets from Berlin Ltd. The assets had the following
fair values at that date:
Plant A £300 000

Plant B 180 000
Furniture A 60 000
Furniture B 50 000
In exchange for these assets, Weinheim Ltd issued 200 000 shares with a fair value of £2.95 per share.
The directors of Weinheim Ltd decided to measure plant at fair value under the revaluation model and
furniture at cost. The plant was considered to have a further 10-year life with benefits being received
evenly over that period, whereas furniture is depreciated evenly over a 5-year period.
At 31 December 2014, Weinheim Ltd assessed the carrying amounts of its assets as follows:
• Plant A was valued at £296 000, with an expected remaining useful life of 8 years.
• Plant B was valued at £168 000, with an expected remaining useful life of 8 years.
• Furniture A’s carrying amount was considered to be less than its recoverable amount.
• Furniture B’s recoverable amount was assessed to be £40 000, with an expected remaining useful life
of 4 years.
Appropriate entries were made at 31 December 2014 for the half-yearly accounts.
At 30 June 2015, Weinheim Ltd assessed the carrying amounts of its assets as follows:
• Plant A was valued at £274 000.
• Plant B was valued at £161 500.
• The carrying amounts of furniture were less than their recoverable amounts.
The tax rate is 30%.
Required
Prepare the journal entries passed during the 2014–15 period in relation to the non-current assets in
accordance with IAS 16 Property, Plant and Equipment.
Solution
The assets acquired are recorded at cost. The total cost of the assets is the fair value of the shares issued,
namely £590 000 (i.e. 200 000 shares at £2.95 per share). This exactly equals the sum of the fair values
of the assets acquired, hence the cost of each of the assets acquired is assumed to be equal to its fair
value. If the amount were different from £590 000, say £550 000, then the cost of each asset would be
determined based on the proportion of fair value to total fair value.
2014
July 1 Plant A Dr 300 000
Plant B Dr 180 000
Furniture A Dr 60 000
Furniture B Dr 50 000
(Acquisition of assets)
At the end of each reporting period, depreciation is calculated and recorded. The next two entries
record the depreciation on Plant A and Plant B after 6 months, at 31 December 2014.
Dec. 31 Depreciation Expense – Plant A Dr 15 000

(Depreciation, 10% × ½ × £300 000)
Depreciation Expense – Plant B Dr 9 000

(Depreciation, 10% × ½ × £180 000)
Plant is measured using the revaluation model. At 31 December, the fair values of plant are assessed.
In relation to Plant A, the carrying amount of the asset is £285 000 (i.e. £300 000 − £15 000). The fair

value is assessed to be £296 000. There is then a revaluation increase of £11 000. The first journal entry
is to write off any accumulated depreciation at the point of revaluation:

Plant A Cr 15 000
(Write down Plant A to its carrying amount)
The second journal entry recognises the increase in other comprehensive income:
Plant A Dr 11 000
(Revaluation of Plant A from carrying amount of
£285 000 to fair value of £296 000)
The third entry recognises the tax effect of the gain:

(Tax effect of gain on revaluation of plant)
The fourth entry accumulates the after-tax gain in equity, in the asset revaluation surplus account:

Asset Revaluation Surplus – Plant A Cr 7 700
Assets are revalued by class. However, accounting for revaluations is on an asset-by-asset basis. It is
therefore important to associate any revaluation surplus with the asset that created that surplus. Accord-
ingly, in the above entry the surplus is associated with Plant A.
With Plant B, the carrying amount at 31 December is £171 000 (i.e. £180 000 − £9000). The fair value
is assessed to be £168 000. The revaluation decrease is £3000. This amount is recognised as a loss in
current period profit or loss.
Accumulated Depreciation – Plant B Dr 9 000

Plant B Cr 9 000
(Write down Plant B to its carrying amount)
Loss on Revaluation of Plant (P/L) Dr 3 000

Plant B Cr 3 000
(Revaluation of Plant B from carrying amount of
£171 000 to fair value of £168 000)
Furniture is measured under the cost model. Depreciation for the 6-month period is calculated based
on an allocation of the cost over a 5-year period:
Depreciation Expense – Furniture A Dr 6 000

(Depreciation, 1/5 × ½ × £60 000)
Depreciation Expense – Furniture B Dr 5 000

(Depreciation, 1/5 × ½ × £50 000)
The carrying amount of Furniture B at 31 December is £45 000 (i.e. £50 000 − £5000). The recover-
able amount is £40 000. The asset is written down to recoverable amount, with the write-down being
added to the accumulated depreciation account, and reported as an impairment loss.
310 PART 2 Elements

Impairment Loss – Furniture B Dr 5 000
Accumulated Depreciation and Impairment
Losses – Furniture B Cr 5 000
(Write-down of asset to recoverable amount)
At 30 June, depreciation is recorded for plant assets based on an allocation of the fair values at 31
December 2014.
June 30 Depreciation Expense – Plant A Dr 18 500

(Depreciation, 1/8 × ½ × £296 000)
Depreciation Expense – Plant B Dr 10 500

(Depreciation, 1/8 × ½ × £168 000)
The fair value of Plant A is assessed to be £274 000. Since the carrying amount is £277 500 (i.e. £296 000 −
£18 500), there is a revaluation decrease of £3500. Before recognising any expense on the revaluation
decrease, there needs to be a reversal of the effects of any previous revaluation increase. For Plant A,
at 31 December 2014, there was a revaluation increase of £11 000 which resulted in the recording of a
£3300 deferred tax liability and a £7700 asset revaluation surplus. Hence, with the revaluation decrease
of £3500, the normal adjustment would be to debit the deferred tax liability with £1050 (being 30% ×
£3500) and debit the asset revaluation surplus with £2450 (being 70% × £3500). However, because of
the bonus dividend, the balance in the asset revaluation surplus for Plant A is only £2100 (i.e. £7700 −
£5600). There is a deficiency of £350 in relation to the surplus.
The required journal entries at 30 June 2015 for Plant A are:
• the elimination of the accumulated depreciation account:

Plant A Cr 18 500
(Write down Plant A to its carrying amount)
• the recognition of the revaluation decrease in other comprehensive income:
Loss on Revaluation of Plant (OCI) Dr 3 500

Plant A Cr 3 500
(Revaluation of Plant A from carrying £277 500 to
• the tax effect of the revaluation write-down:

Loss on Revaluation of Plant (OCI) Cr 1 050
(Tax effect of loss on revaluation of plant)
• the accumulation of the loss on revaluation to equity:
Asset Revaluation Surplus – Plant A Dr 2 450

Loss on Revaluation of Plant (OCI) Cr 2 450
(Accumulation of revaluation loss to equity)
For Plant B, the carrying amount is £157 500 (i.e. £168 000 − £10 500). The fair value is £161 500.
There is a revaluation increase of £4000. The accounting for this increase requires a reversal of any
prior decrease. With Plant B at 31 December 2014, an expense of £3000 was recognised as a result of a
revaluation decrease. The reversal of the previous decrease requires the recognition of income of £3000.
The £1000 balance of the current increase (i.e. £4000 − £3000) is accounted for as other comprehensive
income with a deferred tax liability and asset revaluation surplus being recognised.

The required journal entries for Plant B are:
• the elimination of the accumulated depreciation account:
Accumulated Depreciation – Plant B Dr 10 500

Plant B Cr 10 500
(Write down Plant B to its carrying amount)
• the recognition of both a gain in profit or loss (for the reversal of the prior decrease) and a gain in other
comprehensive income on the revaluation of Plant B:
Plant B Dr 4 000
(Recognition of revaluation increase in profit or
loss and other comprehensive income)
• Tax effect of revaluation gain:

(Tax effect of gain on revaluation of plant)
• accumulation of the revaluation gain in equity:

Asset Revaluation Surplus – Plant B Cr 700
Furniture at cost is depreciated for the final 6 months of the year.
Depreciation Expense – Furniture A Dr 6 000

(Depreciation, 1/5 × ½ × £60 000)
Depreciation Expense – Furniture B Dr 5 000
(Depreciation, 1/5 × ½ × £40 000)
1. How should items of property, plant and equipment be measured at point of initial recognition, and
would gifts be treated differently from acquisitions?
2. How is cost determined?
3. What choices of measurement model exist subsequent to assets being initially recognised?
4. What factors should entities consider in choosing alternative measurement models?
5. What is meant by ‘depreciation expense’?
6. How is useful life determined?
7. What is meant by ‘residual value’ of an asset?
8. Should accounting for revaluation increases and decreases be done on an asset-by-asset basis or on a
class-of-assets basis?
9. What differences occur between asset-by-asset or class-of-asset bases in accounting for revaluation
increases and decreases?
10. When should property, plant and equipment be derecognised?
312 PART 2 Elements

References
Accounting Standards Board 1996, ‘Measurement of tangible fixed assets’, discussion paper, www.frc.org.uk.
Marks & Spencer plc 2014, Annual Report, http://corporate.marksandspencer.com/investors/reports-results-
and-presentations.
International Accounting Standards Board 2011, IASB documents published to accompany International
Accounting Standard 1 Presentation of Financial Statements, IASB, www.ifrs.org.
International Accounting Standards Board 2014, IAS 16 Property, plant & equipment, www.ifrs.org.
Exercise 11.1 FAIR VALUE BASIS FOR MEASUREMENT

★ The management of an entity has decided to use the fair value basis for the measurement of its equipment.
Some of this equipment is very hard to obtain and has in fact increased in value over the current period.
Management is arguing that, as there has been no decline in fair value, no depreciation should be charged
on these pieces of equipment. Discuss.
Exercise 11.2 ANNUAL DEPRECIATION CHARGE

★ A company is in the movie rental business. Movies are generally kept for 2 years and then either sold or
destroyed. However, management wants to show increased profits, and believes that the annual depreci-
ation charge can be lowered by keeping the movies for 3 years. Discuss.
Exercise 11.3 REVALUATION OF ASSETS

★ In the 30 June 2014 annual report of Sonner Ltd, the equipment was reported as follows:
Equipment (at cost) £ 500 000

Accumulated Depreciation (150 000)
350 000
The equipment consisted of two machines, Machine A and Machine B. Machine A had cost £300 000
and had a carrying amount of £180 000 at 30 June 2014, and Machine B had cost £200 000 and was car-
ried at £170 000. Both machines are measured using the cost model, and depreciated on a straight-line
basis over a 10-year period.
On 31 December 2014, the directors of Sonner Ltd decided to change the basis of measuring the equip-
ment from the cost model to the revaluation model. Machine A was revalued to £180 000 with an expected
useful life of 6 years, and Machine B was revalued to £155 000 with an expected useful life of 5 years.
At 30 June 2015, Machine A was assessed to have a fair value of £163 000 with an expected useful life of
5 years, and Machine B’s fair value was £136 500 with an expected useful life of 4 years.
Required
1. Prepare the journal entries during the period 1 July 2014 to 30 June 2015 in relation to the equipment.
2. According to accounting standards, on what basis may management change the method of asset meas-
urement, for example from cost to fair value?
Exercise 11.4 STRAIGHT-LINE DEPRECIATION VS DIMINISHING-BALANCE DEPRECIATION

★★ Asia Ltd uses tractors as a part of its operating equipment, and it applies the straight-line depreciation
method to depreciate these assets. Asia Ltd has just taken over Pacific Ltd, which uses similar tractors in its
operations. However, Pacific Ltd has been using a diminishing-balance method of depreciation for these
tractors. The accountant in Asia Ltd is arguing that for both entities the same depreciation method should
be used for tractors. Provide arguments for and against this proposal.

Exercise 11.5 DEPRECIATION CHARGES
★★ A new accountant has been appointed to Dettum Ltd and has implemented major changes in the calcu-
lation of depreciation. As a result, some parts of the factory have much larger depreciation charges. This
has incensed some operations managers who believe that, as they take particular care with the main-
tenance of their machines, their machines should not attract large depreciation charges that reduce the
profitability of their operations and reflect badly on their management skills. The operations managers
plan to meet the accountant and ask for change. How should the new accountant respond?
Exercise 11.6 EXPENSING OF COSTS

★★ Mehna Ltd has acquired a new building for £500 000. It has incurred incidental costs of £10 000 in the
acquisition process for legal fees, real estate agent’s fees and stamp duties. Management believes that these
costs should be expensed because they have not increased the value of the building and, if the building
was immediately resold, these amounts would not be recouped. In other words, the fair value of the
building is considered to still be £500 000. Discuss how these costs should be accounted for.
Exercise 11.7 DEPRECIATION

★★ Plaaz Ltd was formed on 1 July 2012 to provide delivery services for packages to be taken between the city
and the airport. On this date, the company acquired a delivery truck from Frensdorf Trucks. The company
paid cash of £50 000 to Frensdorf Trucks, which included government charges of £600 and registration of
£400. Insurance costs for the first year amounted to £1200. The truck is expected to have a useful life of
5 years. At the end of the useful life, the asset is expected to be sold for £24 000, with costs relating to the
sale amounting to £400.
The company went extremely well in its first year, and the management of Plaaz Ltd decided at 1 July
2013 to add another vehicle, a flat-top, to the fleet. This vehicle was acquired from a liquidation auction at
a cash price of £30 000. The vehicle needed some repairs for the elimination of rust (cost £2300), major
servicing to the engine (cost £480) and the replacement of all tyres (cost £620). The company believed it
would use the flat-top for another 2 years and then sell it. Expected selling price was £15 000, with selling
costs estimated to be £400. On 1 July 2013, both vehicles were fitted out with a radio communication
system at a cost per vehicle of £300. This was not expected to have any material effect on the future selling
price of either vehicle. Insurance costs for the 2013–14 period were £1200 for the first vehicle and £900 for
the newly acquired vehicle.
All went well for the company except that, on 1 August 2014, the flat-top that had been acquired at
auction broke down. Plaaz Ltd thought about acquiring a new vehicle to replace this one but, after con-
sidering the costs, decided to repair the flat-top instead. The vehicle was given a major overhaul at a cost
of £6500. Although this was a major expense, management believed that the company would keep the
vehicle for another 2 years. The estimated selling price in 3 years’ time is £12 000, with selling costs esti-
mated at £300. Insurance costs for the 2014–15 period were the same as for the previous year.
Required
Prepare the journal entries for the recording of the vehicles and the depreciation of the vehicles for each of
the 3 years. The financial year ends on 30 June.
Exercise 11.8 DEPRECIATION

★★ Red Sun Ltd constructed a building for use by the administration section of the company. The completion
date was 1 July 2007, and the construction cost was £840 000. The company expected to remain in the
building for the next 20 years, at which time the building would probably have no real salvage value and
have to be demolished. It is expected that demolition costs will amount to £15 000. In December 2013,
following some severe weather in the city, the roof of the administration building was considered to be
in poor shape so the company decided to replace it. On 1 July 2014, a new roof was installed at a cost
of £220 000. The new roof was of a different material to the old roof, which was estimated to have cost
only £140 000 in the original construction, although at the time of construction it was thought that the
roof would last for the 20 years that the company expected to use the building. Because the company had
spent the money replacing the roof, it thought that it would delay construction of a new building, thereby
extending the original life of the building from 20 years to 25 years.
Required
Discuss how you would account for the depreciation of the building and how the replacement of the roof
would affect the depreciation calculations.
314 PART 2 Elements

Exercise 11.9 REVALUATION OF ASSETS AND TAX-EFFECT ACCOUNTING
★★ Farida Ltd acquired a machine on 1 July 2012 at a cost of £100 000. The machine has an expected useful
life of 5 years, and the company adopts the straight-line basis of depreciation. The tax depreciation rate for
this type of machine is 12.5% p.a. The company tax rate is 30%.
Farida Ltd measures this asset at fair value. Movements in fair values are as follows:
30 June 2013 $85 000 Remaining useful life: 4 years

30 June 2014 60 000 Remaining useful life: 3 years
30 June 2015 45 000
Owing to a change in economic conditions, Farida Ltd sold the machine for £45 000 on 30 June 2015.
The asset was revalued to fair value immediately before the sale.
Required
1. Provide the journal entries used to account for this machine over the period 2012 to 2015.
2. For each of the 3 years ended 30 June 2013, 2014 and 2015, calculate the carrying amount and the tax base
of the asset, and determine the appropriate tax-effect entry in relation to the machine. Explain your answer.
Exercise 11.10 ACQUISITION AND SALE OF ASSETS, DEPRECIATION

★★ Thader Turf Farm owned the following items of property, plant and equipment as at 30 June 2014:
Land (at cost) £120 000

Office building (at cost) 150 000
Accumulated depreciation (23 375) 126 625
Turf cutter (at cost) 65 000
Water desalinator (at fair value) 189 000
Additional information (at 30 June 2014)

(a) The straight-line method of depreciation is used for all depreciable items of property, plant and equip-
ment. Depreciation is charged to the nearest month and all figures are rounded to the nearest pound.
(b) The office building was constructed on 1 April 2010. Its estimated useful life is 20 years and it has an
estimated residual value of £40 000.
(c) The turf cutter was purchased on 21 January 2011, at which date it had an estimated useful life of 5
years and an estimated residual value of £3200.
(d) The water desalinator was purchased and installed on 2 July 2013 at a cost of £200 000. On 30 June
2014, the plant was revalued upwards by £7000 to its fair value on that day. Additionally, its useful life
and residual value were re-estimated to 9 years and £18 000 respectively.
The following transactions occurred during the year ended 30 June 2015:
(Note: All payments are made in cash.)
(e) On 10 August 2014, new irrigation equipment was purchased from Pond Supplies for £37 000. On
16 August 2014, the business paid £500 to have the equipment delivered to the turf farm. Thomas
Schwazer was contracted to install and test the new system. In the course of installation, pipes worth
£800 were damaged and subsequently replaced on 3 September. The irrigation system was fully oper-
ational by 19 September and Thomas Schwazer was paid £9600 for his services. The system has an
estimated useful life of 4 years and a residual value of £0.
(f) On 1 December 2014, the turf cutter was traded in on a new model worth £80 000. A trade-in allow-
ance of £19 000 was received and the balance paid in cash. The new machine’s useful life and residual
value were estimated at 6 years and £5000 respectively.
(g) On 1 January 2015, the turf farm’s owner Helmut Dorf decided to extend the office building by adding
three new offices and a meeting room. The extension work started on 2 February and was completed
by 28 March at a cost of £49 000. The extension is expected to increase the useful life of the building
by 4 years and increase its residual value by £5000.
(h) On 30 June 2015, depreciation expense for the year was recorded. The fair value of the water desalina-
tion plant was £165 000.
Required
(Show all workings and round amounts to the nearest pound.)
Prepare general journal entries to record the transactions and events for the reporting period ended 30
June 2015 (narrations are not required).

Exercise 11.11 REVALUATION OF ASSETS
★★ On 1 July 2012, Themar Ltd acquired two assets within the same class of plant and equipment. Informa-
tion on these assets is as follows:
Cost Expected useful life
Machine A £100 000 5 years

Machine B 60 000 3 years
The machines are expected to generate benefits evenly over their useful lives. The class of plant and
equipment is measured using fair value.
At 30 June 2013, information about the assets is as follows:
Fair value Expected useful life

Machine B 38 000 2 years
On 1 January 2014, Machine B was sold for £29 000 cash. On the same day, Themar Ltd acquired
Machine C for £80 000 cash. Machine C has an expected useful life of 4 years. Themar Ltd also made a
bonus issue of 10 000 shares at £1 per share, using £8000 from the general reserve and £2000 from the
asset revaluation surplus created as a result of measuring Machine A at fair value.
At 30 June 2014, information on the machines is as follows:
Fair value Expected useful life

Machine C 68 500 3.5 years
The income tax rate is 30%.

Required
Prepare the journal entries in the records of Themar Ltd to record the described events over the period 1
July 2012 to 30 June 2014, assuming the ends of the reporting periods are 30 June 2013 and 30 June 2014.
Exercise 11.12 ACQUISITIONS, DISPOSALS, TRADE-INS, OVERHAULS, DEPRECIATION

★★ Axel Schulz is the owner of Wremen Fishing Charters. The business’s final trial balance on 30 June 2012
(end of the reporting period) included the following balances:
Processing Plant (at cost, purchased 4 April 2010) $148 650

Accumulated Depreciation — Processing plant (81 274)
Charter Boats 291 200
Accumulated Depreciation — Boats 188 330
The following boats were owned at 30 June 2012:
Estimated Estimated
Boat Purchase date Cost useful life residual value
1 23 February 2008 $62 000 5 years $3 000

2 9 September 2008 $66 400 5 years $3 400
3 6 February 2009 $78 600 4 years $3 600
4 20 April 2010 $84 200 6 years $3 800
Wremen Fishing Charters calculates depreciation to the nearest month using straight-line depreciation
for all assets except the processing plant, which is depreciated at 30% on the diminishing-balance method.
Amounts are recorded to the nearest pound.
316 PART 2 Elements

Part A
The following transactions and events occurred during the year ended 30 June 2013:
2012 July 26 Traded in Boat 1 for a new boat (Boat 5) which cost £84 100. A trade-in allowance of
£8900 was received and the balance was paid in cash. Registration and stamp duty costs
of £1500 were also paid in cash. Axel Schulz estimated Boat 5’s useful life and residual
value at 6 years and £4120 respectively.
Dec. 4 Overhauled the processing plant at a cash cost of £62 660. As the modernisation
significantly expanded the plant’s operating capacity and efficiency, Axel Schulz decided
to revise the depreciation rate to 25%.
2013 Feb. 6 Boat 3 reached the end of its useful life but no buyer could be found, so the boat was
scrapped.
June 30 Recorded depreciation.
Required
Prepare general journal entries (narrations are required) to record the transactions and events for the year
ended 30 June 2013.
Part B
On 26 March, Axel Schulz was offered fish-finding equipment with a fair value of £9500 in exchange for
Boat 2. The fish-finder originally cost its owner £26 600 and had a carrying value of £9350 at the date of
offer. The fair value of Boat 2 was £9100.
Required
If Axel Schulz accepts the exchange offer, what amount would the business use to record the acquisition of
the fish-finding equipment? Why? Justify your answer by reference to the requirements of IAS 16 relating
to the initial recognition of a property, plant and equipment item.
Exercise 11.13 REVALUATION OF ASSETS AND TAX-EFFECT ACCOUNTING

★★★ For Chartres Ltd, profit before income tax for the year ended 30 June 2013 amounted to £375 000,
including the following expenses:
Depreciation of plant £50 000

Goodwill impairment* 13 000
Long-service leave 40 000
Holiday pay 30 000
Doubtful debts 55 000
Entertainment* 12 000
Depreciation of furniture 5 000
*Non-deductible for taxation
The statement of financial position of Chartres Ltd at 30 June 2012 and 2013 showed the assets and
liabilities of the company as follows:
Assets 2012 2013

Cash £ 73 000 £ 82 000
Inventory 127 000 158 000
Plant (net) 350 000 320 000
Furniture (net) 75 000 65 000
Goodwill 63 000 50 000
Deferred tax asset 21 000 ?
Liabilities
Payables 247 000 265 000
Provision for long-service leave 30 000 50 000
Provision for holiday pay 20 000 30 000
Deferred tax liability 11 250 ?

(a) Plant and furniture are different classes of assets. Both are measured at fair value. The furniture was
revalued downward to £65 000 at 30 June 2013. Furniture had not previously been revalued upwards.
Tax depreciation for the year ended 30 June 2013 was £7500, giving a carrying amount for tax purposes
at 30 June 2013 of £55 000. The plant was revalued upwards at 30 June 2013 to £320 000. Tax depreci-
ation on plant was £75 000, giving a carrying amount for tax purposes at 30 June 2013 of £250 000.
(b) Total bad debts written off for the 2012–13 year were £35 000.
(c) The tax rate is 30%.
Required
1. Calculate, by using worksheets, the amounts of income tax expense and current and deferred income tax
assets/liabilities for the reporting period ended 30 June 2013.
2. Prepare the deferred tax asset and deferred tax liability accounts.
Exercise 11.14 COST OF ACQUISITION

★★★ Borod Ltd started business early in 2013. During its first 9 months, Borod Ltd acquired real estate for the
construction of a building and other facilities. Operating equipment was purchased and installed, and the
company began operating activities in October 2013. The company’s accountant, who was not sure how
to record some of the transactions, opened a Property ledger account and recorded debits and (credits) to
this account as follows.
(a) Cost of real estate purchased as a building site £ 170 000
(b) Paid architect’s fee for design of new building 23 000
(c) Paid for demolition of old building on building site purchased in (a) 28 000
(d) Paid land tax on the real estate purchased as a building site in (a) 1 700
(e) Paid excavation costs for the new building 15 000
(f) Made the first payment to the building contractor 250 000
(g) Paid for equipment to be installed in the new building 148 000
(h) Received from sale of salvaged materials from demolishing the old building (6 800)
(i) Made final payment to the building contractor 350 000
(j) Paid interest on building loan during construction 22 000
(k) Paid freight on equipment purchased 1 900
(l) Paid installation costs of equipment 4 200
(m) Paid for repair of equipment damaged during installation 2 700
Property ledger account balance £1 009 700
Required
1. Prepare a schedule with the following column headings. Analyse each transaction, enter the payment or
receipt in the appropriate column, and total each column.
Land Manufacturing
Item no. Land Improvements Building equipment Other
2. Prepare the journal entry to close the £1 009 700 balance of the Property ledger account.
318 PART 2 Elements

Depreciation is an inter-period allocation method that is is negatively related to revaluations. Furthermore they find
subject to considerable managerial discretion. It is therefore that the revaluation balance is negatively related to share
interesting to learn whether it could be relevant to users of price and that the revaluation increment is negatively related
financial statements. Barth et al. (2001) argue that if invest- to stock returns. An interpretation of these results is that
ments in depreciable assets generate total cash flows in Brazilian firms that anticipate deterioration in performance
excess of cost, the annual depreciation should be positively take a pre-emptive action to fortify their balance sheets.
associated with future operating cash flows. Their findings The above-mentioned conflicting results may be explained,
are broadly consistent with this prediction, although this at least in part, by whether the revaluations are based on man-
does not hold in several industries analysed in this paper. agers’ estimates or external assessors’ valuations. The latter
In a more direct test of how investors perceive depreciation, may be perceived as more reliable estimates by investors. Barth
Kang and Zhao (2010) find that annual changes in deprecia- and Clinch (1998) find in an Australian sample that revalua-
tion expense are not associated with stock returns. They also tions of PPE by both internal directors and external appraisers
fail to find that accumulated depreciation is associated with are positively associated with stock prices. However, their evi-
stock prices. Therefore, taken together from these two papers, dence seems to suggest that this association is stronger for
the evidence on the usefulness to investors of depreciation internal valuations. This is inconsistent with the notion that
and accumulated depreciation is mixed. internal valuations are more prone to manipulations and is
IAS 16 permits companies to adopt the revaluation model indicative of superior information held by insiders. Cotter and
for property, plant and equipment (PPE). Casual observation Richardson (2002) extend this analysis to model the choice
nevertheless suggests that fewer companies have revalued their of the appraiser, again using an Australian sample. Their anal-
PPE in recent years and that the method was more common ysis suggests that the likelihood of selecting an independent
prior to the adoption of IFRS® Standards. The research on appraiser is negatively related to measures of a CEO’s control
revaluations therefore goes several years back. Easton et al. of the board of directors. Cotter and Richardson (2002) then
(1993) examine a sample of Australian companies that further examine if upward revaluations are followed by rever-
revalued their PPE in the 1980s. Based on interviews with the sals, and whether this is dependent on appraiser type. They
chief financial officers, the authors conjecture that revalua- argue that reversals can be used as a measure of the reliability
tions are reported with the view to lower the debt-to-equity of the initial upward revaluation. For plant and equipment
ratio in order to be seen as less leveraged. This opportunistic they find that independent revaluations are more reliable than
behaviour possibly contrasts with a motivation to give a ‘true internal revaluations. However, this result is not robust to an
and fair view’ of the financial statements, which was also high- alternative measure of reliability.
lighted as another reason for revaluations given by company Prior to the adoption of IFRS Standards it was required in
officers. Consistent with information usefulness perspective, the UK that fair values are recognised for investment property
this paper documents a positive association between revalu- companies. Dietrich et al. (2001) argue that the reliability of
ation reserve (and changes in the reserve) and the market-to- fair values reported can be examined by reference to gains or
book ratio. The documented association, however, is stronger losses booked when the properties are sold. If revaluations
for higher debt-to-equity firms. A potential explanation of this are good estimates of sale prices, one should not observe large
is that revaluing firms avoid violation of debt covenants and losses or gains upon disposal of the properties. They examine
that the market perceives this as a beneficial outcome. How- a sample of 76 firms for the period 1988–1996 and find that,
ever, stock returns are unrelated to the change in the revalu- on average, disposals of investment properties entail a gain
ation reserve in almost all years examined. The latter may be that is equivalent to 6% of the selling price. This is consis-
explained by poor timeliness of revaluation disclosure. tent with conservative fair value estimates used for revalua-
Aboody et al. (1999) examine 347 UK firms that revalued tions. An alternative explanation is that managers select to
their PPE upward during 1983–1995. They find that these sell assets that increased in value after the last revaluation.
have predictive ability with respect to 1–3-year ahead changes Dietrich et al. (2001) further find that annual revaluations
in operating income and changes in operating cash flows. are positively related to future debt issues, which is broadly
Similar to Easton et al. (1993) they examine the association consistent with the debt-related motivation identified by
of revaluation information with stock prices and stock returns Easton et al. (1993). Muller and Riedl (2002) also employ
and find it is positive and significant. In additional analysis a sample of UK investment property companies to investi-
the authors find that their results are weaker for high debt-to- gate if the choice of internal vs. external appraiser is capable
equity firms. This is suggestive of opportunistic revaluations. of reducing information asymmetry. They provide evidence
Notwithstanding the statistical significance of these results, from an analysis of bid–ask spreads that suggests valuations
they are somewhat hard to interpret. First, the authors do not carried out by external appraisers reduce information asym-
outline the theoretical link between revaluations and future metry more than internal appraisers. This is indicative of
performance. Second, the exclusion of negative revaluations higher accuracy of externally generated estimates.
does not permit a more comprehensive view of the infor- There are only a few studies that directly examine reporting
mation role of revaluations. More recent analysis of revalua- requirements set in IAS 16 and IAS 40. Muller et al. (2011)
tions of fixed assets is presented by Lopes and Walker (2012). provide direct evidence as to the effect of mandating IAS
They analyse 177 Brazilian firms that revalued their fixed 40 following the adoption of IFRS Standards on informa-
assets during 1998–2004. Employing research design similar tion asymmetry. In a sample of European investment prop-
to Aboody et al. (1999) they find that future performance erty companies they find that companies that disclosed fair

values of their investment properties prior to IFRS Standards Christensen, H. B., and Nikolaev, V. V. 2013. Does fair value
did not benefit from a decline in information asymmetry. accounting for non-financial assets pass the market test?
However, such a decline was observed for firms that dis- Review of Accounting Studies, 18(3), 734–775.
closed the required information only following the adoption. Cotter, J., and Richardson, S. 2002. Reliability
This speaks as to the benefits to investors of disclosing fair of asset revaluations: The impact of appraiser
value estimates of certain long-lived assets. Christensen and independence. Review of Accounting Studies, 7(4),
Nikolaev (2013) postulate that market forces are a factor in 435–457.
firms’ choice whether to revalue their PPE when IFRS Stand- Dietrich, D., Harris, M., and Muller, K. 2001. The reliability
ards offer this option. Specifically, they argue that the demand of investment property fair value estimates. Journal of
for revaluations is stronger in the UK than in Germany. They Accounting and Economics, 30(2), 125–158.
also conjecture that revaluations are more common for invest- Easton, P., Eddey, P., and Harris, T. 1993. An investigation
ment properties than PPE. They find that UK (German) firms of revaluations of tangible long-lived assets. Journal of
are more likely to use fair value model (historical cost basis), Accounting Research, 31 (Supplement), 1–38.
but that in both countries investment property companies Kang, S. H., and Zhao, Y. 2010. Information content
tend to use the fair value model more than companies from and value relevance of depreciation: A cross-industry
other industries. analysis. The Accounting Review, 85(1), 227–260.
Lopes, A. B., and Walker, M. 2012. Asset revaluations, future
firm performance and firm-level corporate governance
References arrangements: New evidence from Brazil. The British
Accounting Review, 44(2), 53–67.
Aboody, D., Barth, M. E., and Kasznik, R. 1999. Muller, K., and Riedl. E. 2002. External monitoring of
Revaluations of fixed assets and future firm performance, property appraisal estimates and information asymmetry.
evidence from the UK. Journal of Accounting and Economics, Journal of Accounting Research, 40(3), 865–881.
26(1–3), 149–178. Muller, K., Riedl, E., and Sellhorn, T. 2011. Mandatory fair
Barth, M., and Clinch, G. 1998. Revalued financial, tangible, value accounting and information asymmetry: Evidence
and intangible Assets: Associations with share prices and from the European real estate industry. Management
non-market based value estimates. Journal of Accounting Science, 57(6), 1138–1153.
Research, 36 (Supplement), 199–233.
Barth, M., Cram, D. P., and Nelson K. K. 2001. Accruals and
the prediction of future cash flows. The Accounting Review,
76(1), 27–58.
320 PART 2 Elements

12 Leases
ACCOUNTING IAS 17 Leases
STANDARDS
IN FOCUS

OBJECTIVES
1 discuss the characteristics of a lease
2 explain the difference between a finance lease and an operating lease
3 understand and apply the guidance necessary to classify leases
4 account for finance leases from the perspective of a lessee
5 account for finance leases from the perspective of a lessor
6 account for finance leases by manufacturer or dealer lessors
7 account for operating leases from the perspective of both lessors and lessees
8 recognise and account for sale and leaseback transactions
9 discuss the 2016 changes to lease accounting.
CHAPTER 12 Leases 321

INTRODUCTION
The rapid growth of leasing as a means of gaining access to the economic benefits embodied in assets
during the 1970s led to a concern among standard setters worldwide that the credibility of financial reports
was compromised by extensive use of such ‘off-balance-sheet’ arrangements. Accordingly, the 1980s saw
the issue of leasing standards by both international and national standard-setting bodies. These standards
adopted similar accounting treatments based on the premise that, when a lease transfers substantially all
of the risks and rewards incidental to ownership to the lessee, that lease is in substance equivalent to the
acquisition of an asset on credit by the lessee, and to a sale or financing by the lessor (i.e. a ‘finance lease’).
The mandatory recognition of the asset/liability relating to a finance lease is justified by two arguments put
forth in IAS 17 Leases.
First:
Although the legal form of a lease agreement is that the lessee may acquire no legal title to the leased asset, in
the case of finance leases the substance and financial reality are that the lessee acquires the economic benefits of
the use of the leased asset for the major part of its economic life in return for entering into an obligation to pay
for that right an amount approximating, at the inception of the lease, the fair value of the asset and the related
finance charge (paragraph 21).
Second:
If such lease transactions are not reflected in the lessee’s statement of financial position, the economic resources
and the level of obligations of an entity are understated, thereby distorting financial ratios (paragraph 22).
Interestingly, these justifications for the recognition of lease assets and liabilities make no reference
to the Conceptual Framework definitions and recognition criteria, but concentrate on the substance of the
exchange of benefits and the reliability of financial information. This rationale seems to view a finance
lease transaction as the quasi-purchase of an asset, in the sense that an entity records the acquisition of an
asset even though no transfer of legal title takes place.
The leasing standards have remained essentially unchanged over time even though there were many
calls for major change. In 2006, the International Accounting Standards Board (IASB®) and the Financial
Accounting Standards Board in the United States each decided to add a leasing project to its respective
agenda, but those projects would be undertaken jointly. In March 2009, the IASB and the FASB issued
a discussion paper entitled Leases — Preliminary Views. In August 2010, the IASB and FASB issued nearly
identical exposure drafts (EDs) of a proposed, converged new standard on leases. As a result of comments
received on the ED and after redeliberations, the IASB and the FASB issued a second ED in May 2013. Rede-
liberations on the second ED took place in 2014 and 2015 with the IASB and the FASB reaching different
decisions relating to lease classification and the recognition, measurement and presentation of leases for
lessees and lessors. The IASB issued its new standard, IFRS 16 Leases, in 2016. IFRS 16 is effective from 1
January 2019, with limited early application permitted. The FASB also issued its new leases standard in 2016.
LO1 12.1 WHAT IS A LEASE?

IAS 17 paragraph 4 defines a lease as:
an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to
use an asset for an agreed period of time.
Thus, under a lease agreement the lessee acquires, not the asset itself, but the right to use the asset for a
set time. Lease agreements may also result in the eventual transfer of ownership from lessor to lessee. For
example, under a hire purchase agreement, the lessee will use the asset while paying for its acquisition. The
agreed period of time may vary from a short period, such as the daily hire of a motor vehicle, to a longer
period, such as the rental of office space by a company. The key feature of a lease is the existence of an asset
owned by one party (the lessor) but used, for some or all of its economic life, by another party (the lessee).
IFRIC® Interpretation 4 Determining whether an Arrangement contains a Lease (IFRIC 4 paragraph 1) was
issued to assist account preparers in determining whether arrangements that are not in the legal form of a
lease may in fact convey the right to use an item for an agreed period of time in return for a series of pay-
ments, and should, therefore, be treated as a lease for accounting purposes. Such arrangements may include:
• outsourcing arrangements . . .
• arrangements in the telecommunications industry, in which suppliers of network capacity enter into contracts
to provide purchasers with rights to capacity
• take-or-pay contracts, in which purchasers must make specified payments regardless of whether they take
delivery of the contracted products or services.
The assessment of whether an arrangement contains a lease must be done at the inception of the arrange-
ment using the information available at that time. If the provisions of the arrangement are subsequently
changed, a reassessment will be made. Under IFRIC 4 paragraph 6, an arrangement contains a lease if:
(a) fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset); and
(b) the arrangement conveys a right to use the asset.
322 PART 2 Elements

IFRIC 4 uses an illustrative example of a purchaser who enters into a take-or-pay arrangement with
an industrial gas supplier. If that supplier provides the gas from a plant that is built on the purchaser’s
premises, to the purchaser’s specifications and is used solely to provide gas under the arrangement then,
applying the above criteria, the arrangement contains a lease of the gas plant.
If an arrangement contains a lease component, then that part of the arrangement must be segregated
and accounted for in accordance with IAS 17. This would require classification as an operating or finance
lease at the inception of the arrangement. Payments made under the arrangement would need to be sep-
arated into lease payments and payments for other services based on their relative fair values, as specified
in IFRIC 4.
Service agreements relating to the provision of services, such as cleaning or maintenance, between
two parties are not regarded as leases because the contract does not involve the use of an asset. These
agreements are regarded as executory contracts (addressed in sections 12.3.2 and 12.5.2) — that is, both
parties are still to perform to an equal degree the actions required by the contract. Thus, each party is
regarded as having a right and obligation to participate in a future exchange or, alternatively, to com-
pensate or be compensated for the consequences of not doing so. A cleaning contract entitles an entity
to receive cleaning services on a regular basis and creates an obligation to pay for those services after
they have been received. The key issue is the performance of the service. Until the cleaning services are
delivered, the contract is merely an exchange of promises, not of future economic benefits. The existence
of a non-cancellable service agreement or one that includes significant penalties for non-performance
may, however, result in the service recipient acquiring control over future economic benefits (the right to
receive cleaning services) that are likely to be delivered and can be reliably measured — in other words,
an asset.
12.1.1 Scope of application of IAS 17

IAS 17 excludes the following types of arrangements from its scope:
• lease agreements to explore for or use minerals, oil, natural gas and similar non-regenerative resources
• licensing agreements for such items as motion picture films, video recordings, plays, manuscripts,
patents and copyrights.
No explanation is given for the exclusion of resource exploitation rights and licensing agreements,
which means that the standard is generally applied only to leases for assets with physical substance. An
agreement allowing a licensee to use a patented process provides future economic benefits to that licensee
and meets the Conceptual Framework’s definition of an asset in just the same way as a motor vehicle lease.
The exclusion of these agreements from the scope of IAS 17 is difficult to justify other than by citing the
fact that the standard ‘applies to agreements that transfer the right to use assets’ (IAS 17 paragraph 3),
not the right of access, which is generally the right that is conveyed in non-exclusive license agreements.
Presumably, the expectation when IAS 17 was issued was that accounting standards on extractive indus-
tries, self-generating and renewable assets and intangibles would deal with leases of this type.
Additionally, the standard must not be applied as the basis of measurement for leased investment prop-
erties or leased biological assets, because the measurement requirements for such assets are contained in
IAS 40 Investment Property and IAS 41 Agriculture, respectively.
LO2 12.2 CLASSIFICATION OF LEASES

IAS 17 requires both lessees and lessors to classify each lease arrangement as either an operating lease or a
finance lease and to make this classification at the inception of the lease. ‘Inception’ is defined as ‘the earlier
of the date of the lease agreement and the date of commitment by the parties to the principal provisions
of the lease’ (IAS 17 paragraph 4). This classification process is vitally important because the accounting
treatment and disclosures prescribed by the standard for each type of lease differ significantly.
A finance lease is defined as ‘a lease that transfers substantially all the risks and rewards incidental to
ownership of an asset. Title may or may not eventually be transferred’ (IAS 17 paragraph 4). An operating
lease is simply defined as ‘a lease other than a finance lease’ (IAS 17 paragraph 4).
The key criterion of a finance lease is the transfer of substantially all the risks and rewards without
a transfer of ownership. The classification process, therefore, consists of two steps. First, the potential
rewards and potential risks associated with the asset must be identified. Second, the lease agreement
must be analysed to determine the nature and extent of the rewards and risks transferred from the lessor
to the lessee.
The risks of ownership include:
• unsatisfactory performance, with the asset unable to provide benefits or service at the expected level or
quality
• obsolescence, particularly with regard to the development of more technically advanced items
• idle capacity
• decline in residual value or losses on eventual sale of the asset
• uninsured damage and condemnation of the asset.

The rewards include:
• any benefits obtained from using the asset to provide benefit or service to the entity
• appreciation in residual value or gains on the eventual sale of the asset.
The risks and rewards relating to movements in realisable value are the most difficult to transfer without
transferring the title. If the leased asset is to be returned to the lessor, then the risk of an adverse movement
in realisable value has not been transferred unless the lessee guarantees some or all of the value of the
asset at the end of the lease term.
LO3 12.3 CLASSIFICATION GUIDANCE

IAS 17 (paragraph 10) provides examples of situations that individually or in combination would nor-
mally lead to a lease transaction being classified as a finance lease:
(a) the lease transfers ownership of the asset by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the
fair value at the date the option becomes exercisable for it to be reasonably certain that the option will
be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
(d) at the inception of the lease, the present value of the minimum lease payments amounts to substantially all
of the fair value of the leased asset; and
(e) the leased assets are of such a specialised nature that only the lessee can use them without major modification.
IAS 17 paragraph 11 also provides indicators of situations that individually or in combination also
could lead to a lease being classified as a finance lease:
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee; and
(c) the lessee has the ability to continue the lease for a secondary period at a rental that is substantially less than
market rent.
Note that these examples and indicators are guidelines in assessing whether substantially all the risks
and rewards are transferred. Each example or indicator then relates to some measure of risk or reward.
Although not described in IAS 17 as such, the examples and indicators are often referred to as lease
classification ‘tests’. Unlike the application of similar tests in US GAAP, the existence of only one of the
examples or indicators would not necessarily result in a lease being classified as a finance lease except
when:
• the ownership of the leased asset transfers to the lessee (example (a) above); or
• the lessee is reasonably certain to exercise an option to purchase the underlying asset (example (b) above).
Throughout this chapter, the examples and indicators (hereinafter referred to as ‘guidelines’) have been
restated as eight questions, as represented in figure 12.1, to aid in classifying lease arrangements as either
operating leases or finance leases.
Therefore when classifying leases, account preparers will need to examine three main conditions of the
lease agreement:
• whether the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
• whether the lessee is reasonably certain to exercise an option to purchase the underlying asset; and
• whether the lease otherwise transfers substantially all the risks and rewards incidental to ownership of
the underlying asset.
IAS 17 does not define the terms ‘major part’ (example (c) above) or ‘substantially all’ (example (d)
above) or prescribe classification criteria. This is left as a judgement call. By omitting quantitative examples,
the IASB has placed the classification decision back in the hands of account preparers, who must decide
what is ‘major’ and ‘substantially all’ for their entity and particular circumstances. The disadvantage of this
approach is that similar or even identical lease agreements may be classified differently because of varying
interpretations of what the terms ‘major part’ and ‘substantially all’ mean.
12.3.1 Lease term

An important element in the classification process is to determine the term of the lease. The lease term is
defined in IAS 17 paragraph 4 as:
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.
A non-cancellable lease locks both parties into the agreement and ensures that the exchange of risks and
rewards will occur. The definition of a non-cancellable lease provided in IAS 17 deems cancellable leases
with the following characteristics to be ‘non-cancellable’:
• leases that can be cancelled only upon the occurrence of some remote contingency
• leases that can be cancelled only with the permission of the lessor
324 PART 2 Elements

Does the lease transfer ownership of the
underlying asset to the lessee by the end of
the lease term? Yes
No
Situations that individually Is the lessee reasonably certain to exercise

or in combination would an option to purchase the underlying asset? Yes
normally indicate that the
lease otherwise transfers
No
substantially all the risks and
rewards include:
Does the lease otherwise transfer
The lease term is for a substantially all the risks and rewards
major part of the economic incidental to ownership of the underlying Yes
life of the leased asset. asset?
The present value of the

minimum lease payments
amounts to substantially all No
of the fair value of the
leased asset at lease
inception.
The leased asset is of such

a specialised nature that it
is expected to have no
alternative use to the lessor
at the end of the lease term.
If the lessee can cancel

the lease, the lessee is
responsible for any losses
incurred by the lessor.
The lessee is entitled to the

gains or losses from the
fluctuation in the fair value
of the residual asset.
The lessee can continue the

lease for further periods at
rent substantially less than
market rent. Operating lease Finance lease
FIGURE 12.1 Guidelines for classifying a lease
• leases in which the lessee, upon cancellation, is committed to enter into a further lease for the same or
equivalent asset with the same lessor
• leases that provide that the lessee, upon cancellation, incurs a penalty large enough to discourage
cancellation in normal circumstances.
A careful examination of the lease agreement is necessary to ensure that cancellable leases are correctly
designated.
IAS 17 does not define ‘reasonably certain’. The assessment of whether the lessee is reasonably cer-
tain to exercise an option to extend a lease beyond the initial non-cancellable period of the lease is
not based on the lessee’s intentions or past practice. Instead, it is based on facts and circumstances at
lease inception relevant to the decision the lessee will make to exercise or not to exercise the option.

Following are examples of circumstances in which an option to extend a lease is considered reasonably
certain of exercise:
• the option is priced significantly below market
• the lessee has made significant leasehold improvements to the asset that are expected to have
significant economic value when the option to extend becomes exercisable
• the design of the asset and/or the location of the asset is specialised for the lessee such that the costs
associated with identifying another asset or location and costs associated with negotiating and securing
a replacement asset are not economic.
12.3.2 Lease classification guidelines

Does the lease transfer ownership of the underlying asset to the lessee by the end
of the lease term?
When ownership of the underlying asset transfers to the lessee at the end of the lease term, the arrange-
ment is, in effect, a purchase and sale of the asset. As such, the lessor has transferred the risks and rewards
of ownership to the lessee and such a lease is normally classified as a finance lease.
Is the lessee reasonably certain to exercise an option to purchase the underlying
asset?
Lease arrangements often contain an option for the lessee to purchase the underlying asset at the end of the
lease term. As previously stated, IAS 17 does not define ‘reasonably certain’. In practice, a purchase option is
considered reasonably certain of exercise when the option price is significantly below market (i.e. a bargain
purchase option). When a lease contains a bargain purchase option, it is normally classified as a finance lease.
Is the lease term for a major part of the economic life of the leased asset?
This classification guideline requires measurement of the lease term against the asset’s economic life. IAS 17
paragraph 4 defines an asset’s economic life as either:
(a) the period over which an asset is expected to be economically usable by one or more users; or
(b) the number of production or similar units expected to be obtained from the asset by one or more users.
This guideline represents an attempt to measure the extent of the transfer of rewards to the lessee. What
percentage of the asset’s economic life represents a ‘major’ part — 60%? 70%? 80%? The lack of clear guid-
ance in the accounting standard could result in differing classifications of similar lease arrangements. For
example, a 6-year lease of an asset with an economic life of 8 years could be classified as a finance lease by
entity A on the grounds that the lease term is 74% of the asset’s economic life, but treated as an operating
lease by entity B, which applies an 85% ‘cut off’.
This classification guideline assumes that the consumption pattern of economic benefits across the eco-
nomic life of the asset will be straight-line (equal in each year). However, some assets, such as vehicles,
may provide more of their benefits in the early years of their economic lives, so a time-based classification
criterion may not be appropriate.
When a lease is for the major part of the economic life of an asset, it is unlikely that the lessor expects
to earn its return on the asset from another party. However, this guideline is not necessarily conclusive as
there may be other factors that suggest the lessor retains the risks and rewards associated with the asset,
such as obsolescence risks. Therefore, judgement is required when evaluating this guideline.
Does the present value of minimum lease payments amount to substantially all of
the fair value of the lease asset at lease inception?
The minimum lease payments represent payments for benefits transferred to the lessee. At lease inception
date, the relationship of the present value of the minimum lease payments to the fair value of the asset
indicates the proportion of benefits being paid for by the lessee.
To apply this guideline, the following information must be gathered or determined at the inception of
the lease:
• fair value of the leased asset;
• minimum lease payments for each period; and
• discount rate.
Fair value of the leased asset
Fair value is defined in IAS 17 paragraph 4 as ’the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arm’s length transaction.’
This definition of fair value is different from the definition in IFRS 13 Fair Value Measurement (see chapter 3
for a discussion of fair value measurement). Under IAS 17, fair value is normally a market price. However, if
the lease relates to specialised equipment constructed or obtained for the lease contract, a fair value may
be difficult to obtain. The fair value is regarded as representing the future rewards available to the user
of the asset, discounted by the market to allow for the risk that the rewards will not eventuate and for
changes in the purchasing power of money over time.
326 PART 2 Elements

Minimum lease payments
The definition of minimum lease payments in IAS 17 can be expressed as follows:
Minimum lease payments = (i) Payments over the lease term

+ (ii) Guaranteed residual value
+ (iii) Bargain purchase option
− (iv) Contingent rent
− (v) Reimbursement of costs paid by the lessor
(i) Payments over the lease term are simply the total of all amounts payable under the lease agreement.
(ii) The guaranteed residual value is that part of the residual value of the leased asset guaranteed by the
lessee or a third party.
The lessor will estimate the residual value of the leased asset at the end of the lease term based on
market conditions at the inception of the lease, and the lessee will guarantee that, when the asset is
returned to the lessor, it will realise at least that amount. The guarantee may range from 1% to 100%
of the residual value, and is a matter for negotiation between the lessor and lessee. If the guarantee is
provided by a party related to the lessor rather than the lessee, that part of the residual value is regard-
ed, for the purposes of IAS 17, as unguaranteed. When a lessee guarantees some or all of the residual
value of the asset, the lessor has transferred risks associated with movements in the residual value to
the lessee.
Lessees include in minimum lease payments amounts the lessee guarantees or amounts guaranteed
by a party related to the lessee. Lessors include in minimum lease payments residual value guarantees
by the lessee, a related party of the lessee or a third-party financially able to settle the guarantee.
(iii) A bargain purchase option is a clause in the lease agreement allowing the lessee to purchase the asset
at the end of the lease for a pre-set amount significantly less than the expected residual value at the
end of the lease term.
Together, amounts (i), (ii) and (iii) above represent the maximum possible payment the lessee is legally
obliged to make under the lease agreement, assuming that the guaranteed amount must be paid in full or
the purchase option will be exercised.
(iv) Payments may be increased during the lease term by the occurrence of events specified in the lease agree-
ment. Additional payments arising from such changes are called contingent rent. For example, an agree-
ment to lease a photocopier may specify an additional charge when the number of copies made in a month
exceeds 100 000. These charges relate to the use of the leased asset but, as the occurrence of the contingent
event is uncertain at lease inception date, they are ignored when calculating the minimum lease payments.
(v) Payments under a lease may include two components: a charge for using the asset, and a charge to
reimburse the lessor for operating expenses paid on behalf of the lessee. Operating expenses generally
include insurance, maintenance, consumable supplies, replacement parts and rates. These expenses
are referred to as ‘executory costs’ in this chapter. Amounts paid to reimburse such costs are excluded
from minimum lease payments because they do not relate to the value of the asset transferred be-
tween lessor and lessee. Payments for executory costs are recognised in the financial statements in the
period they are incurred, separate from ‘lease payments’.
Discount rate
The minimum lease payments are discounted to present value by applying an appropriate discount rate.
Discounting is not necessary if the lease contains a bargain purchase option or a 100% guaranteed residual
value because, in both cases, the present value of the minimum lease payments will equal the fair value of
the leased asset. Hence, a complete transfer of risks and rewards is deemed to have taken place.
To discount the minimum lease payments, the lessee/lessor will need to determine the interest rate
implicit in the lease. This is defined in IAS 17 paragraph 4 as:
the discount rate that, at the inception of the lease, causes the aggregate present value of
(a) the minimum lease payments; and
(b) the unguaranteed residual value
to be equal to the sum of
(i) the fair value of the leased asset, and
(ii) any initial direct costs of the lessor.
Initial direct costs of the lessor are incremental costs that are directly attributable to negotiating and
arranging a lease, except for such costs incurred by manufacturer or dealer lessors. Examples include
commissions, legal fees and internal costs, but exclude general overheads such as those incurred by a sales
and marketing team. Such costs incurred by a manufacturer/dealer lessor are excluded from the definition
of initial direct costs in IAS 17 paragraph 46 because the costs of negotiating and arranging a finance
lease are ‘mainly related to earning the manufacturer’s or dealer’s selling profit’. Thus, for the purposes
of determining the interest rate implicit in the lease, any initial direct costs incurred by a lessee or a
manufacturer/dealer lessor are ignored.

The interest rate implicit in the lease is determined at the inception date of the lease, and this may differ
from the commencement date of the lease term, which is a date set by the agreement. This may lead to the
use of a distorted discount rate if the inception date of the lease differs significantly from the commence-
ment of the lease term, the latter being the date from which the lessee is entitled to exercise its right to use
the leased asset and presumably the date from which the lessor is entitled to receive the lease payments. As
minimum lease payments and the unguaranteed residual value equal the future economic rewards obtain-
able from the asset, the interest rate is that used by the market to determine the fair value. From this comes
the notion that the rate is implicit in the terms of the agreement.
If it is not possible for the lessee to determine the residual value at the end of the lease term, initial
direct costs of the lessor, or, in the unusual case of a highly specialised asset, the fair value of the asset at
the inception of the lease, then the interest rate implicit in the lease cannot be calculated. In this situation,
the lessee uses its incremental borrowing rate to discount the minimum lease payments. The incremental
borrowing rate is the rate of interest the lessee would have to pay on a similar lease or, if this is not deter-
minable, the rate that (at the inception of the lease) the lessee would incur to borrow over a similar term,
and with a similar security, the funds necessary to purchase the asset.
Substantial transfer?
As previously discussed, IAS 17 does not define ‘substantially all’. Some national GAAPs contain a threshold
of 90% and in practice IFRS reporters often use this as a guideline. However, because of a lack of quantita-
tive guidelines in the standard, a judgement must be made as to whether the present value of the minimum
lease payments represents the transfer of ‘substantially all’ of the fair value of the asset from the lessor to the
lessee. This exercise of judgement may result in the inconsistent classification of similar lease arrangements.
Is the leased asset of such a specialised nature that it is expected to have no
alternative use to the lessor at the end of the lease term?
In some arrangements, the lessor manufactures an asset for the specific needs of the lessee and the asset is
not able to be used by another lessee without the lessor incurring significant costs to modify it. In this situa-
tion, it is likely that other guidelines above also have been met as the arrangement would be designed for the
lessor to generate all of its returns from the one lessee, and such a lease normally would be a finance lease.
If the lessee can cancel the lease, is the lessee responsible for any losses incurred
by the lessor?
This guideline suggests that the residual value risk is essentially borne by the lessee. Suppose a lessee
leases a car for 5 years and is required to compensate the lessor for any decreases in the residual value if
the lessee decides to cancel the lease after 3 years. If the residual value is lower than anticipated, the lessee
bears more of the risks and rewards associated with the asset, which may indicate a finance lease.
Is the lessee entitled to the gains or exposed to the losses from the fluctuation in
the fair value of the residual asset?
If, for example, a lessee is required to reimburse the lessor for declines in the fair value of the asset at the
end of the lease, the lessee would be exposed to the risks of the residual value in the asset. This would
indicate that the lessor was compensated for the asset from the payments received from the lessee and
suggests a finance lease.
Can the lessee continue the lease for futher periods at a rent substantially less
than market rent?
• An option to renew a lease at substantially less than market rent, i.e a ‘bargain renewal option’, is
considered reasonably certain of exercise. Therefore, the periods covered by such an option are included
in the lease term when assessing whether the lease term is for a major part of the economic life of the
leased asset, as discussed above. Depending on the number of renewal terms and the renewal period in
relation to the economic life of the asset, such options could result in a finance lease.
ILLUSTRATIVE EXAMPLE 12.1 Classification of a lease agreement
On 31 December 2015, Gisborne Ltd leased a vehicle to Phillip Ltd. Gisborne Ltd had purchased the vehicle
on that day at an amount equal to its fair value of £89 721. The lease agreement, which cost Gisborne Ltd
£1457 to have drawn up, contained the following terms:
Lease term 4 years

Annual payment, payable in advance on 31 December each year £23 900
Economic life of vehicle 6 years
Estimated residual value at end of lease term £15 000
Residual value guaranteed by lessee £7 500
328 PART 2 Elements

If Phillip Ltd terminates the lease before the end of the 4-year lease term, Phillip Ltd will incur a mon-
etary penalty equivalent to 2 years rental payments.
Included in the annual payment is an amount of £1900 to cover reimbursement for the costs of insur-
ance and maintenance paid by Gisborne Ltd.
IAS 17 requires the lease to be classified as either a finance lease or an operating lease, based on the
extent to which the risks and rewards associated with the vehicle have been transferred from Gisborne
Ltd to Phillip Ltd.
Does the lease transfer ownership of the vehicle by the end of the lease term?
The lease terms do not transfer ownership of the vehicle to Phillip Ltd.
Is Phillip Ltd reasonably certain to exercise an option to purchase the vehicle?
The lease terms do not contain an option to purchase the underlying asset.
Is the lease term for a major part of the economic life of the vehicle?
Because Phillip Ltd is required to pay a termination payment equivalent to the present value of the
remaining lease payments, the lease is essentially non-cancellable as it is reasonably certain that Phillip
Ltd will continue the lease for the term specified in the lease agreement. Such term is included when
assessing whether the lease term is for a major part of the economic life of the vehicle.
The lease term is 4 years, which is 66% of the vehicle’s economic life of 6 years. If expected benefits
were receivable evenly over the vehicle’s useful life, it would be doubtful that the lease arrangement is
for the major part of its life.
Is the present value of the minimum lease payments substantially all of the fair value of the vehicle?
The minimum lease payments consist of:
• lease payments net of cost reimbursement — there is an immediate payment of £22 000 (being
£23 900 − $1900) and four subsequent payments of £22 000
• guaranteed residual value — an amount of £7500 is guaranteed at the end of the fourth year.
The unguaranteed residual value is £7500.
Interest rate implicit in the lease
The discount rate is the rate that discounts the rental payments and the residual value to £91 178, which
is the sum of the vehicle’s fair value at 1 January 2014 of £89 721 and the initial direct costs (IDC) of
£1457 incurred by Gisborne Ltd. This rate is found by trial and error using present value tables or a
financial calculator.
The implicit interest rate in this example is 7%, that is:
Present value = £22 000 + (£22 000 × 2.6243 [T2 7% 3y]) + (£15 000 × 0.7629 [T1 7% 4y])
= £22 000 + £57 735 + £11443
= £91 178
when T = present value table
y = years
Note the following:

• As the first payment is made at the inception of the lease, it is not discounted.
• The discount factor used is an annuity factor based on three equal payments of £22 000 for the next
3 years at 7%.
• The discount factor used is based on a single payment of £15 000 (the residual value) at the end of
the lease term in 4 years at a rate of 7%. The £15 000 comprises £7500 guaranteed by the lessee plus
the unguaranteed balance of £7500.
The present value is equal to the fair value (FV) plus IDC, so the interest rate implicit in the lease is 7%.
Present value of minimum lease payments (PV of MLP)
PV of MLP = £22 000 + (£22 000 × 2.6243 [T2 7% 3y]) + (£7500 × 0.7629 [T1 7% 4y])
= £22 000 + £57 735 + £5722
= £85 457
FV + IDC = £91 178
PV/(FV + IDC) = (£85 457/£91 178) × 100%
= 93.7%

At a 93.7% level, Phillip Ltd considers the present value of the minimum lease payments to be sub-
stantially all of the fair value of the vehicle.
Other considerations required by IAS 17
• Is the leased asset of such a specialised nature that it is expected to have no alternative use to
Gisborne Ltd at the end of the lease term? No.
• Is Phillip Ltd responsible for any losses incurred by Gisborne Ltd if Phillip Ltd decides to cancel the
lease before the end of the lease term? No.
• Is Phillip Ltd entitled to the gains or losses from the fluctuation in the fair value of the residual
asset? No.
• Can Phillip Ltd continue to use the leased asset for further periods at rent substantially less than
market rent? No. The terms of the lease agreement do not contain any renewal options. If Phillip Ltd
decides to continue to lease the vehicle, this would be subject to new negotiations with Gisborne Ltd
and a new agreement, which would require a new analysis of classification under IAS 17.
Classification of the lease
Application of the lease classification guidelines provides mixed signals. The key criterion in classifying
leases is whether substantially all the risks and rewards incidental to ownership have been transferred.
This requires an overall analysis of the arrangement. The different signals coming from the lease term
guideline and the present value guideline may be due to the fact that the majority of the rewards will
be transferred in the early stages of the life of the asset, which is the case with motor vehicles. This is
reflected in the relatively low residual value at the end of the lease term. These mixed signals demon-
strate that the classification guidelines must be used for guidance only and not treated as specific criteria
that must be met.
Based on the nature of the asset and the assessment that the lessee will pay substantially all of the fair
value of the asset over the lease term, it is concluded that the lease agreement should be classified as a
finance lease because substantially all the risks and rewards incident to ownership have been passed to
the lessee.
LO4 12.4 ACCOUNTING FOR FINANCE LEASES BY LESSEES

Once an arrangement has been classified as a finance lease, the asset and liability arising from it must be
determined and recognised in the accounts.
12.4.1 Initial recognition

When a lease has been classified as a finance lease, IAS 17 requires the lessee to recognise, at the com-
mencement of the lease term, an asset and a liability, each determined at the inception of the lease, equal
in amount to the fair value of the leased property or, if lower, the present value of the minimum lease
payments. The form of the entry is:
Lease Asset Dr PV of MLP

Lease Liability Cr PV of MLP
The commencement of the lease term is the date from which the lessee is entitled to exercise its right
to use the leased asset, and may be the same date as the inception of the lease or a later date. If the lessee
incurs initial direct costs associated with negotiating and securing the lease arrangement, these costs are
added to the amount recognised as an asset. The journal entry is:
Lease Asset Dr PV of MLP + IDC

Lease Liability Cr PV of MLP
Cash Cr IDC

After initial recognition, IAS 17 prescribes differing accounting treatments for the lease asset and the lease
liability.
330 PART 2 Elements

Leased assets
Leased assets under finance leases are depreciated in a manner consistent with owned assets, as prescribed
by IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets.
Depreciable assets are those whose future benefits are expected to expire over time or by use. The asset is
depreciated over its useful life in a pattern reflecting the consumption or loss of the rewards embodied in
the asset. The length of a leased asset’s useful life depends on whether or not ownership of the asset will
transfer at the end of the lease term. If the asset is to be returned to the lessor, then its useful life is the
lease term. If ownership is reasonably certain to transfer to the lessee, then its useful life is its economic
life or remainder thereof. Additionally, to determine whether a leased asset has become impaired, the
lessee must apply IAS 36 Impairment of Assets.
Lease liability
Because lease payments are made over the lease term, the lease liability is increased by interest expense
incurred and decreased by the minimum lease payments made. The lease liability recognised at the
commencement of the lease term represents the present value of future lease payments relating to the
use of the asset. This present value is determined, as described in section 12.3.2, by applying the interest
rate implicit in the lease. In practice, lessees may not be able to determine the rate implicit in the lease
and, therefore, will use their incremental borrowing rate. The interest expense is calculated by applying
the same rate to the outstanding lease liability at the beginning of the payment period. A payments
schedule can be used to determine the interest expense and the reduction in the liability over the lease
period.
Accounting for the reimbursement of lessor costs and contingent rent
The standard is silent about the component of lease payments that represents a reimbursement of costs
incurred by the lessor other than stating that these costs are not minimum lease payments and, there-
fore, are not reflected in the lease liability or the lease asset. As discussed in 12.3.2, these ‘executory costs’
are effectively borne by the lessee, and the payments are recognised as an expense. Consideration must
be given to the pattern of consumption relating to those expenses and normal prepayment and accrual
requirements apply.
Contingent rent must be recognised as an expense of the period in which it is incurred.
ILLUSTRATIVE EXAMPLE 12.2 Accounting for finance leases by lessees
Using the facts from illustrative example 12.1, the lease payments schedule prepared by Phillip Ltd,
based on annual lease payments of £22 000 for the vehicle and an interest rate of 7%, would be:
PHILLIP LTD
Lease Payments schedule
Minimum lease Interest Reduction in Balance of

payments(a) expense(b) liability(c) liability(d)
31 December 2015(e) £85 457(f)
31 December 2015 £22 000 £ — £22 000 63 457
31 December 2016 22 000 4 442 17 558 45 899
31 December 2017 22 000 3 213 18 787 27 112
31 December 2018 22 000 1 898 20 102 7 010
31 December 2019 7 500 490 7 010 —
£95 500 £10 043 £85 457
(a) Four annual payments of £22 000 payable in advance on 31 December of each year, plus a guaranteed
residual value of £7500 on the last day of the lease.
(b) Interest expense = balance of liability each prior year-end multiplied by 7%. No interest expense is incurred
in the year ended 31 December 2015 because payment is made at 31 December 2015, the commencement of
the lease.
(c) Reduction in liability = minimum lease payments less interest expense. The total of this column must equal the
initial liability, which may require rounding the final interest expense figure.
(d) The balance is reduced each year by the amount in column 3.
(e) At lease inception.
(f) Initial liability = present value of minimum lease payments. As the present value of minimum lease
payments is less than the fair value of the asset, paragraph 20 of IAS 17 requires the lower amount to be
recognised.

The payment schedule is used to prepare lease journal entries and financial statement disclosures each
year. The journal entries recorded by Phillip Ltd for the 4 years of the lease in accordance with IAS 17 are:
PHILLIP LTD
General Journal

31 December 2015:
Leased Vehicle Dr 85 457
Lease Liability Cr 85 457
(Initial recording of lease asset/liability)
Lease Liability Dr 22 000
Prepaid Executory Costs* Dr 1 900
Cash Cr 23 900
(First lease payment)
*Executory costs have been recognised as an asset because the insurance and maintenance benefits will not be received
until the next reporting period.

1 January 2016:
Executory Costs Dr 1 900
Prepaid Executory Costs Cr 1 900
(Reversal of prepayment)**
31 December 2016:
Prepaid Executory Costs Dr 1 900
Cash Cr 23 900
(Second lease payment)
(Depreciation charge for the period [£85 457 − £7 500]/4)***
***Because the asset will be returned at the end of the lease term, the useful life is the lease term of 4 years and the
depreciable amount is the net present value of the minimum lease payments less the guaranteed residual value.

1 January 2017:
31 December 2017:
Cash Cr 23 900
(Third lease payment)
(Depreciation charge for the period [£85 457 − £7 500]/4)
1 January 2018:
31 December 2018:
Cash Cr 23 900
(Fourth lease payment)
332 PART 2 Elements


1 January 2019:
31 December 2019:
Leased Vehicle Cr 7 500
(Return of leased vehicle)****
****The final ‘payment’ is the return of the asset at its guaranteed residual value. If the asset is being purchased,
this entry will record a cash payment. Another entry will then be required to reclassify the undepreciated
balance of the asset from a ‘leased’ asset to an ‘owned’ asset.

Leased Vehicle Cr 77 957
(Fully depreciated asset written off)
**For simplicity, reversal of executory costs is shown on 1 January. However, executory costs are recognised as
incurred, which in this example would be over the entire year.
If the fair value of the leased asset is lower than the guaranteed residual value of £7500, Phillip Ltd would
recognise additional expense.
12.4.3 Disclosures required

Figure 12.2 shows the lease accounting policy disclosures and extracts from the expenses; property, plant
and equipment; long-term borrowings; and commitments notes to the financial statements of International
Airlines Group for the year ended 31 December 2014.
FIGURE 12.2 Note extracts from International Airlines Group annual report 31 December 2014
2 Summary of significant accounting policies

Foreign currency translation
...
d Leased assets
Where assets are financed through finance leases, under which substantially all the risks and rewards
of ownership are transferred to the Group, the assets are treated as if they had been purchased outright.
The amount included in the cost of property, plant and equipment represents the aggregate of the capital
elements payable during the lease term. The corresponding obligation, reduced by the appropriate
proportion of lease payments made, is included in borrowings.
The amount included in the cost of property, plant and equipment is depreciated on the basis described
in the preceding paragraphs on fleet and the interest element of lease payments made is included as an
interest expense in the income statement.
Total minimum payments measured at inception, under all other lease arrangements, known as operating
leases, are charged to the income statement in equal annual amounts over the period of the lease. In
respect of aircraft, certain operating lease arrangements allow the Group to terminate the leases after a
limited initial period, without further material financial obligations. In certain cases the Group is entitled to
extend the initial lease period on predetermined terms; such leases are described as extendable operating
leases.
...
(continued)

g Lease classification
A lease is classified as a finance lease when substantially all the risks and rewards of ownership are
transferred to the Group. In determining the appropriate classification, the substance of the transaction
rather than the form is considered. Factors considered include but are not limited to the following: whether
the lease transfers ownership of the asset to the lessee by the end of the lease term; the lessee has the
option to purchase the asset at the price that is sufficiently lower than the fair value exercise date; the lease
term is for the major part of the economic life of the asset; and the present value of the minimum lease
payments amounts to at least substantially all the fair value of the leased asset.
6 Expenses by nature
Operating profit is after charging/(crediting)
Operating lease costs:
€ million 2014 2013
Minimum lease rentals — aircraft 551 499

— property and equipment 187 186
Sub-lease rentals received (54) (38)
684 647
13 Property, plant and equipment
€ million
Net book values
31 December 2014 9 974 1 260 550 11 784

31 December 2013 8 515 1 218 495 10 228
Analysis at 31 December 2014

Owned 4 290 1 173 411 5 874
Finance leased 5 398 5 32 5 435
Progress payments 286 82 107 475
Property, plant and equipment 9 974 1 260 550 11 784
Analysis at 31 December 2013

Owned 4 274 1 153 422 5 849
Finance leased 3 789 5 48 3 842
Progress payments 452 60 25 537
Property, plant and equipment 8 515 1 218 495 10 228
23 Long-term borrowings continued

d Total loans and finance leases
Finance leases
US dollar $3 772 $2 935
Euro €1 084 €456
Japanese yen ¥37 105 ¥18 557
Pound sterling £771 £874
€5 384 €3 770
€6 617 €5 122
e Obligations under finance leases

The Group uses finance leases principally to acquire aircraft. These leases have both renewal options and
purchase options at the option of the Group. Future minimum lease payments under finance leases are as
follows:
334 PART 2 Elements

€ million 2014 2013
Future minimum payments due:

Within 1 year 676 492
After more than 1 year but within 5 years 2 463 1 893
In 5 years or more 3 100 1 858
6 239 4 243
Less: Finance charges (855) (473)
Present value of minimum lease payments 5 384 3 770
The present value of minimum lease payments is analysed as follows:

Within 1 year 549 404
After more than 1 year but within 5 years 2 079 1 650
In 5 years or more 2 756 1 716
5 384 3 770
The Group’s finance lease for one Airbus A340-600 is subject to financial covenants which are tested
annually. The lease is part of a syndicate family. The Group has informed the syndicate that it had failed to
meet the covenants for the year to 31 December 2014. As a result of these covenant breaches, the finance
lease has technically become repayable on demand and $79 million (€65 million) has been classified as
current. The institutions formally waived the breach on 25 February 2015.
24 Operating lease commitments
The Group has entered into commercial leases on certain properties, equipment and aircraft. These leases
have durations ranging from less than 1 year for aircraft to 132 years for ground leases. Certain leases
contain options for renewal.
The aggregate payments, for which there are commitments under operating leases, fall due as follows:
2014 2013
Property, plant Property, plant
€ million Fleet and equipment Total Fleet and equipment Total
Within 1 year 712 171 883 543 156 699
Between 1 and 5 years 1 580 325 1 905 1 537 383 1 920
Over 5 years 934 2 027 2 961 1 009 1 958 2 967
3 226 2 523 5 749 3 089 2 497 5 586
Sub-leasing
Sub-leases entered into by the Group relate to surplus rental properties and aircraft assets held under
non-cancellable leases to the third parties. These leases have remaining terms of 1 to 23 years and the
assets are surplus to the Group’s requirements. Future minimum rentals receivable under non-cancellable
operating leases are as follows:
2014 2013
Property, plant Property, plant
€ million Fleet and equipment Total Fleet and equipment Total
Within 1 year 2 12 14 - 9 9
Between 1 and 5 years - 6 6 - 14 14
Over 5 years - 2 2 - 3 3
2 20 22 - 26 26
Three of the Group’s Airbus A340-600 operating leases are also subject to financial covenants which are
tested annually. The Group has informed the syndicate that it had failed to meet the covenants for the
year to 31 December 2014. The remaining operating lease payments of $156 million (€128 million) will
technically fall due within 1 year. The institutions have provided positive feedback and are expected to
formally waive the breach in March 2015.
Source: International Airlines Group, Annual Report 2014 (pp. 102–103, 109, 113, 120, 130–131).

Figure 12.3 provides an illustration of the disclosures required by IAS 17, and is based on the figures
used in illustrative example 12.2 for the year ended 31 December 2017.
IAS 17
paragraph
Leasing
The Entity leases vehicles under finance leases with terms of 4 years. Leases are classified as 31(e)
finance leases whenever the terms of the lease transfer substantially all the risks and rewards of
ownership to the Entity. All other leases are classified as operating leases
The Entity as a lessee
Assets held under finance leases are recognised as assets of the Entity at their fair value at the
date of acquisition or, if lower, at the present value of the minimum lease payments.
The corresponding liability to the lessor is included in the statement of financial position
as a finance lease liability. Lease payments are apportioned between finance charges and
reduction of the lease liability to achieve a constant rate of interest on the remaining balance
of the liability. Finance charges are charged directly against income unless they are directly
attributable to qualifying assets, in which case they are capitalised in accordance with the
Entity’s general policy on borrowing costs.
Note 16: Property, plant and equipment (extract)
The carrying amount of the Entity’s plant and equipment includes an amount of 31(a)
£46 479 (2016: £65 968) relating to leased assets.
Note 36: Finance lease liabilities

The following is a summary of future minimum lease payments for finance leases:
Minimum PV of Minimum PV of
lease payments payments lease payments payments
2017 2017 2016 2016
Amounts payable under
finance leases:
Within 1 year 22 000 20 102 22 000 18 787 31(b)
After 1 year but not 7 500 7 010 29 500 27 112
more than 5 years(1)
Total minimum lease 29 500 27 112 51 500 45 899
payments (2 388) (5 601)
Less: Finance charges
Present value of 27 112 45 899
minimum lease
payments
(1) If the lease term in illustrative example 12.2 was for more than 5 years, Phillip Ltd would also disclose the total
amounts payable more than 5 years.
FIGURE 12.3 Illustrative disclosures required by IAS 17 for lessees of finance leases
If Phillip Ltd’s lease contained contingent rentals, renewal or purchase options, escalation clauses or
any restrictions (such as those limiting the payment of dividends), those terms would be required to
be disclosed (IAS 17 paragraphs 31(c) and (e)). In addition, if Phillip Ltd sublet the vehicle, the future
minimum lease payments under that sub-lease arrangement (if it were non-cancellable) also would be
required to be disclosed (IAS 17 paragraph 31(d)).
LO5 12.5 ACCOUNTING FOR FINANCE LEASES BY LESSORS

When a lease is classified as a finance lease, the lessor will need to derecognise the leased asset and record
a lease receivable.
12.5.1 Initial recognition

In theory, the classification process required by IAS 17 should result in identical classifications by
both lessors and lessees. In reality, differing circumstances may result in the same lease being classified
336 PART 2 Elements

differently; for example, when the lessor benefits from a residual value guarantee provided by a party
unrelated to the lessee.
Paragraph 36 of IAS 17 requires the lessor to recognise an asset held under a finance lease in its state-
ment of financial position and present it as a receivable at an amount equal to the net investment in the
lease. In paragraph 4 the net investment in the lease is defined as ‘the gross investment in the lease dis-
counted at the interest rate implicit in the lease‘ and the gross investment is the total of:
(a) the minimum lease payments receivable by the lessor . . . and
(b) any unguaranteed residual value accruing to the lessor.
This value would normally equate to the fair value of the asset at the inception of the lease. Initial direct
costs (except those incurred by manufacturer or dealer lessors) are included in the initial measurement
of the finance lease receivable and in the calculation of the implicit interest rate, thereby reducing the
amount of interest revenue recognised over the lease term. Lessees are required to recognise assets and lia-
bilities associated with finance leases at the commencement of the lease term but no date for recognition
is specified for lessors; presumably, it would be the same date.
The recognition of the fair value of the leased asset as a receivable raises a conceptual issue in that the
‘receivable’, for leases with no purchase option, has both a monetary component (the rent payments)
and non-monetary component (the return of the asset). As discussed in section 12.9, lessor accounting is
substantially unchanged under the IASB’s new leases standard and, therefore, this conceptual flaw will
continue to exist.

Because the lease payments are received from the lessee over the lease term, the lease receivable is
increased by interest revenue earned and decreased by minimum lease payments received (i.e. lease pay-
ments excluding payments for services and contingent rent). The lease receivable recognised at the com-
mencement of the lease term represents the present value of future lease payments relating to the use of
the asset. This present value is determined by applying the interest rate implicit in the lease. The interest
revenue can be obtained by applying the same rate to the outstanding lease receivable at the beginning of
the payment period. A receipts schedule can be used to determine the interest revenue and the reduction
in the receivable over the lease period.
Accounting for executory costs and contingent rentals
Payments for services, such as insurance or maintenance (i.e. executory costs), are not included in the lease
receivable. Receipts for executory costs are recorded as revenue in the same period in which the related
expenses are incurred, when the lessor is acting as principal (see discussion of the principal/agent distinction
in section 4.9.3).
IAS 17 is silent on lessor treatment of contingent rent. However, as these receipts meet the definition of
income in the Conceptual Framework, contingent rent is recognised as revenue in the period it is earned.
ILLUSTRATIVE EXAMPLE 12.3 Accounting for fi nance leases by lessors
On 31 December 2015, Gisborne Ltd leased a vehicle to Phillip Ltd. Gisborne Ltd had purchased the
vehicle on that day at an amount equal to its fair value of £89 721. The lease agreement, which cost
Gisborne Ltd £1457 to have drawn up, contained the following terms:
Lease term 4 years

Annual payment, payable in advance on 31 December each year £23 900
Economic life of vehicle 6 years
Estimated residual value at end of economic life £2 000
Estimated residual value at end of lease term £15 000
Residual value guaranteed by lessee £7 500
If Phillip Ltd terminates the lease before the end of the 4-year lease term, Phillip Ltd will incur a mon-
etary penalty equivalent to 2 years‘ rental payments.
Included in the annual payments is an amount of £1900 to cover reimbursement for the costs of
insurance and maintenance paid by the lessor.
IAS 17 requires the lease to be classified as either a finance lease or an operating lease, based on the
extent to which the risks and rewards associated with the vehicle have been transferred from Gisborne
Ltd to Phillip Ltd.
Classification of the lease by the lessor
Gisborne Ltd applies the IAS 17 guidelines and classifies the lease as a finance lease. See illustrative
example 12.1 for workings.

The lease receipts schedule based on annual payments of £22 000 for the vehicle and an interest rate
implicit in the lease of 7% shows:
GISBORNE LTD
Lease Receipts Schedule
Minimum lease Interest Reduction in Balance of

receipts(a) revenue(b) receivable(c) receivable(d)
31 December 2015(e) £91 178(f)
31 December 2015 £ 22 000 £ — £22 000 69 178
31 December 2016 22 000 4 842 17 158 52 020
31 December 2017 22 000 3 641 18 359 33 661
31 December 2018 22 000 2 356 19 644 14 017
31 December 2019 15 000 983 14 017 —
£103 000 £11 822 £91 178
(a) Four annual receipts of £22 000 payable in advance on 31 December of each year, plus a residual value of
£15 000 (of which £7 500 is guaranteed by the lessee) on the last day of the lease.
(b) Interest revenue = balance of receivable each prior year-end multiplied by 7%. No interest revenue is
earned in the year ended 31 December 2015 because the payment is received at 31 December 2015, the
commencement of the lease.
(c) Reduction in receivable = minimum lease payments received less interest revenue. The total of this column
must equal the initial receivable, which may require rounding the final interest revenue figure.
(d) The balance is reduced each year by the amount in column 3.
(e) At lease inception.
(f) Initial receivable = vehicle’s fair value of £89 721 plus IDC of £1 457. This figure equals the present value of
minimum lease payments receivable and the present value of the unguaranteed residual value.
The lease receipts schedule is used to prepare lease journal entries and financial statement disclosures
each year. The journal entries recorded by Gisborne Ltd for the 4 years of the lease in accordance with
IAS 17 are:
GISBORNE LTD
General Journal

31 December 2015:
Vehicle Dr 89 721
Cash Cr 89 721
(Purchase of motor vehicle)
Lease Receivable Dr 89 721

Vehicle Cr 89 721
(Lease of vehicle to Phillip Ltd)
Lease Receivable Dr 1 457

Cash Cr 1 457
(Payment of IDC)
Cash Dr 23 900
Lease Receivable Cr 22 000
Reimbursement in Advance* Cr 1 900
(Receipt of first lease payment)
* The reimbursement of executory cost has been carried forward to 2015, when Gisborne Ltd will pay the costs.

1 January 2016:
Reimbursement in Advance Dr 1 900
Reimbursement Revenue Cr 1 900
(Reversal of accrual)**
31 December 2016:
Insurance and Maintenance** Dr 1 900
Cash Cr 1 900
(Payment of costs on behalf of lessee)
338 PART 2 Elements

Cash Dr 23 900
Interest Revenue Cr 4 842
Reimbursement in Advance Cr 1 900
(Receipt of second lease payment)
1 January 2017:
31 December 2017:
Cash Cr 1 900
Cash Dr 23 900
(Receipt of third lease payment)
1 January 2018:
31 December 2018:
Cash Cr 1 900
Cash Dr 23 900
(Receipt of fourth lease payment)
1 January 2019:
31 December 2019:
Cash Cr 1 900
Vehicle Dr 15 000
Interest Revenue Cr 983
(Return of vehicle at end of lease)
**For simplicity, recognition of executory costs and associated revenue are recognised on 1 January 2015 and 31
December 2015, respectively. However, the costs would be incurred and associated revenue generally would be
earned over the entire year.
12.5.3 The initial direct costs anomaly

The inclusion (by the standard setters) of initial direct costs incurred by lessors in the definition of the
interest rate implicit in the lease creates an interest rate differential between the lessee and lessor when a
lease agreement transfers all of the risks and rewards related to an asset.
To illustrate: consider the same situation as described in illustrative example 12.3 but increasing the guar-
anteed residual value to £15 000 (100% of the residual), which effectively transfers all of the benefits of

the vehicle from Gisborne Ltd to Phillip Ltd. The present value of the minimum lease payments would
then be:
PV of MLP = £22 000 + (£22 000 × 2.6243 [T2 7% 3y]) + (£15 000 × 0.7629 [T1 7% 4y])
= £22 000 + £57 735 + £11 443
= £91 178
Generally, the rate of return the lessor expects to earn will be different depending on
whether the residual value is guaranteed or not, and the lease payments would be adjusted
accordingly. For simplicity, the lease payments are not changed in this example.
This figure equals the fair value of the asset, £89 721, plus the IDC incurred by the lessor of £1457.
However, paragraph 20 of IAS 17 requires lessees to recognise, at the commencement of the lease, an
asset and a liability equal to the inception date fair value of the leased asset or, if lower, the present value
of the minimum lease payments. As the present value of the minimum lease payments using the 7%
interest rate implicit in the lease is higher than the asset’s fair value, it cannot be recognised by the lessee
even though it would be recognised by the lessor. The lessee, Phillip Ltd, can only recognise a lease asset
and liability of £89 721, and must recalculate the interest rate implicit in the lease in order to determine
interest expense charges over the lease term.
The interest rate that discounts the lease payments to £89 721 is 8%, so Phillip Ltd will calculate its
interest expense at 8% and Gisborne Ltd will calculate its interest revenue at 7%. The difference represents
the recovery of the IDC by Gisborne Ltd via the lease payments received.

Figure 12.4 provides an illustration of the disclosures required by IAS 17. The information used in this figure
is derived from the Gisborne Ltd lease shown in illustrative example 12.3 for the year ended 31 December 2017.
FIGURE 12.4 Illustrative disclosures required by IAS 17 for lessors of finance leases
IAS 17
paragraph

Leasing
The Entity leases vehicles under finance leases with terms of 4 years. Leases are 47(f)
classified as finance leases whenever the terms of the lease transfer substantially all
the risks and rewards of ownership to the lessee. All other leases are classified as
operating leases.
The Entity as a lessor

Amounts due from lessees under finance leases are recorded as a receivable at the amount
of the Entity’s net investment in the leases. Finance lease income is allocated to accounting
periods, so as to reflect a constant periodic rate of return on the Entity’s net investment
outstanding in respect of the leases.
Note 36: Finance lease receivables

Future minimum lease payments receivable under finance leases are as follows:
Investment PV of Investment PV of
in lease receivables in lease receivables
2017 2017 2016 2016
Amounts receivable under finance 47(a)

leases:
Within 1 year 22 000 19 644 22 000 18 359
After 1 year but not more
than 5 years(1) 15 000 14 017 37 000 33 661
Total minimum lease payments

receivable 37 000 33 661 59 000 52 020
Less: Unearned finance
income (3 339) (6 980) 47(b)
Present value of minimum lease

payments 33 661 52 020
340 PART 2 Elements

Unguaranteed residual values of assets leased under finance leases at the end of the reporting 47(c)
period are estimated at 7500 (2015: 7500)
(1) If the lease term in illustrative example 12.3 was for more than 5 years, Gisborne Ltd would also
disclose the total amounts receivable more than 5 years.
If Gisborne Ltd’s lease contained contingent rentals or if Gisborne Ltd recognised an allowance for
uncollectible minimum lease payments receivable, those amounts would be required to be disclosed (IAS 17
paragraphs 47(e) and (d), respectively).
LO6 12.6 ACCOUNTING FOR FINANCE LEASES BY

MANUFACTURER OR DEALER LESSORS
When manufacturers or dealers offer customers the choice of either buying or leasing an asset, a lease
arrangement gives rise to two types of income:
• profit or loss equivalent to the outright sale of the asset being leased
• finance income over the lease term.
Accounting for the lease is identical to that required by non-manufacturer/dealer lessors except for an
initial entry to recognise profit or loss and the treatment of initial direct costs, which is described below.
IAS 17 requires manufacturer and dealer lessors to recognise selling profit or loss at the commencement
of the lease, in accordance with their policy for sales. When artificially low interest rates have been offered
to entice the customer to enter the lease, the selling profit recorded must be limited to the selling profit
that would be realised if the manufacturer/dealer charged a market rate of interest.
The sales revenue recognised is equal to the fair value of the asset or, if lower, the minimum lease pay-
ments calculated at a market rate of interest. The cost of sales expense is the cost or carrying amount of the
leased property less the present value of any unguaranteed residual value. Sales revenue less cost of sales
expense equals selling profit or loss. Additionally, the initial direct costs incurred by the manufacturer or
dealer in negotiating and arranging the lease are recognised as an expense when the profit is recognised.
Such costs are regarded as part of earning the profit on sale rather than a cost of leasing.
ILLUSTRATIVE EXAMPLE 12.4 Calculating and recognising profi t on sale with initial direct costs
Napier S.A. manufactures specialised moulding machinery for both sale and lease. On 1 January 2016,
Napier S.A. leased a machine to Bliss S.A., incurring €1500 in costs to negotiate, prepare and execute the
lease document. The machine cost Napier S.A. €195 000 to manufacture, and its fair value at the incep-
tion of the lease was €212 515. The interest rate implicit in the lease is 10%, which is in line with cur-
rent market rates. Under the terms of the lease, Bliss S.A. has guaranteed €25 000 of the asset’s expected
residual value of €37 000 at the end of the 5-year lease term.
After classifying the lease as a finance lease, Napier S.A. records the following entries on 1 January 2016:
Lease Receivable(a) Dr 212 515

Cost of Sales(b) Dr 187 548
Inventory(c) Cr 195 000
Sales Revenue(d) Cr 205 063
(Initial recognition of lease receivable and recording
sale of machinery)
Lease Costs Dr 1 500

Cash Cr 1 500
Payment of IDC
Notes:
(a) The lease receivable represents the net investment in the lease and is equal to the fair value of the leased machine.
(b) Cost of sales represents the cost of the leased machine (€195 000) less the present value of the unguaranteed
residual value (€12 000 × 0.620921 = €7452).
(c) Inventory is reduced by the cost of the leased machine.
(d) Sales revenue represents the present value of the minimum lease payments, which in this situation is less than the
fair value of the asset due to the existence of an unguaranteed residual value.

LO7 12.7 ACCOUNTING FOR OPERATING LEASES
Operating leases are all leases other than those in which substantially all the risks and rewards incidental
to ownership are transferred to the lessee. Operating leases are treated like executory arrangements, with
lessees recognising no asset or liability on their statement of financial position and lessors continuing to
carry the asset on their statement of financial position.
12.7.1 Accounting treatment

Lessees
IAS 17 paragraph 33 requires the lessee to recognise lease payments ‘as an expense on a straight-line basis over
the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit.’
Lessors
Lease receipts
IAS 17 paragraph 50 requires lessors to account for receipts from operating leases as ‘income on a straight-
line basis over the lease term, unless another systematic basis is more representative of the time pattern in
which the benefit derived from the leased asset is diminished.’
Initial direct costs
As discussed previously, the IAS 17 definition of initial direct costs excludes costs incurred by manufacturers
and dealers in negotiating and executing a lease. Any initial direct costs incurred by non-dealer/manufacturer
lessors in negotiating operating leases are ‘added to the carrying amount of the leased asset and recognised as an
expense over the lease term on the same basis as the lease income‘ (paragraph 52). This is illustrated as follows:
Asset € xxx
Less: Accumulated depreciation ( xxx)
xxx
Plus: Initial direct costs xxx
xxx
Depreciation of leased assets

Leased assets are required to be presented in the statement of financial position according to the nature
of the asset. Depreciation of assets under operating leases must be consistent with the lessor’s normal
depreciation policy for similar assets, and calculated in accordance with IAS 16 and IAS 38.
ILLUSTRATIVE EXAMPLE 12.5 Accounting for operating leases
On 1 January 2015, Matheson Corporation leased a bobcat from West Inc. The bobcat cost West Inc.
€35 966 on that same day. The lease agreement, which cost West Inc. €381 to have drawn up, contained
the following terms:
Lease term 3 years
Estimated economic life of the bobcat 10 years
Annual rental payment, in arrears (commencing 31 December 2015) €3 900
Residual value at end of the lease term €31 000
Residual guaranteed by Matheson Corporation €0
Interest rate implicit in lease 6%
IAS 17 requires the lease to be classified as either a finance lease or an operating lease based on
the extent to which the risks and rewards associated with the vehicle have been effectively transferred
between Matheson Corporation and West Inc.
Does the lease transfer ownership of the bobcat by the end of the lease term?
The lease terms do not transfer ownership of the bobcat to Matheson Corporation.
Is Matheson Corporation reasonably certain to exercise an option to purchase the bobcat?
The lease terms do not contain an option for Matheson Corporation to purchase the bobcat.
Is the lease term for the major part of the economic life of the bobcat?
The lease term is 3 years, which is only 30% of the bobcat’s economic life of 10 years. Therefore, it
would appear that the lease arrangement is not for the major part of the asset’s life.
Is the present value of the minimum lease payments substantially all of the fair value of the bobcat?
The minimum lease payments consist of three payments, in arrears, of €3900. There are no residual
value guarantees by any party.
342 PART 2 Elements

Present value of minimum lease payments
PV of MLP = €3 900 × 2.6730 [3 years T2 6%] = €10 425

PV/FV = €10 425/€35 966
= 29%
At 29%, the present value of the minimum lease payments is not substantially all of the fair value of
the bobcat.
Other considerations required by IAS 17
• Is the bobcat of such a specialised nature that it is expected to have no alternative use to West Inc. at
the end of the lease term? No.
• Is Matheson Corporation responsible for any losses incurred by West Inc. if Matheson Corporation
decides to cancel the lease before the end of the lease term? No.
• Is Matheson Corporation entitled to the gains or losses from the fluctuation in the fair value of the
residual asset? No.
• Can Matheson Corporation continue to use the bobcat for further periods at rent substantially
less than market rent? No. The terms of the lease agreement do not contain any renewal options.
If Matheson Corporation decides to continue to lease the bobcat, this would be subject to
new negotiations with West Inc. and a new agreement, which would require a new analysis of
classification under IAS 17.
Classification of the lease
On the basis of the facts presented, there has not been a transfer of substantially all the risks and
rewards associated with the bobcat to Matheson Corporation. Hence, the lease would be classified and
accounted for as an operating lease.
Journal entries
The following journal entries would be recorded in the books of both Matheson Corporation and West Inc.
MATHESON CORPORATION
General Journal
31 December 2015:
Lease Expense Dr 3 900
Cash Cr 3 900
(Payment of first year’s rental in arrears)
Note: Expense would accrue throughout the period; it is illustrated at 31 December for simplicity.
WEST INC.
General Journal
1 January 2015:
Plant and Equipment Dr 35 966
Cash Cr 35 966
(Purchase of bobcat)
Deferred IDC— Plant and Equipment Dr 381
Cash Cr 381
(IDC incurred for lease)
31 December 2015:
Cash Dr 3 900
Lease Income Cr 3 900
(Receipt of first year’s rental in arrears)
Deferred IDC— Plant and Equipment Cr 127
(Recognition of initial direct cost: €381/3 years)
(Depreciation charge for the period: €35,966/10)

Lessees
Figure 12.5 provides an illustration of the disclosures required by IAS 17. The information used in this
figure is derived from the Matheson Corporation lease shown in illustrative example 12.5 for the fiscal
year ended 31 December 2016.
IAS 17
paragraph
Leasing
The Entity leases equipment under operating leases with terms of three years. Leases are 35(d)
classified as finance leases whenever the terms of the lease transfer substantially all the risks
and rewards of ownership to the Entity. All other leases are classified as operating leases.
The entity as a lessee

Rentals payable under operating leases are charged to income on a straight-line basis over
the term of the relevant lease.
Note 43: Operating lease arrangements
Minimum lease payments recorded as expense amounted to €3 900 35(c)
(2015: €3 900) for the period.
Future minimum lease payments under non-cancellable operating leases are as follows:
2016 2015
Within 1 year 3 900 3 900 35(a)
After 1 year but not more than 5 years(1) 3 900
3 900 7 800
(1) If the lease term in illustrative example 12.5 was for more than 5 years, the entity would also disclose the total
amounts payable more than 5 years.
FIGURE 12.5 Illustrative disclosures required by IAS 17 for lessees of operating leases
If Matheson Corporation’s lease contained contingent rentals, renewal or purchase options, esca-
lation clauses or any restrictions (such as those limiting the payment of dividends), those terms would
be required to be disclosed (IAS 17 paragraph 35(d)). In addition, if Matheson Corporation sublet the
bobcat, the future minimum lease payments under that sub-lease arrangement (if it were non-cancellable)
also would be required to be disclosed (IAS 17 paragraph 35 (c)).
The key feature of these disclosures is the identification of future commitments with respect to those
operating leases which are non-cancellable. This information allows users of financial statements to factor
in lease expenses against expected future profits, and alerts potential creditors to the fact that some future
cash flows are not available to service new liabilities.
Lessors
Figure 12.6 provides an illustration of the disclosures required by IAS 17 for lessors of operating leases. It
is not based on illustrative examples from elsewhere in this chapter.
FIGURE 12.6 Illustrative disclosures required by IAS 17 for lessors of operating leases
IAS 17
paragraph
Leasing
The Entity is the lessor in lease agreements for machinery and equipment. These leases have 56(c)
remaining terms of 12 years as at 31 December 2016. Some of the Entity’s leases provide
for contingent rentals based upon usage. The terms of the Entity’s leases generally contain
renewal options.
Leases are classified as finance leases whenever the terms of the lease transfer substantially all the
risks and rewards of ownership to the lessee. All other leases are classified as operating leases.
The Entity as a lessor

Rental income from operating leases is recognised on a straight-line basis over the term of
the relevant lease.
344 PART 2 Elements

Note 43: Operating lease arrangements

Future minimum lease payments receivable under non-cancellable operating leases are as
follows:
2016 2015
Within 1 year 81 000 60 200 56(a)
After 1 year but not more than 5 years 317 900 324 000
More than 5 years 153 900 228 800
552 800 613 000
Contingent rent income amounting to €15 600 (2015: nil) was recognised during the period. 56(b)
12.7.3 Accounting for lease incentives

In order to induce prospective lessees to enter into non-cancellable operating leases, lessors may offer lease
incentives such as rent-free periods, upfront cash payments or contributions towards lessee expenses such
as fit-out or removal costs. However attractive these incentives appear, it is unlikely that they are truly free
because the lessor will structure the rental payments so as to recover the costs of the incentives over the
lease term. Thus, rental payments will be higher than for leases that do not offer incentives.
IAS 17 is silent about incentives, and deals only with accounting for the rental payments made under the oper-
ating lease agreement. As a result, SIC (Standing Interpretations Committee) Interpretation 15 Operating Leases
— Incentives (SIC 15) provides guidance on accounting for incentives by both lessors and lessees. SIC 15 requires
that all incentives associated with an operating lease be regarded as part of the net consideration agreed for the
use of the leased asset, irrespective of the nature or form of the incentive or the timing of the lease payments.
• For lessors — the aggregate cost of the incentives is treated as a reduction in rental income over the
lease term on a straight-line basis.
• For lessees — the aggregate benefit of incentives is treated as a reduction in rental expense over the
lease term on a straight-line basis.
In both cases, another systematic basis can be used if it better represents the diminishment of the leased asset.
ILLUSTRATIVE EXAMPLE 12.6 Accounting for lease incentives
As an incentive to enter a 4-year operating lease for a warehouse, Nelson Ltd receives an upfront cash
payment of €600 upon signing an agreement to pay Hutt Ltd an annual rental of €11 150.
Nelson Ltd will make the following journal entries with respect to the lease incentive:
At inception of the lease

Cash Dr 600
Incentive from Lessor Cr 600
(Recognition of liability to lessor)
Payment entry (year 1)

Lease Expense Dr 11 000
Incentive from Lessor* Dr 150
Cash Cr 11 150
(Record payment of rent and reduction in liability)
*Being 600/4.
Hutt Ltd will make the following journal entries with respect to the lease incentive:
At inception of the lease

Incentive to Lessee Dr 600
Cash Cr 600
(Recognition of receivable)
Receipt entry (year 1)
Cash Dr 11 150
Incentive to Lessee* Cr 150
Rent income Cr 11 000
(Record receipt of rent and reduction in receivable)
*Being 600/4.

This broad-brush approach assumes that all incentives are the same, but a number of issues are not
addressed in SIC 15 or elsewhere in the standards, including:
• distinguishing between capital incentives such as property fit-outs, particularly in the retail industry,
and cash incentives such as rent-free periods;
• distinguishing between property fit-outs that became part of the structure of a leased property and
owned by the lessor, and fit-outs that are owned by the lessee; and
• determining whether market rentals are being paid by tenants who received incentives to lease space.
LO8 12.8 ACCOUNTING FOR SALE AND LEASEBACK

TRANSACTIONS
A ‘sale and leaseback’ is a type of arrangement that involves the sale of an asset that is then leased back from
the purchaser for all or part of its remaining economic life. Hence, the original owner becomes the lessee. In
substance, the lessee gives up legal ownership but still retains control over some or all of the asset’s future
economic benefits via the lease agreement. Generally, the asset is sold at a price equal to, lesser or greater
than its fair value, and is leased back for lease payments sufficient to repay the purchaser for the cash invested
plus a reasonable return. Therefore, the lease payment and the sale price are usually interdependent because
they are negotiated as a package.
Entities normally enter into sale and leaseback arrangements to generate immediate cash flows while still
retaining the use of the asset. Such arrangements are particularly attractive when the fair value of an asset is con-
siderably higher than its carrying amount, or when a large amount of capital is tied up in property and plant.
The major accounting issue revolves around the sale rather than the lease component of the transaction. The
lease is classified and accounted for in exactly the same fashion as normal lease transactions, but accounting for
the sale transaction differs according to whether the lease is classified as a finance lease or an operating lease.
12.8.1 Finance leasebacks

If a sale and leaseback transaction results in a finance lease, the excess of proceeds over the carrying
amount is deferred and amortised over the lease term rather than recognised immediately. This accounting
treatment is justified on the basis that the leaseback of the asset negates the sale transaction. In other
words, there is a finance agreement between the lessor and the lessee — not a sale — with the asset used
as security. For this reason any excess of sales proceeds over the carrying amount is not reflected as income.
The standard provides no guidance on how the deferred income is to be classified in the statement of
financial position. In this chapter, any deferred income is recognised separately and classified as ‘other’
liabilities on the statement of financial position. Amortisation is on a straight-line basis over the lease term.
ILLUSTRATIVE EXAMPLE 12.7 Sale and leaseback
In an attempt to alleviate its liquidity problems, Napier S.A. entered into an agreement on 1 January
2016 to sell its processing plant to Whale Company for €3.5 million (which is the fair value of the
plant). At the date of sale, the plant had a carrying amount of €2.75 million. Whale Company immedi-
ately leased the processing plant back to Napier S.A. The terms of the lease agreement were:
Lease term 6 years

Economic life of plant 8 years
Annual rental payment, in arrears (commencing 31 December 2016) €765 000
Residual value of plant at end of lease term (fully guaranteed) €560 000
Interest rate implicit in the lease 10%
The lease is non-cancellable. The annual rental payment includes €35 000 to reimburse the lessor for
maintenance costs incurred on behalf of the lessee.
Accounting for the sale of the processing plant
Step 1 — Classify the leaseback
Napier S.A. must determine whether the leaseback has resulted in the company retaining substantially
all of the risks and rewards associated with the processing plant, even though legal title has passed to
Whale Company, before classifying the lease as a finance lease in accordance with IAS 17 requirements.
Based on the following, both Napier S.A. and Whale Company conclude that the lease should be
classified as a finance lease:
• the lease term is a major part of the economic life of the processing plant
• the present value of the minimum lease payments is substantially all of the fair value of the
processing plant. It was calculated as follows:
346 PART 2 Elements

PV of MLP = (€730 000 x 4.3553) + (€560 000 x 0.5645)
= €3 179 369 + €316 120 = €3 495 489
PV/FV = €3 495 489/€3 500 000
= 99.9%
Step 2 — Record the ‘sale’ transaction

This illustrative example shows only those journal entries relating to the sale of the processing plant to
Whale Company. The lease is recorded as shown in illustrative example 12.2.
NAPIER S.A.
GENERAL JOURNAL
1 January 2016:
Cash Dr 3 500 000
Deferred Gain on Sale Cr 750 000
Processing Plant Cr 2 750 000
(Sale of plant under sale and leaseback agreement)
31 December 2016:
Deferred Gain on Sale Dr 125 000
Gain on Sale of Leased Plant Cr 125 000
(Amortisation of deferred gain: €750 000/6)
The deferred gain is recognised as income on a straight-line basis over the lease term.
In addition, the leaseback would lead to the recognition of property, plant and equipment of
€3 495 489 and a corresponding lease liability.
12.8.2 Operating leasebacks

All operating leases are accounted for in the same way regardless of whether a sale and leaseback transaction
is involved. The only accounting issue involves the initial recognition of the sale transaction.
The accounting treatment of the gain or loss on sale is determined by the relationship between the
sale price of the asset and the asset’s fair value on the date of sale. Essentially, a gain or loss on sale can
be recognised immediately only when it equates to the gain or loss that would have been earned on a
sale at fair value. Excess or reduced gains or losses that are not recognised immediately are deferred and
amortised over the lease term. Table 12.1 is part of the implementation guidance to IAS 17, and sets out
the alternative treatments as required by paragraphs 61–63 of the standard.
Table 12.1 Alternative treatments of gain or loss on sale
Carrying amount equal Carrying amount Carrying amount

to fair value less than fair value above fair value
Sale price at fair value (paragraph 61)

Profit No profit Recognise profit immediately Not applicable
Loss No loss Not applicable Recognise loss
immediately
Sale price below fair value (paragraph 61)
Profit No profit Recognise profit immediately No profit
(note 1)
Loss not compensated for Recognise loss Recognise loss immediately (note 1)
by future lease payments immediately
at below market price
Loss compensated for by Defer and amortise loss Defer and amortise loss (note 1)
future lease payments at
below market price
(continued)

Table 12.1 (continued)
Carrying amount equal Carrying amount Carrying amount

to fair value less than fair value above fair value
Sale price above fair value (paragraph 61)
Profit Defer and amortise Defer and amortise excess Defer and amortise
profit of profit profit
(note 3) (note 2)
Loss No loss No loss (note 1)
Notes:
1. These parts of the table represent circumstances dealt with in paragraph 63 of the standard. Paragraph 63 requires the
carrying amount of an asset to be written down to fair value where it is subject to a sale and leaseback.
2. Profit is the difference between the fair value and sale price because the carrying amount would have been written
down to fair value in accordance with paragraph 63.
3. The excess profit (the excess of selling price over fair value) is deferred and amortised over the period for which the
asset is expected to be used. Any excess of fair value over the carrying amount is recognised immediately.
Source: IAS 17, Guidance on Implementing IAS 17 Leases.

Sale and leaseback transactions are subject to the same disclosure requirements for lessees and lessors
under both operating and finance leases. Unique or unusual provisions of the agreement are disclosed as
part of the required description of material leasing arrangements. Additionally, sale and leaseback trans-
actions may fall under the separate disclosure criteria in IAS 1 Presentation of Financial Statements with res-
pect to gains or losses on the sale of assets.
LO9 12.9 CHANGES TO THE LEASING STANDARDS

Accounting for leases in most countries is very comparable, in that most countries require the application
of principles similar to those in IAS 17. However, it is also recognised that those accounting principles
have flaws.
In July 2006, as a result of the agreement between the IASB and the FASB to converge accounting stan-
dards, a joint working party was formed between the two bodies to develop a new accounting standard on
leases. The aims of the project were:
• to produce an improved accounting standard that faithfully reports the economics of leasing
transactions
• to develop a principles-based standard
• to produce a converged standard that can be applied internationally.
The main concerns about IAS 17 are:
• the dividing line between finance and operating leases is hard to define in a principled way
• any dividing line means that similar transactions are accounted for differently
• obligations under non-cancellable leases are little different from borrowings, but for operating leases
they are not recognised as liabilities
• assets used in a lessee’s business that are held under operating leases are not shown on the statement
of financial position, thereby overstating return on assets
• leases are scoped out of the financial instruments standards, leading to inconsistencies between leases
and similar transactions.
Since 2006, the IASB and the FASB issued one discussion paper and two exposure drafts of a proposed
new leasing standard. The Boards issued their respective new standards in 2016. In many respects the IASB
and the FASB standards are converged, but they do contain some differences relating to lease classification
and the recognition, measurement and presentation of leases for lessees and lessors.
Under IFRS 16, a lease is defined as ‘a contract, or part of a contract, that conveys the right to use an
asset (the underlying asset) for a period of time in exchange for consideration’ (IFRS 16 Leases, Appendix A,
Defined terms).
Lessees will be required to recognise right-of-use assets and lease liabilities for most leases. That is,
most leases will be on the statement of financial position. Lessees applying IFRS will have a single
accounting model for all leases, with exemptions for leases of ‘low-value assets’ and short-term leases.
Lessor accounting for IFRS reporters is substantially unchanged from IAS 17. Lessees and lessors applying
US GAAP will have a dual model for all recognised leases, similar to the two lease classifications for lessees
today, with lessees having a recognition exemption for short-term leases.
348 PART 2 Elements

Lessees will recognise a liability to pay rentals with a corresponding asset. Under the IASB’s standard,
lessees will recognise separate amounts for interest and depreciation resulting in an accelerated expense
recognition pattern (for lessees that use straight-line depreciation) as compared to today’s operating leases.
Lessees will be required to reassess certain key considerations (e.g. lease term, variable rents based on an
index or rate, discount rate) upon certain events.
The IASB decided to include an overall disclosure objective to enable users of the financial statements to
assess the effect that leases have on the financial position, financial performance and cash flows of lessees
and lessors. IFRS 16 requires lessees and lessors to make more extensive disclosures than under IAS 17.
IFRS 16 will have a major effect on lessees that have a large number of operating leases as these will be
accounted for in essentially the same way as finance leases today. There is little change for lessors.
Some have questioned the conceptual merit of differentiating lease arrangements and non-lease exec-
utory contracts due to the very different accounting that would result under the new standard. The IASB
concluded that lease arrangements create rights and obligations for the lessee that meet the definitions of
an asset and a liability under the Conceptual Framework. The IASB believes that at the commencement of a
lease, the lessor fulfils its obligation under the contract by delivering the asset to the lessee and, therefore,
the lessee has an unconditional obligation to pay for the right to use the asset. In a non-lease executory con-
tract, at the commencement of the arrangement the customer does not receive an asset it controls and the
vendor has remaining obligations; consequently, the customer ‘typically has an unconditional obligation
to pay only for services provided to date. In addition, although fulfilment of a service contract will often
require the use of assets, ‘fulfilment typically does not require making those assets available for use by the
customer throughout the contractual term.’ (Basis for Conclusions, IFRS 16, Leases, paragraph BC34).
The new standard is effective for annual periods beginning on or after 1 January 2019.
SUMMARY
Leases are arrangements whereby the right to use an asset is transferred to a lessee but ownership is
retained by the lessor. By definition, finance leases transfer substantially all of the risks and rewards inci-
dental to ownership from the lessor to the lessee. Operating leases do not. All leases must be classified as
either operating leases or finance leases at the inception of the lease.
For finance leases, lessees must record a lease asset and a lease liability measured at the lower of the fair
value of the leased property and the present value of the minimum lease payments. The asset is subse-
quently depreciated over the lease term or its economic life if ownership is to be transferred at the end of
the lease. The liability is reduced as lease payments are made.
For finance leases, lessors must transfer their net investment in the lease to a receivable account, which
is subsequently reduced by lease receipts and the eventual return of the asset at the end of the lease. Manu-
facturer and dealer lessors also record a profit or loss on sale of the asset at the beginning of the lease term.
Operating leases are treated as a rental arrangement with lessors recording rental revenue and lessees
recording rental expense over the term of the lease.
IAS 17 has been subject to criticism for many years for, among other reasons, enabling economically
similar transactions to be accounted for very differently and, thus, reducing comparability. The IASB issued
a new lease accounting standard in 2016 that will address many of the criticisms of accounting for leases
by lessees.
1. What are ‘minimum lease payments’?
2. If a lease agreement states that ‘the lessee guarantees a residual value, at the end of the lease term, of
$20 000’, what does this mean?
3. What is meant by ‘the interest rate implicit in a lease’?
4. Identify three possible adverse effects on a lessee entity’s financial statements arising from the classifi-
cation of a lease arrangement as a finance lease.
5. How, according to IAS 17 requirements, are operating leases accounted for by lessees?
6. Explain how a profit made by a lessee on a sale and leaseback transaction is to be accounted for.
Exercise 12.1 IDENTIFICATION OF LEASES

★ For the following arrangements, discuss whether they are ‘in substance’ lease transactions, and thus fall
under the ambit of IAS 17.
(a) Entity A leases an asset to Entity B, and obtains a non-recourse loan from a financial institution using
the lease rentals and asset as collateral. Entity A sells the asset subject to the lease and the loan to a
trustee, and leases the same asset back.

(b) Entity A enters into an arrangement to buy petroleum products from Entity B. The products are
produced in a refinery built and operated by Entity B on a site owned by Entity A. Although Entity B
could provide the products from other refineries which it owns, it is not practical to do so. Entity B
retains the right to sell products produced by the refinery to other customers but there is only a remote
possibility that it will do so. The arrangement requires Entity A to make both fixed unavoidable pay-
ments and variable payments based on input costs at a target level of efficiency to Entity B.
(c) Entity A leases an asset to Entity B for its entire economic life and leases the same asset back under the
same terms and conditions as the original lease. The two entities have a legally enforceable right to set
off the amounts owing to one another, and an intention to settle these amounts on a net basis.
(d) Entity A enters into a non-cancellable 4-year lease with Entity B for an asset with an expected economic
life of 10 years. Entity A has an option to renew the lease for a further 4 years at the end of the lease
term. At the conclusion of the lease arrangement, the asset will revert back to Entity B. In a separate
agreement, Entity B is granted a put option to sell the asset to Entity A should its market value at the
end of the lease be less than the residual value.
Exercise 12.2 LEASE CLASSIFICATION AND DETERMINATION OF INTEREST RATES

★ This exercise contains three multiple-choice questions. Select the correct answer and show any workings required.
1. Pukekohe Ltd sells land that originally cost $150 000 to Taupo Ltd for $230 000 when the land’s fair
value is $215 000, and then enters into a cancellable lease agreement to use the land for 2 years at an
annual rental of $2000. In the current year, how much profit would Pukekohe Ltd record on the sale of
the land?
(a) $15 000
(b) $80 000
(c) $65 000
(d) Nil
2. Using the information from part 1 above, how would Taupo Ltd record the annual cash received from
Pukekohe Ltd?
(a) As rental revenue
(b) As a reduction of the lease receivable
(c) As rental expense
(d) As interest revenue and a reduction of the lease receivable
3. On 1 July 2016, Masterton Ltd leases a machine with a fair value of $109 445 to Tokoroa Ltd for 5 years
at an annual rental (in advance) of $25 000, and Tokoroa Ltd guarantees in full the estimated residual
value of $15 000 on return of the asset. What would be the interest rate implicit in the lease?
(a) 10% (c) 9%
(b) 12% (d) 14%
Exercise 12.3 FINANCE LEASE

★ If a lease has been capitalised as a finance lease, identify two circumstances in which the lease receivable
raised by the lessor will differ from the lease asset raised by the lessee.
Exercise 12.4 LEASE CLASSIFICATION; ACCOUNTING BY LESSEE

On 1 July 2016, Otago Ltd leased a plastic-moulding machine from Nelson Ltd. The machine cost Nelson
$130 000 to manufacture and had a fair value of $154 109 on 1 July 2016. The lease agreement contained
the following provisions:
Lease term 4 years

Annual rental payment, in advance on 1 July
each year $41 500
Residual value at end of the lease term $15 000
Residual guaranteed by lessee nil
The lease is cancellable only with the
permission of the lessor.
The expected useful life of the machine is 6 years. Otago Ltd intends to return the machine to the lessor
at the end of the lease term. Included in the annual rental payment is an amount of $1500 to cover the
costs of maintenance and insurance paid for by the lessor.
350 PART 2 Elements

Required
1. Classify the lease for both lessee and lessor based on the guidance provided in IAS 17. Justify your
answer.
2. Prepare (a) the lease schedules for the lessee (show all workings), and (b) the journal entries in the
books of the lessee for the year ended 30 June 2017.
Exercise 12.5 ACCOUNTING BY LESSEE AND LESSOR

On 1 July 2016, Christchurch Ltd leased a processing plant to Wellington Ltd. The plant was purchased by
Christchurch Ltd on 1 July 2016 for its fair value of $467 112. The lease agreement contained the following
provisions:
Lease term 3 years

Economic life of plant 5 years
Annual rental payment, in arrears (commencing
30/6/2017) $150 000
Residual value at end of the lease term $90 000
Residual guaranteed by lessee $60 000
The lease is cancellable only with the
permission of the lessor.
Wellington Ltd intends to return the processing plant to the lessor at the end of the lease term. The lease
has been classified as a finance lease by both the lessee and the lessor.
Required
1. Prepare:
(a) the lease payment schedule for the lessee (show all workings)
(b) the journal entries in the records of the lessee for the year ended 30 June 2018.
2. Prepare:
(a) the lease receipt schedule for the lessor (show all workings)
(b) the journal entries in the records of the lessor for the year ended 30 June 2018.
Exercise 12.6 LEASE SCHEDULES AND JOURNAL ENTRIES (YEAR 1)

On 1 July 2016, Island Ltd leased a crane from Pacific Ltd. The crane cost Pacific Ltd $120 307, considered
to be its fair value on that same day. The finance lease agreement contained the following provisions:
The lease term is for 3 years, starting on

The lease is non-cancellable 1 July 2016
Annual lease payment, payable on 30 June each
year $39 000
Estimated useful life of crane 4 years
Estimated residual value of crane at end of lease
term $22 000
Residual value guaranteed by Island Ltd $16 000
The lease was classified as a finance lease by
both Island Ltd and Pacific Ltd at 1 July 2016.
Required
1. Prepare the lease schedules for both the lessee and the lessor.
2. Prepare the journal entries in the records of the lessee only for the year ended 30 June 2017.
Exercise 12.7 FINANCE LEASE — LESSEE (INCLUDING DISCLOSURES)

Dunedin Ltd decided to lease from Rotorua Ltd a motor vehicle that had a fair value at 30 June 2014 of
$38 960. The lease agreement contained the following provisions:

Lease term (non-cancellable) 3 years
Annual rental payments (commencing 30/6/14) $11 200
Guaranteed residual value (expected fair value
at end of lease term) $12 000
Extra rental per annum if the car is used outside
the metropolitan area $1 000
The expected useful life of the vehicle is 5 years. At the end of the 3-year lease term, the car was returned
to the lessor, which sold it for $10 000. The annual rental payments include an amount of $1200 to cover
the cost of maintenance and insurance arranged and paid for by the lessor. The car was used outside the
metropolitan area in the 2015–16 year. The lease is considered to be a finance lease.
Required
1. Prepare the journal entries for Dunedin Ltd from 30 June 2014 to 30 June 2017.
2. Prepare the relevant disclosures required under IAS 17 for the years ending 30 June 2012 and 30 June
2016.
3. How would your answer to requirement 1 change if the guaranteed residual value was only $10 000,
and the expected fair value at the end of the lease term was $12 000?
Exercise 12.8 LEASE CLASSIFICATION; ACCOUNTING AND DISCLOSURES

Birkenhead Ltd has entered into an agreement to lease a D9 bulldozer to Albert Ltd. The lease agreement
details are as follows:
Length of lease 5 years

Commencement date 1 July 2015
Annual lease payment, payable 30 June each
year commencing 30 June 2014 $8 000
Fair value of the bulldozer at 1 July 2013 $34 797
Estimated economic life of the bulldozer 8 years
Estimated residual value of the plant at the end
of its economic life $2000
Residual value at the end of the lease term, of
which 50% is guaranteed by Albert Ltd $7200
The lease is cancellable, but a penalty equal to 50% of the total lease payments is payable on cancella-
tion. Albert Ltd does not intend to buy the bulldozer at the end of the lease term. Birkenhead Ltd incurred
$1000 to negotiate and execute the lease agreement. Birkenhead Ltd purchased the bulldozer for $34 797
just before the inception of the lease.
Required
1. State how both companies should classify the lease. Give reasons for your answer.
2. Prepare a schedule of lease payments for Albert Ltd.
3. Prepare a schedule of lease receipts for Birkenhead Ltd.
4. Prepare journal entries to record the lease transactions for the year ended 30 June 2016 in the records
of both companies.
5. Prepare an appropriate note to the financial statements of both companies as at 30 June 2016.
Exercise 12.9 FINANCE LEASE — LESSEE AND LESSOR

On 1 July 2014, Wellington Ltd acquired a new car. The manager of Wellington Ltd, Jack Wellington, went
to the local car yard, Hamilton Autos, and discussed the price of a new Racer Special with John Hamilton.
Jack and John agreed on a price of $37 876. As Hamilton Autos had acquired the vehicle from the manu-
facturer for $32 000, John was pleased with the deal. On discussing the financial arrangements in relation
to the car, Jack decided that a lease arrangement was the most suitable. John agreed to arrange for Dunedin
Ltd, a local finance company, to set up the lease agreement. Hamilton Autos then sold the car to Dunedin
Ltd for $37 876.
Dunedin Ltd wrote a lease agreement, incurring initial direct costs of $534 in the process.
352 PART 2 Elements

The lease agreement contained the following clauses:
Initial payment on 1 July 2014 $13 000

Payments on 1 July 2015 and 1 July 2016 $13 000
The lease agreement also specified for Dunedin Ltd to pay for the insurance and maintenance of the
vehicle, the latter to be carried out by Hamilton Autos at regular intervals. A cost of $3000 per annum was
included in the lease payments to cover these services.
Jack wanted the lease to be considered an operating lease for accounting purposes. To achieve this, the
lease agreement was worded as follows:
• The lease is cancellable by Wellington Ltd at any stage. However, if the lease is cancelled, Wellington
Ltd agrees to lease, on similar terms, another car from Dunedin Ltd.
• Wellington Ltd is not required to guarantee the payment of any residual value. At the end of the lease
term, 30 June 2017, or if cancelled earlier, the car automatically reverts to the lessor with no payments
being required from Wellington Ltd.
The vehicle had an expected economic life of 6 years. The expected fair value of the vehicle at 30 June
2017 was $12 000. Because of concern over the residual value, Dunedin Ltd required Jack to sign another
contractual arrangement separate from the lease agreement which gave Dunedin Ltd the right to sell the
car to Wellington Ltd if the fair value of the car at the end of the lease term was less than $10 000.
Costs of maintenance and insurance paid by Dunedin Ltd to Hamilton Autos over the years ended 30
June 2015 to 30 June 2017 were $2810, $3020 and $2750.
At 30 June 2017, Jack returned the vehicle to Dunedin Ltd. The fair value of the car was determined by to
be $9000. Dunedin Ltd invoked the second agreement. With the consent of Wellington, Dunedin Ltd sold
the car to Hamilton Autos for a price of $9000 on 5 July 2017, and invoiced Wellington Ltd for $1000.
Wellington Ltd subsequently paid this amount on 13 July 2017.
Required
Assuming the lease is classified as a finance lease, prepare:
1. a schedule of lease payments for Wellington Ltd
2. journal entries in the records of Wellington Ltd for the years ending 30 June 2015, 30 June 2017 and
30 June 2018
3. a schedule of lease receipts for Dunedin Ltd
4. journal entries in the records of Dunedin Ltd for the years ending 30 June 2015, 30 June 2017 and 30
June 2018.

Early research into the accounting for leases was concerned adjust the interest charge accordingly. In other words, the
with measuring the magnitude of the off-balance-sheet interest banks charge on their loans is expected to be a func-
financing that operating leases represent. In particular, the tion of leverage and other ratios that are adjusted for the
concern has been that leaving assets and debt off the bal- capitalisation of operating leasees. They first report that the
ance sheet distorts commonly used ratios. Imhoff et al. interest charge is higher the larger the amount of outstanding
(1991) posit that it is quite plausible that managers “game” payments on operating leases. They then show that models
the accounting rules to avoid classifying lease contracts as that feature adjusted ratios explain the variations in interest
finance leases. They propose a method for capitalisation of charges. However, this is not the case for operating leases in
operating leases and assess its impact for a small sample the retail business. They conclude that leases of store space
of firms chosen from several industries. Their calculations are regarded as periodic expense by lending banks.
suggest that the effect of capitalising operating leases on Ely (1995) adopts a shareholders’ perspective rather
ratios such as return on assets (ROA) and debt-to-equity than creditors’ perspective as in Altamuro et al. (2014). She
can be very large. For example, they calculate that ROA can argues that the distinguishing factor between operating and
decrease by 55% while debt-to-equity can increase by more finance leases is the degree to which the lessee is exposed to
than 300%. Beattie et al. (1998) employ the method sug- risk from employing the leased assets. She therefore relates
gested by Imhoff et al. (1991) to a large UK sample com- equity risk to two key ratios: ROA (capturing asset risk) and
prising 300 firms that reported operating leases during 1981 debt-to-equity (capturing financial risk). Her sample is based
to 1994. They examine a wide range of ratios for this sample on 212 US firms that provide disclosures about minimum
and demonstrate that the effect of capitalisation on many of lease payments (MLPs) that are classified as operating lease
the ratios can be very large. Cornaggia et al. (2013) provide in 1987 and 102 firms that disclosed no information about
recent analysis that also looks at the trend over time in the operating leases. As with other studies, Ely (1995) capitalises
use of operating leases. They document an increasing ten- these MLPs to examine, in her case, the association with a
dency by US firms to use off-balance-sheet financing through measure of equity risk. She finds that debt-to-equity ratios
operating leases in the past three decades. Over the same adjusted for the capitalised amounts are positively related to
time, on-balance-sheet financing through finance leases has equity risk. This result suggests that investors perceive oper-
fallen. This suggests that for analytical purposes it is increas- ating lease obligations as similar to debt. Nevertheless, the
ingly important to capitalise operating leases. results regarding ROA are mixed and it is not clear if inves-
Researchers have also been interested in the degree to tors perceive operating leases as increased asset risk.
which leases are used as a substitute, or perhaps as a com-
plement, to ordinary debt financing. Ang and Petersen (1984)
expect to find a substitutive effect whereby more (less) debt
is associated with less (more) lease financing. However, in a
References
study spanning the 1976 to 1981 period that includes only Adedeji, A., and Stapleton, R. C. 1996. Leases debt and
finance leases they fail to find consistent relation. Adedeji taxable capacity. Applied Financial Economics, 6, 71–83.
and Stapleton (1996) rectify several methodological prob- Altamuro, J., Johnston, R., Pandit, S. S., and Zhang, H.
lems in the approach taken by Ang and Petersen (1984) H. 2014. Operating leases and credit assessments.
using a UK sample and find that there is a substitution Contemporary Accounting Research, 31(2), 551–580.
effect whereby a reduction of £1 in debt is associated with Ang, J., and Peterson, P. P. 1984. The leasing puzzle. Journal of
an increase in leases of roughly £2. Further evidence sup- Finance, 39, 1055–1065.
porting a substitutive effect is provided by Schallheim et al. Beattie, V. A., Edwards, K., and Goodacre, A. 1998. The
(2013) who examine a sample of sale-and-leaseback trans- impact of constructive operating lease capitalisation on
actions. The advantage of this sample vis-à-vis other studies key accounting ratios. Accounting and Business Research, 28,
is that the underlying asset base is kept the same because 233–254.
the leased-back asset is retained by the lessee. Beattie et al. Beattie, V., Goodacre, A., and Thomson, S. 2000. Operating
(2000) take this research further by incorporating measures leases and the assessment of lease–debt substitutability.
of capitalised operating leases. They examine a sample of Journal of Banking & Finance, 24(3), 427–470.
over 560 UK firms during 1990 to 1994 and find that, once Cornaggia, K. J., Franzen, L. A., and Simin, T. T. 2013.
operating leases are capitalised, debt and leases are substi- Bringing leased assets onto the balance sheet. Journal of
tutes. Moreover, since most of lease-borrowing stems from Corporate Finance, 22, 345–360.
operating leases, this result suggests that the substitutive Ely, K. M. 1995. Operating lease accounting and the market’s
effect is largely due to operating lease financing. assessment of equity risk. Journal of Accounting Research,
All the above mentioned studies, however, do not address 33(2), 397–415.
the question of whether users of financial statements regard Imhoff, E. A., Lipe, R. C., and Wright, D. A. 1991. Operating
operating leases as debt financing. Altamuro et al. (2014) leases: Impact of constructive capitalization. Accounting
provide helpful and rare input into this question. They Horizons, 5, 51–63.
examine whether banks regard operating leases as debt (that Schallheim, J., Wells, K., and Whitby, R. J. 2013. Do leases
is, as finance leases) or periodic expense. They argue that if expand debt capacity? Journal of Corporate Finance, 23,
operating leases are in-substance debt, then banks should 368–381.
354 PART 2 Elements

13 Intangible assets
ACCOUNTING IAS 38 Intangible Assets
STANDARDS
IN FOCUS

OBJECTIVES
1 understand the key characteristics of an intangible asset
2 explain the criteria relating to the initial recognition of intangible assets and their measurement
at point of initial recognition, distinguishing between acquired and internally generated
intangibles
3 explain how to measure intangibles subsequent to initial recognition, including the principles
relating to the amortisation of intangibles
4 explain the accounting for retirement and disposal of intangible assets
5 apply the disclosure requirements of IAS 38.
CHAPTER 13 Intangible assets 355

INTRODUCTION
Chapter 11 discusses the accounting standards for the tangible assets of property, plant and equipment.
This chapter examines the standards for intangible assets. The International Accounting Standards Board
(IASB®) believes it is necessary to distinguish between tangible assets (such as property, plant and equip-
ment) and intangible assets (such as patents and brand names). In analysing the accounting for intangible
assets, the question that must always be kept in mind is whether there should be any difference in the
accounting treatment for tangible and intangible assets. What is it that is different about intangible assets
that makes a separate accounting standard, and presumably different accounting rules, for intangible and
tangible assets necessary?
Historically, it is common for entities to report all their tangible assets on the statement of financial
position but be less consistent in the reporting of intangible assets. As a result, there are sometimes large
differences between the market value of an entity and its recorded net assets. As Jenkins and Upton (2001,
p. 4) noted:
The problem that confronts businesses, users of business and financial reporting, standard-setters and regulators
is how best to understand and communicate the difference between the value of a company (usually expressed
as the market capitalisation) and the accounting book value of that company.
To assist in understanding the difference between these two numbers, Jenkins and Upton (2001, p. 5)
provided the analysis shown in figure 13.1. Item 6 in this figure is not an area that accounting can directly
address, although the quality of the accounting may affect the degree to which it exists. At 31 December
2000, the market-to-book gap of Enron was approximately $64 billion. However, Lev (2002, pp. 133–4)
argued that this was not related to intangibles:
The best evidence that Enron lacked substantial intangibles is that its demise made hardly a ripple in the energy
trading market, and had practically no effect on electricity prices. Intangibles, by definition, are unique factors of
production that cannot be quickly imitated by competitors. The fact that Enron’s competitors quickly stepped in
to fill the gap is inconsistent with the existence of intangibles conferring on their owners sustained competitive
advantages.
So the answer to the question posed at the opening of this note — where have Enron’s intangibles gone? — is
a simple one. Nowhere. Enron did not have substantial intangibles, that is, if hype, glib, and earnings manipu-
lation do not count as intangibles.
1. Accounting book value £ xxx

2. + Market assessments of differences between accounting measurement and underlying value
of recognised assets and liabilities xxx
3. + Market assessments of the underlying value of items that meet the definition of assets and
liabilities but are not recognised in financial statements (e.g. patents developed through
internal research and development) xxx
4. + Market assessments of intangible value drivers or value impairers that do not meet the
definition of assets and liabilities (e.g. employee morale) xxx
5. + Market assessments of the entity’s future plans, opportunities and business risks xxx
6. + Other factors, including puffery, pessimism and market psychology xxx
7. Market capitalisation £ xxx
FIGURE 13.1 Differences between market capitalisation and accounting book value
Source: Jenkins and Upton (2001, p. 5). © 2001. Reproduced with the permission of CPA Australia Ltd.
How can accounting assist in providing more information about what causes the gap between accounting
book value and market capitalisation numbers? How much information should be provided about all the
assets and liabilities of an entity? What should be in the financial statements and what should be in the
notes to those statements? These are questions for accounting standard setters to solve.
The standards on accounting for intangibles are contained in IAS 38 Intangible Assets. In its 2004 revi-
sion, the IASB did not attempt to revisit all areas of accounting for intangibles. Its emphasis in this revi-
sion was to reflect changes as a result of decisions made in the Business Combinations project, particularly
relating to accounting for intangibles acquired as part of a business combination. Hence, there still may be
areas of inconsistency between accounting for intangibles obtained outside a business combination and
those acquired as part of a business combination.
IAS 38 covers the accounting for all intangible assets except, as detailed in paragraphs 2 and 3, those
specifically covered by another accounting standard: financial assets; and mineral rights and expenditure
on exploration for, or development and extraction of, minerals, oil, natural gas and similar non-regenera-
tive resources. Other intangible assets specifically covered by standards other than IAS 38 are:
• intangible assets held by an entity for sale in the ordinary course of business (see IAS 2 Inventories)
• intangible assets arising from insurance contracts with policyholders (IFRS 4 Insurance Contracts)
• deferred tax assets (IAS 12 Income Taxes)
356 PART 2 Elements

• leases within the scope of IAS 17 Leases
• assets arising from employee benefits (IAS 19 Employee Benefits)
• goodwill acquired in a business combination (IFRS 3 Business Combinations)
• non-current intangible assets held for sale (IFRS 5 Non-current Assets Held for Sale and Discontinued
Operations).
An example of the assets that are being considered in this chapter is shown in figure 13.2, which con-
tains the intangible assets disclosed by Christian Dior in its 2014 annual report. Note that brands and
trade names comprise the majority of the intangible assets but other intangibles include licences and com-
puter software.
FIGURE 13.2 Examples of intangible assets
NOTE 3 — BRANDS, TRADE NAMES AND OTHER INTANGIBLE ASSETS

June 30, April 30,
June 30, 2014 2013 2013
(12 months) (2 months) (12 months)
Amortization
(EUR millions) Gross and impairment Net Net Net
Brands 13 261 (543) 12 718 11 420 11 444
Trade names 3 285 (1 337) 1 948 2 024 2 025
License rights 24 (23) 1 — —
Leasehold rights 723 (331) 392 306 310
Software, websites 981 (739) 242 199 203
Other 567 (318) 249 225 228
TOTAL 18 841 (3 291) 15 550 14 174 14 210
Of which:
Assets held under finance leases 14 (14) — — —
3.3 Brands and trade names

The breakdown of brands and trade names by business group is as follows:
June 30, April 30,

June 30, 2014 2013 2013
(12 months) (2 months) (12 months)
Amortization
(EUR millions) Gross and impairment Net Net Net
Christian Dior Couture 34 (10) 24 32 32

Wines and Spirits 2 990 (77) 2 913 2 914 2 922
Fashion and Leather Goods 5 189 (369) 4 820 3 527 3 530
Perfumes and Cosmetics 1 284 (23) 1 261 1 264 1 264
Watches and Jewelry 3 524 (6) 3 518 3 498 3 509
Selective Retailing 3 243 (1 290) 1 953 2 029 2 030
Other activities 282 (105) 177 180 182
BRANDS AND TRADE NAMES 16 546 (1 880) 14 666 13 444 13 469
The brands and trade names recognized are those that the Group has acquired. The principal acquired
brands and trade names as of June 30, 2014 are:
• Wines and Spirits: Hennessy, Moët & Chandon, Veuve Clicquot, Krug, Château d’Yquem, Château Cheval
Blanc, Belvedere, Glenmorangie, Newton Vineyards and Numanthia Termes;
• Fashion and Leather Goods: Louis Vuitton, Loro Piana, Fendi, Donna Karan New York, Céline, Loewe,
Givenchy, Kenzo, Thomas Pink, Berluti and Pucci;
• Perfumes and Cosmetics: Parfums Christian Dior, Guerlain, Parfums Givenchy, Make Up for Ever, Benefit
Cosmetics, Fresh and Acqua di Parma;
• Watches and Jewelry: Bulgari, TAG Heuer, Zenith, Hublot, Chaumet and Fred;
• Selective Retailing: DFS Galleria, Sephora, Le Bon Marché, Ile de Beauté and Ole Henriksen;
• Other activities: the publications of the media group Les Echos-Investir, the Royal Van Lent-Feadship brand
and the patisserie brand Cova.
(continued)

These brands and trade names are recognized in the balance sheet at their value determined as of the date
of their acquisition by the Group, which may be much less than their value in use or their net selling price
as of the closing date for the consolidated financial statements of the Group. This is notably the case for the
brands Louis Vuitton, Christian Dior Couture, Veuve Clicquot, and Parfums Christian Dior, or the trade name
Sephora, with the understanding that this list must not be considered as exhaustive.
Brands developed by the Group, notably Dom Pérignon, as well as the De Beers Diamond Jewellers
brand developed as a joint venture with the De Beers group, are not capitalized in the balance sheet.
Brands and trade names developed by the Group, in addition to Louis Vuitton, Moët & Chandon, Ruinart,
Hennessy, Veuve Clicquot, Parfums Christian Dior and Sephora, represented 34% of total brands and trade
names capitalized in the balance sheet and 59% of the Group’s consolidated revenue.
Please refer also to Note 5 for the impairment testing of brands, trade names and other intangible assets
with indefinite useful lives.
Source: Christian Dior (2014, pp. 131, 133, 134).
LO1 13.1 THE NATURE OF INTANGIBLE ASSETS

Paragraph 8 of IAS 38 defines an intangible asset as follows:
an identifiable non-monetary asset without physical substance.
According to the IAS 38 definition, there are three key characteristics of an intangible asset: identifiable,
non-monetary in nature and without physical substance. Each characteristic is there for a reason, generally
to exclude certain assets from being classified as intangible assets.
13.1.1 Non-monetary in nature

Monetary assets are defined in IAS 38 as ‘money held and assets to be received in fixed or determinable amounts
of money’. The reason for including ‘non-monetary’ in the definition of intangible assets is to exclude financial
assets such as loans and receivables from being classified as intangible assets. The accounting for financial assets
is covered in IFRS 9 Financial Instruments and IAS 39 Financial Instruments: Recognition and Measurement.
13.1.2 Identifiable
IAS 38 does not contain a definition of ‘identifiable’. However, paragraph 12 of this standard sets down two
criteria, either of which must be met for an asset to be classified as an intangible asset. Paragraph 12 states:
An asset is identifiable if it either:
(a) is separable, i.e. is capable of being separated or divided from the entity and sold, transferred, licensed,
rented or exchanged, either individually or together with a related contract, identifiable asset or liability,
regardless of whether the entity intends to do so; or
(b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable
from the entity or from other rights and obligations.
There are thus two parts to the concept of identifiability.
First, consider the criterion of separability. Separability tests whether an entity can divide an asset from
other assets and transfer it to another party.
Consider the cost of the advertising campaign. It is not separable as it cannot be separated from the
entity and sold, transferred, rented or exchanged. Furthermore, the advertising campaign does not arise
from contractual or legal rights. Thus the cost of the advertising campaign is not identifiable.
Although many intangible assets are both separable and arise from contractual or legal rights, under the
laws of some jurisdictions, for example, some licences granted to an entity are not transferable except by
sale of the entity as a whole.
IAS 38’s requirement that an intangible asset must be ‘identifiable’ was introduced to try to distinguish
it from internally generated goodwill (which, outside a business combination, should not be recognised
as an asset), but also to emphasise that, especially in the context of a business combination, there will
be previously unrecorded items that should be recognised in the financial statements as intangible assets
separately from goodwill.
Examples include assets such as high staff morale and customer relationships, which may be capable of
being named and discussed, and actions may be taken to adjust the levels of them within an entity, but
such assets cannot be transferred to another entity.
Why was the criterion of separability included in the definition of an intangible asset? The answer is reli-
ability of measurement. If an asset can be transferred to another entity, then probably a market exists for
that asset. If no transfer can occur, then there will be no market. If there is no market, there is no market
358 PART 2 Elements

price. It would seem that the standard setters are afraid that preparers of financial statements will include
assets such as staff morale on their balance sheet at some form of non-market valuation, and they are con-
cerned about the reliability of such measurements. By including separability in the definition of intangible
assets, there is a limit placed on the assets that could potentially appear on a balance sheet.
The second criterion to the concept of identifiability is if it ‘arises from contractual or other legal rights’.
As noted earlier, this criterion is an alternative to separability. Hence there are some intangible assets that
are not separable but meet the definition of an intangible asset because of part (b) in paragraph 12 of IAS
38. In paragraph BC10 of the Basis for Conclusions on IAS 38, the IASB stated:
Some contractual-legal rights establish property interests that are not readily separable from the entity as a
whole. For example, under the laws of some jurisdictions some licences granted to an entity are not transferable
except by sale of the entity as a whole.
Examples of assets fitting into this category generally relate to situations where a government gives or
sells a right to an entity, such as:
• an entity has a right to use 2 million litres of water per annum in its production process
• an entity has a right to emit a specified quantity of greenhouse gases into the atmosphere per annum.
A condition of receiving this right is that the right cannot be transferred between entities; hence, if an
entity used only 1 million litres of water, it could not sell/transfer the remaining right to 1 million litres of
water to another entity. The right is then not separable. However the IASB believed that these assets could
be distinguished from other assets held by an entity and should be disclosed as intangible assets. Separa-
bility was then not seen as the only criterion for identifiability.
As noted earlier, one of the problems with non-separable assets is the ability to measure them. Some
assets, such as an excellent workforce and a high level of customer satisfaction, are interrelated in that very
good employees will lead to high customer satisfaction. To recognise these as separate assets would raise
difficulties in determining the value of one separately from the other. With the measurement of tangible
assets, the emphasis is generally not on measuring the benefits from the asset, but on recording the cost of
the asset. Benefits from assets are often measured at the level of a cash-generating unit rather than at the
individual asset level, as is the case when determining impairment of assets (see chapter 15).
13.1.3 Lack of physical substance

Lack of physical substance is the third characteristic in the definition of an intangible asset. It is the charac-
teristic that separates assets such as property, plant and equipment from intangible assets, in that property,
plant and equipment would generally meet both the other criteria of an intangible asset; that is, IAS 16
Property, Plant and Equipment provides accounting policies for identifiable, non-monetary assets.
Note at the outset that some intangible assets may be associated with a physical item, such as software
contained on a computer disk. However, the asset is really the software and not the disk itself. As noted
in paragraph 4 of IAS 38, judgement in some cases is required to determine which element, tangible or
intangible, is most important to the classification of the asset. Use of the physical substance characteristic
is interesting in that paragraph 4.11 of the Conceptual Framework states:
physical form is not essential to the existence of an asset; hence patents and copyrights, for example, are assets
if future economic benefits are expected to flow from them to the entity and if they are controlled by the entity.
If physical substance is not intrinsic to the determination of assets, why then is it necessary to distin-
guish between physical and non-physical assets?
Lev (2001, p. 47) answers this question as follows:
Intangibles are inherently difficult to trade. Legal property rights are often hazy, contingent contracts are dif-
ficult to draw, and the cost structure of many intangibles (large sunk costs, negligible marginal costs) is not
conducive to stable pricing. Accordingly, at present there are no active, organized markets in intangibles. This
could soon change with the advent of Internet-based exchanges, but it will require specific enabling mech-
anisms, such as valuation and insurance schemes. Private trades in intangibles in the form of licensing and
alliances proliferate, but they do not provide information essential for the measurement and valuation of
intangibles.
Because non-physical assets have the above characteristics, they cause particular problems for account-
ants. The two key activities for accountants in relation to assets are the recognition and measurement
of the assets. With non-physical assets, the determination of when they should be recognised (Should
one wait for a point of discovery? Does an asset exist when the investment is made? Is there an asset
at the point employee training occurs?), and how they should be measured (Where is the market? Can
the specific benefits be isolated? Are the property rights over the expected benefits fuzzy?) is in general
more difficult. Hence, the need for a specific standard on non-physical assets arises from the need for
extra guidance on the recognition and measurement of those assets — not because such assets are of any
greater or lesser value than physical assets. With physical assets, where there are thin markets or where the
assets are of a specialised nature, the guidance in IAS 38 could be considered to be equally applicable to
tangible assets.

13.1.4 The definition of an asset and identifying intangible assets
Paragraph 4.4 of the Conceptual Framework describes an asset as ‘a resource controlled by the entity’. Para-
graphs 13–16 of IAS 38 discuss the application of the characteristic of ‘control’ and the classification of
certain items as intangible assets.
The crux of the debate is whether items that probably do not meet the identifiability criterion —
such as effective advertising programmes, trained staff, favourable government relations and fundraising
capabilities — qualify as assets. According to paragraphs 13–16 of IAS 38, items such as market and tech-
nical knowledge (paragraph 14), staff skills, specific management or technical talent (paragraph 15) and a
portfolio of customers, market share, customer relationships and customer loyalty (paragraph 16) do not
meet the definition of intangible assets. The key reason for excluding such items as assets is the interpreta-
tion of the term ‘control’ as used in the definition of an asset. According to paragraph 13 of IAS 38, control
normally stems from ‘legal rights that are enforceable in a court of law’. In the absence of legal rights, it is
more difficult to demonstrate control.
Consider an entity that invests in its future staff by outlaying funds on training programmes. The entity
has invested in its staff, but it has no control over whether staff remain employed by it. Nevertheless, it
has an expectation that it will receive most if not all of the benefits from the training programmes. If
the staff stay, the entity has control over the benefits from the increased sales that arise from the training
programmes. Access to the future benefits that arise from the well-trained staff who stay with the entity
can be denied to other entities. Not all the expected benefits may eventuate but, if they do, they belong to
the entity. In fact, if past experience indicates that the entity has a fine record of retaining staff, it can be
inferred or construed from the facts in the particular situation that the benefits will flow to the entity. So, if
custom and usual business practice are a guide, the benefits will flow to the entity. Although the staff could
decide to go to another entity and provide it with the benefits of their training, that entity cannot argue
that there are any grounds, such as normal business practice, for suggesting that this will occur. The second
entity may form an expectation that the other entity’s staff will change employment but there are no legal,
equitable or constructive reasons for suggesting that its expectation is any more than a hope.
The difficulties in determining whether certain intangibles meet the definition of an asset caused the
standard setters to introduce the further test of identifiability. By requiring identifiability for recognition of
intangibles, they diffused the debate as to whether an item such as good staff relations is an asset. Regard-
less of whether it is an asset, it is not an intangible asset because it does not meet the identifiability crite-
rion, and so can only be recognised, if at all, as part of goodwill. However, reducing the number of assets
recognised in the financial statements because of measurement problems may also reduce the relevance of
the information provided in those financial statements.
LO2 13.2 RECOGNITION AND INITIAL MEASUREMENT

IAS 38 sets out the principles in relation to the recognition and initial measurement of intangible assets.
13.2.1 Criteria for recognition and initial measurement

After determining that an asset exists and that it meets the definition of an intangible asset, the asset must
meet the two criteria in paragraph 21 of IAS 38 before it can be recognised. The criteria are:
• it is probable that the future economic benefits attributable to the asset will flow to the entity
• the cost of the asset can be measured reliably.
These criteria are the same as those for the recognition of property, plant and equipment in IAS 16 Prop-
erty, Plant and Equipment. If the cost of the asset cannot be reliably measured, but the fair value is determi-
nable, an asset cannot be recognised under either IAS 16 or IAS 38 because both standards require initial
measurement at cost. As noted later, this has consequences for the recognition of intangible assets that are
internally generated rather than acquired, as well as causing differences in the statements of financial pos-
ition of entities that internally generate assets and those that acquire assets.
In relation to the initial measurement of an intangible asset, paragraph 24 of IAS 38 states:
An intangible asset shall be measured initially at cost.
With the reliable measurement of cost as one of the recognition criteria, this cost forms the basis for
initial measurement.
These recognition criteria and the requirement for initial measurement should be viewed as general
principles only. Having established these criteria, IAS 38 then proceeds to examine the accounting for
intangibles based upon how these assets were generated. The standard analyses intangibles in terms of
four ways in which an entity could have obtained the assets:
• separate acquisition
• acquisition as part of a business acquisition
• acquisition by way of a government grant
• internally generated assets.
360 PART 2 Elements

For each of these situations, IAS 38 provides specific recognition criteria and measurement rules. It is
these that are applied in accounting for intangibles rather than the general criteria noted in paragraphs
21 and 24. Presumably the standard setters considered that there were particular measurement issues that
arose under each of these situations requiring different principles to be established for each situation.
13.2.2 Separate acquisition

In recognising assets acquired separately, paragraph 25 of IAS 38 notes that:
the probability recognition criterion in paragraph 21(a) is always considered to be satisfied for separately
acquired intangible assets.
The standard setters argue that the price paid for the asset automatically takes into account the prob-
ability of the expected benefits being received; hence, it is unnecessary to apply a further probability test.
For example, if an asset had expected cash inflows of £1000, and the probability of these inflows being
received was 40%, then an acquirer would pay £400 for the asset. The standard setters argue that these
benefits are now automatically probable. Further, paragraph 26 of IAS 38 states:
In addition, the cost of a separately acquired intangible asset can usually be measured reliably. This is particu-
larly so when the purchase consideration is in the form of cash or other monetary assets.
The measurement of cost may, however, be more difficult if the exchange involves the acquirer giving up
non-monetary assets rather than cash.
An intangible asset acquired separately is initially measured at cost. As with property, plant and equip-
ment, the cost of an asset is the sum of the purchase price and the directly attributable costs (IAS 38 para-
graph 27). The purchase price is measured as the fair value of what is given up by the acquirer in order
to acquire the asset, and the directly attributable costs are those necessarily incurred to get the asset into
the condition where it is capable of operating in the manner intended by management. (These concepts are
discussed further in sections 11.3.1 and 11.3.2 in relation to property, plant and equipment.) The principles of
accounting for separately acquired intangibles and property, plant and equipment are the same.
In summary, where a for-profit entity acquires an intangible asset as a separate asset, there is only one
recognition criterion to be applied, namely reliable measurement of the cost of the asset.
13.2.3 Acquisition as part of a business combination

Where assets are acquired as part of a business combination, IFRS 3 Business Combinations is applied.
Appendix A of this standard contains a definition of a ‘business combination’ and a ‘business’. This standard
is discussed in detail in chapter 14. In this section, a reference to a business combination indicates that the
acquiring entity has acquired a group of assets rather than a single asset and one of the assets in that group
is an intangible asset. The group of assets could be an operating division or a segment of another entity.
The key issue is then how to account for the acquisition of an intangible asset when it is acquired as part
of a group of assets rather than as a single asset. Note, however, that IFRS 3 prescribes different accounting
for the acquisition of a group of assets that constitutes a business and for a group that does not constitute
a business. In applying the principles in IAS 38 relating to acquisition of assets as part of a business com-
bination, it is first necessary to ensure that the group of assets being acquired is a business.
With respect to recognition criteria to apply when intangible assets are acquired in a business combina-
tion, IAS 38 states that no recognition criteria need be applied. Provided the assets meet the definition of an
intangible asset, they must be recognised as separate assets. As with separately acquired intangible assets,
paragraph 33 of IAS 38 provides that, where intangible assets are acquired as part of a business combination,
the effect of probability is reflected in the measurement of the asset. Hence, the probability recognition crite-
rion is automatically met. Further, it is argued in paragraph 33 of IAS 38 that the requirement for reliability
of measurement is always met as sufficient information always exists to measure reliably the fair value of
the asset. This non-application of recognition criteria in accounting for intangibles acquired in a business
combination is also seen in IFRS 3 where paragraphs 11 and 12 note that the recognition conditions for the
identifiable assets must meet the definition of an asset in the Conceptual Framework, as well as be a part of
what the acquirer and the acquiree exchanged in the business combination transaction.
In dissenting from the issue of IAS 38, Professor Whittington (a former IASB member) argued that the
probability test in paragraph 21(a) should be applied in testing the recognition of all intangibles, stating
that issues relating to the recognition criteria in the Conceptual Framework should be resolved before having
different recognition criteria for intangible assets acquired in a business combination. The justification for
different criteria is presumably that there is an increased relevance of information in reporting the separate
intangible assets rather than subsuming them into goodwill.
The application of these recognition requirements means that an acquirer must, in recognising separ-
ately the acquiree’s intangible assets, recognise intangible assets that the acquiree has not recognised in its
records, such as in-process research and development that cannot be recognised under IAS 38 as internally
generated assets (discussed later in this section). As noted in paragraph 34, recognition by an acquirer of an
acquiree’s in-process research and development project only depends on whether the project meets the
definition of an intangible asset. It can be seen that entities that acquire intangible assets in a business

combination will be able, and in fact are required, to recognise intangible assets that are not separately
recognisable when acquired by other means.
The measurement of intangible assets acquired in a business combination is established in paragraph
33 of IAS 38:
In accordance with IFRS 3 Business Combinations, if an intangible asset is acquired in a business combination, the
cost of that intangible asset is its fair value at the acquisition date.
Note firstly that it is IFRS 3 that determines the measurement of assets acquired in a business combi-
nation. Under IFRS 3 acquired assets are measured at fair value. Hence, intangible assets acquired in a
business combination must be measured at initial recognition at fair value. This is then a departure from
the general measurement rule in paragraph 24. Paragraph 33 of IAS 38 does say that ‘the cost . . . is its fair
value’; however, the acquiring entity does not attempt to measure the cost, rather it measures the fair value.
The measurement of fair value is determined in accordance with IFRS 13 Fair Value Measurement. IFRS
13 defines fair value in Appendix A as:
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between
Chapter 3 provides information on the measurement of fair value under IFRS 13.
13.2.4 Acquisition by way of a government grant

According to paragraph 44 of IAS 38, some intangible assets, such as licences to operate radio or television
stations, are allocated to entities via government grants. These intangibles are accounted for in accordance
with IAS 20 Accounting for Government Grants and Disclosure of Government Assistance, whereby an entity
may choose to initially recognise both the intangible asset and the grant at fair value. If an entity does not
choose to use the fair value measurement option, it will recognise the asset initially at a nominal amount
plus directly attributable costs.
13.2.5 Internally generated intangible assets

The recognition criteria and measurement rules are different for intangible assets acquired as a separate
asset or acquired in a business combination. The approach taken in accounting for internally generated
assets is different again. The recognition criteria in paragraph 21 are not applied at all. The measurement
approach used is one of capitalisation of outlays incurred by the entity.
This continuous change in accounting for intangible assets leaves the standard setters open to criticism for lack
of consistency in the accounting for acquired intangibles versus internally generated intangibles. The problem
from an accounting point of view with internally generated intangibles is determining at what point in time an
asset should be recognised. An entity may outlay funds in an exploratory project, such as developing software
to overcome a specific problem, or designing a tool for a special purpose. There is no guarantee of success at
the start of the project. The program may not work or the tool may be unsatisfactory for the purpose. Should
the accountant capitalise the costs from the beginning of the project, or wait until there is some indication of
success? A further problem with some intangible assets such as brand names is whether the costs outlaid relate
solely to increasing the worth of the brand name or simply to enhancing the overall reputation of the entity.
The standard setters’ solution to the problem of when to begin capitalising costs is to classify the gener-
ation of the asset into two phases: the research phase and the development phase. These terms are defined
in paragraph 8 of IAS 38 as follows:
Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical
knowledge and understanding.
Development is the application of research findings or other knowledge to a plan or design for the production
of new or substantially improved materials, devices, products, processes, systems or services before the start of
commercial production or use.
It can be seen from these definitions that the earlier stages of a project are defined as research and,
at some point in time, the project moves from a research phase to a development phase. Examples of
research activities are given in paragraph 56 of IAS 38, such as the search for new knowledge or for alter-
natives for materials, devices, products, processes, systems or services. Examples of development activities
are found in paragraph 59, such as the design, construction and operation of a non-commercial pilot
plant, and the design of pre-production prototypes and models. From an accounting perspective, expend-
iture on research is expensed when incurred (paragraph 54), and expenditure on development is capital-
ised as an intangible asset. It is obviously important to be able to distinguish one phase from the other.
Paragraph 57 of IAS 38 is the key paragraph in this regard. It contains a list of criteria, all of which must
be met in order for a development outlay to be capitalised. In order to capitalise development outlays, an
entity must be able to demonstrate all of the following:
(a) the technical feasibility of completing the intangible asset so that it will be available for use or sale;
(b) its intention to complete the intangible asset and use or sell it;
(c) its ability to use or sell the intangible asset;
362 PART 2 Elements

(d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can
demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if
it is to be used internally, the usefulness of the intangible asset;
(e) the availability of adequate technical, financial and other resources to complete the development and to use
or sell the intangible asset; and
(f ) its ability to measure reliably the expenditure attributable to the intangible asset during its development.
Given the degree of difficulty in distinguishing research activities from development activities, it seems
simpler to disregard any attempt to distinguish between the two activities and just allow capitalisation
when the criteria in paragraph 57 are met. In other words, for an entity to decide whether to capitalise an
outlay, the decision will not be based on an application of the definitions of research and development,
but rather on whether the criteria in paragraph 57 are met. If the criteria are met, it will then be decided
that the project is in the development stage. The definitions of research and development are then super-
fluous. The recognition criteria for an internally generated intangible asset are then those contained in
paragraphs 18, 21 and 57 of IAS 38.
The criteria in paragraph 57 are designed to help determine whether, in relation to a project, it is prob-
able that there will be future benefits flowing to the entity. If there are markets for the output, the project
is feasible, and the resources are available to complete the project, then it becomes probable that there
will be future cash inflows. The criteria in paragraph 57 are then an elaboration — the provision of more
detailed requirements — on the criteria in paragraph 18. This approach in IAS 38 provides more certainty
in obtaining comparable accounting across entities than simply relying on an accounting principle that
states that, if there are probable expected future benefits, an entity should capitalise the outlay.
If the criteria in paragraph 57 are all met, IAS 38 requires the intangible asset to be measured at cost.
This cost is not, however, the total cost relating to the project. The amount to be capitalised is the ‘sum
of expenditure incurred from the date when the intangible asset first meets the recognition criteria in
paragraphs 21, 22 and 57’ (paragraph 65). Paragraph 71 explicitly prohibits the reinstatement of amounts
previously expensed. Recognition of an asset that is not yet available for use requires an entity to subject
that asset to an annual impairment test as per IAS 36 Impairment of Assets. Paragraphs 66–67 of IAS 38 note
that the cost comprises all directly attributable costs necessary to create, produce and prepare the asset to
be capable of operating in a manner intended by management, and provide examples of such costs as well
as items that are not components of the cost.
It may seem that the use of the terms ‘research’ and ‘development’, which may be associated with such
assets as patents and software development, are not applicable to all internally generated intangibles, such
as brand names. However, it needs to be remembered that all intangible assets must meet the identifia-
bility criterion, one part of which is separability, which is the capability of being separated and sold or
transferred. In relation to certain assets, paragraph 63 of IAS 38 provides a major exclusion in an entity’s
ability to capitalise internally generated intangibles:
Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not
be recognised as intangible assets.
The standard setters concluded that, even though the criteria in paragraph 57(a)–(f) are met, the listed items
in paragraph 63 cannot be recognised. As paragraph 64 states, the standard setters do not believe that the costs
associated with developing the listed assets can be distinguished from the cost of developing the business as a
whole. For example, it may be argued that funds spent on developing a brand name also enhance the overall
image of the entity, and therefore the outlays cannot be solely attributable to the brand name.
13.2.6 Explaining the non-recognition of internally

generated assets
There are a number of problems associated with the treatment of internally generated assets versus that
required for acquired intangibles. In particular, there are inconsistencies in the accounting for internally
generated intangibles and intangibles acquired in a business combination. Note, in this regard:
(a) The initial recognition of intangible assets. IAS 38 requires intangible assets to be initially recognised at cost.
However, for assets acquired in a business combination, an intangible asset can be recognised at fair value.
Internally generated intangibles cannot be recognised, even if the fair value can be reliably measured.
For example, outlays on research cannot be recognised as an asset. However, if an entity acquires another
entity that has in-process research, an intangible asset can be recognised if the fair value can be measured
reliably. Further, the research so recognised can be revalued if this class of asset is measured at fair value.
(b) The measurement of fair value. One of the reasons given in paragraph BCZ38(c) of the Basis for Conclu-
sions on IAS 38 for disallowing the recognition of internally generated intangible assets is the impossi-
bility of determining the fair value of an intangible asset reliably if no active market exists for the asset,
and active markets are unlikely to exist for internally generated intangible assets. However, for intangible
assets recognised in a business combination, it is assumed that fair value can be measured (reliably, it is
hoped) without the existence of active markets. IAS 38 allows the use of other measurement techniques
or even what an entity would have paid based on the best information available. Hence, in a business

combination, the fair values of intangibles can be measured reliably using measures determined outside
an active market, but these same measures cannot be used to measure the fair values of internally gen-
erated assets for asset recognition purposes. As a protection, the requirements of IAS 36 Impairment of
Assets can be applied to both acquired and internally generated intangible assets.
(c) Brands, mastheads, publishing titles and customer lists. Paragraph 63 of IAS 38 prohibits the recognition
of internally generated brands and items similar in substance. However, such assets can be recognised
when acquired in a business combination (as well as if acquired as a separate asset). As far as the meas-
urement of the fair value of these assets goes, the argument presented in point (b) applies — if the fair
value of a brand can be determined in a business combination then it can be determined if internally
generated. Further, it has been noted previously that the reason given in paragraph 64 of IAS 38 for
non-recognition of internally generated brands is that the cost of these items ‘cannot be distinguished
from the cost of developing the business as a whole’. If this argument is true for internally generated
brands, the same argument could be applied to acquired brands.
13.2.7 Recognition of an expense

Paragraphs 68–71 of IAS 38 cover the issue of when expenditure on an intangible asset should be expensed.
However, if the previous rules in IAS 38 are followed, then the appropriate outlays are expensed when the
criteria are not met. These paragraphs add nothing particularly new to the accounting for intangible assets.
However, paragraph 69 provides a list of other examples of outlays that should always be recognised as an
expense when incurred, these being expenditures on:
• start-up activities
• training activities
• advertising and promotional activities
• relocating or reorganising part or all of an entity.
Provision of this list ensures no asset will be recognised in relation to these activities, taking the judge-
ment away from preparers of the financial statements.
Paragraph 46 of the Basis for Conclusions on IAS 38 clarifies and makes an important distinction
between expenditure incurred on future advertising and promotional activities and prepayments for adver-
tising and promotional activities.
Where an entity has received goods or services that it would use to develop or communicate an advertisement
or promotion (for example, brochures), the entity should not recognise as an asset goods or services in respect
of its future advertising or promotional activities. This expenditure should be expensed on receipt of the goods
or services and not when they are used (for example, when the brochures are distributed). However, if an
entity pays for advertising goods or services in advance and the other party has not yet provided those goods
or services, the entity has a different asset. That asset is the right to receive those goods and services.
Paragraph 71 is important. This paragraph prohibits the recognition at a later date of past expenditure
as assets. In other words, if amounts relating to research have been expensed, these amounts cannot then
be capitalised, nor can appropriate adjustments to equity be made, when an intangible asset is created at
the development stage.
13.2.8 Internally generated goodwill

Paragraph 49 of IAS 38 states categorically that internally generated goodwill is not recognised as an asset.
Hence, goodwill can be recognised only when it is acquired as part of a business combination and meas-
ured in accordance with IFRS 3 Business Combinations.
The reason given in paragraph 49 of IAS 38 for non-recognition is that goodwill is not identifiable; that is,
it is not separable, nor does it arise from contractual or other legal rights. A second reason given for non-rec-
ognition, as stated in paragraph 49, is that the cost of internally generated goodwill cannot be reliably deter-
mined. The fair value of goodwill could be determined by comparing the fair value of the entity as a whole
and subtracting the sum of the fair values of the identifiable assets and liabilities of the entity. However,
under IAS 38, the principle for recognition is that identifiable intangible assets as well as goodwill must ini-
tially be measured at cost, not at fair value. As is discussed in more detail in the next section, this principle makes
the recognition of internally generated intangibles harder than the recognition of acquired intangibles.
LO3 13.3 MEASUREMENT SUBSEQUENT TO INITIAL

RECOGNITION
13.3.1 Measurement basis
Consistent with IAS 16, after the initial recognition of an intangible asset at cost, an entity must choose for
each class of intangible asset whether to measure the assets using the cost model or the revaluation model —
see paragraph 72. (These models are discussed in greater detail in chapter 11.)
364 PART 2 Elements

Cost model
Under the cost model, the asset is recorded at the initial cost of acquisition and is then subject to amor-
tisation (see section 13.3.3) and impairment testing (see chapter 15).
Revaluation model
Under the revaluation model, the asset is carried at fair value, and is subject to amortisation and impair-
ment charges. As with property, plant and equipment, if this model is chosen, revaluations are made with
sufficient regularity so that the carrying amount of the asset does not materially differ from the current fair
value at the end of the reporting period.
One specification that applies to intangible assets but is not required for property, plant and equipment
is how the fair value is to be measured. Under paragraph 75 of IAS 38, the fair value must be measured by
reference to an active market. An active market is defined in IFRS 13 as a market in which transactions for
the asset or liability take place with sufficient frequency and volume to provide pricing information on an
ongoing basis. This means that an intangible asset acquired in a business combination and measured at
fair value using some measurement technique cannot subsequently use that same measurement technique
if it adopts the revaluation model. In the absence of an active market, the intangible asset would be kept
at the fair value determined at the date of the business combination and accounted for by the cost basis.
As paragraph 76 notes, the choice of revaluation model does not allow the recognition of intangible assets
that cannot be recognised initially at cost. However, paragraph 77 allows an asset for which only part of
the cost was recognised to be fully revalued to fair value.
Paragraph 78 of IAS 38 states that intangibles such as brands, newspaper mastheads, patents and trade-
marks cannot be measured at fair value, as there is no active market for these assets because they are
unique. As with the recognition of these types of intangible assets, the standard setters have stated specifi-
cally that they can be measured only at cost.
Selection of the revaluation model requires all assets in the one class to be measured at fair value.
Because of the insistence on using active markets for the measurement of fair value, the standard recog-
nises that there will be cases where fair values cannot be determined for all assets within one class. Hence,
under paragraph 81 of IAS 38, where there is no active market for an asset, the asset can be measured at
cost even if the class is measured using the revaluation model. Further, if the ability to measure the asset at
fair value disappears because the market for the asset no longer meets the criteria to be classified as active,
the asset is carried at the latest revalued amount and effectively accounted for under the cost model. If the
market again becomes active, the revaluation model can be resumed.
Accounting for intangible assets measured using the revaluation model is exactly the same as for
property, plant and equipment (see chapter 11). Where there is a revaluation increase, the asset is
increased and the increase is credited directly to a revaluation surplus. However, if the revaluation
increase reverses a previous revaluation decrease relating to the same asset, the revaluation increase is
recognised as income (IAS 38 paragraph 85). Any accumulated amortisation is eliminated at the time
of revaluation.
Where there is a revaluation decrease, the decrease is recognised as an expense unless there has been
a previous revaluation increase. In the latter case, the adjustment must first be made against any existing
revaluation surplus before recognising an expense (IAS 38 paragraph 86). Any accumulated amortisation
is eliminated at the time of the revaluation.
As with a revaluation surplus on property, plant and equipment, paragraph 87 of IAS 38 states that the
revaluation surplus may be transferred to retained earnings when the surplus is realised on the retirement
or disposal of the asset. Alternatively, the revaluation surplus may progressively be taken to retained earn-
ings in proportion to the amortisation of the asset.
13.3.2 Subsequent expenditures

Paragraph 20 of IAS 38 discusses subsequent expenditures in general. It is argued in this paragraph that
the unique nature of intangibles means that subsequent expenditures should be expensed rather than
capitalised. Subsequent expenditures maintain expected benefits rather than increase them. Further, with
many subsequent expenditures, it may be difficult to attribute them to specific intangible assets rather than
to the entity as a whole. Paragraph 20 notes that with the paragraph 63 intangibles, whether acquired or
internally generated, subsequent expenditures are always expensed.
Paragraph 42 provides specific guidance on subsequent expenditures relating to acquired in-process
research and development projects. Effectively, the same criteria for initially recognising an asset and
expensing are applied to account for subsequent expenditures. The results of this application are:
• to expense research outlays
• to expense development outlays not meeting the criteria in paragraph 57
• to add to the acquired in-process research or development project if the development expenditure
satisfies the paragraph 57 criteria.

13.3.3 Amortisation of intangible assets
Useful life
A key determinant in the amortisation process for intangible assets is whether the useful life is finite or
indefinite. If finite, then the asset has to be amortised over that life. If the asset has an indefinite life, then
there is no annual amortisation charge. Paragraph 88 of IAS 38 states:
An entity shall assess whether the useful life of an intangible asset is finite or indefinite and, if finite, the
length of, or number of production or similar units constituting, that useful life. An intangible asset shall
be regarded by the entity as having an indefinite useful life when, based on an analysis of all the relevant
factors, there is no foreseeable limit to the period over which the asset is expected to generate net cash
inflows for the entity.
The term ‘indefinite’ does not mean that the asset has an infinite life; that is, that it is going to last
forever. As paragraph 91 notes, an indefinite life means that, with the proper maintenance, there is no
foreseeable end to the life of the asset. Paragraph 90 provides a list of factors that should be considered in
determining the useful life of the asset:
• the expected use of the asset by the entity and whether the asset could be managed efficiently by
another management team
• typical product life cycles for the asset, and public information on estimates of useful lives of similar
assets that are used in a similar way
• technical, technological, commercial or other types of obsolescence
• the stability of the industry, and changes in market demand
• expected actions by competitors
• the level of maintenance expenditure required and the entity’s ability and intent to reach such a level
• the period of control over the asset and legal or similar limits on the use of the asset
• whether the useful life of the asset depends on the useful lives of other assets of the entity.
Paragraph 94 of IAS 38 notes that, as a general rule, assets whose lives depend on contractual or legal
lives will be amortised over those lives or shorter periods in some cases. If renewal is possible, then the
useful life applied can include the renewal period providing there is evidence to support renewal by the
entity without significant cost.
Figure 13.3 contains two examples from those in the illustrative examples accompanying IAS 38 in
relation to the assessment of useful lives.
Example: An acquired broadcasting licence that expires in 5 years

The broadcasting licence is renewable every 10 years if the entity provides at least an average level of
service to its customers and complies with the relevant legislative requirements. The licence may be renewed
indefinitely at little cost and has been renewed twice before the most recent acquisition. The acquiring
entity intends to renew the licence indefinitely and evidence supports its ability to do so. Historically,
there has been no compelling challenge to the licence renewal. The technology used in broadcasting is not
expected to be replaced by another technology at any time in the foreseeable future. Therefore, the licence
is expected to contribute to the entity’s net cash inflows indefinitely.
The broadcasting licence would be treated as having an indefinite useful life because it is expected to
contribute to the entity’s net cash inflows indefinitely. Therefore, the licence would not be amortised until its
useful life is determined to be finite. The licence would be tested for impairment under IAS 36 annually and
whenever there is an indication that it may be impaired.
Example: An acquired trademark used to identify and distinguish a leading consumer product that has been
a market-share leader for the past 8 years
The trademark has a remaining legal life of 5 years but is renewable every 10 years at little cost. The
acquiring entity intends to renew the trademark continuously and evidence supports its ability to do so.
An analysis of (1) product life cycles, (2) market, competitive and environmental trends, and (3) brand
extension opportunities provides evidence that the trademarked product will generate net cash inflows for
the acquiring entity for an indefinite period.
The trademark would be treated as having an indefinite useful life because it is expected to contribute
to net cash inflows indefinitely. Therefore, the trademark would not be amortised until its useful life is
determined to be finite. It would be tested for impairment under IAS 36 annually and whenever there is an
indication that it may be impaired.
FIGURE 13.3 Examples of indefinite lives for intangible assets
Rather than considering the existence of an indefinite life for intangible assets, the standard setters
could have set a maximum useful life such as 40 years. However, as noted in paragraph BC63 of the
Basis for Conclusions on IAS 38, the IASB considers that writing standards in such a fashion would
366 PART 2 Elements

not accord with the principle that the accounting numbers should be representationally faithful. The
principles in IAS 38 provide management with more discretion but allow for the provision of more
relevant information. In order for an intangible asset (such as a trademark) to have an indefinite life, an
entity is required to outlay funds on an annual basis to maintain the trademark. Consider in this regard
the annual expenditure by soft-drink companies to maintain the value of their trademarks. The annual
profit figure is then affected by these outlays. To require amortisation charges to be levied as well, when
the asset is being maintained, would be to affect the statement of profit or loss and other comprehensive
income twice.
Intangible assets with finite useful lives

Paragraph 97 of IAS 38 states the principles relating to the amortisation period and choice of amortisa-
tion method. In general, the principles of amortisation are the same as those for depreciating property,
plant and equipment under IAS 16. In both cases, the process involves the allocation of the depreciable
amount on a systematic basis over the useful life, with the method chosen reflecting the pattern in which
the expected benefits are expected to be consumed by the entity. Paragraph 98 notes that an amortisa-
tion method will rarely result in an amortisation charge that is lower than if a straight-line method had
been used. Further, in accordance with paragraph 104, the amortisation period and amortisation method
should be reviewed at least at the end of each annual reporting period, which is the same for property,
plant and equipment.
However, IAS 38 contains a number of rules that are specific to intangible assets, presumably because of
the relative uncertainty associated with intangible assets:
• Where the pattern of benefits cannot be determined reliably, the straight-line method is to be
used (paragraph 97). This is, presumably, to bring some consistency and comparability into the
calculations.
• The residual value is assumed to be zero unless there is a commitment by a third party to purchase the
asset at the end of its useful life, or there is an active market for the asset, and:
– residual value can be determined by reference to that market and
– it is probable that such a market will exist at the end of the asset’s useful life (paragraph 100).
Any changes in residual value, amortisation method or useful life are changes in accounting estimates,
and accounted for prospectively with an effect on the current and future amortisation charges.
Intangible assets with indefinite useful lives

As noted earlier, where an intangible asset has an indefinite useful life, there is no amortisation charge
(IAS 38 paragraph 107). As with finite useful lives, the useful life of an intangible that is not being
amortised must be reviewed each period (paragraph 109). Any change from indefinite to finite useful
life for an asset is treated as a change in estimate and affects the amortisation charge in current and
future periods. Intangible assets with indefinite useful lives are subject to annual impairment tests (see
chapter 15).
LO4 13.4 RETIREMENTS AND DISPOSALS

Accounting for the retirements and disposals of intangible assets is identical to that for property, plant and
equipment under IAS 16. In particular, under IAS 38:
• intangible assets are to be derecognised on disposal or when there are no expected future benefits from
the asset (paragraph 112)
• gains or losses on disposal are calculated as the difference between the proceeds on disposal
and the carrying amount at point of sale, with amortisation calculated up to the point of sale
(paragraph 113)
• amortisation of an intangible with a finite useful life does not cease when the asset becomes
temporarily idle or is retired from active use (paragraph 117).
LO5 13.5 DISCLOSURE

Paragraph 118 of IAS 38 requires disclosures for each class of intangibles, and for internally generated intan-
gibles to be distinguished from other intangibles. Examples of separate classes are given in paragraph 119:
• brand names
• mastheads and publishing titles
• computer software
• licences and franchises
• copyrights, patents and other industrial property rights, service and operating rights
• recipes, formulas, models, designs and prototypes
• intangible assets under development.

Disclosures required by paragraph 118(a) and (b) would be contained in the summary of significant
accounting policies, as illustrated in figure 13.4. Disclosures required by paragraphs 118 and 122 of IAS 38
are illustrated in figure 13.5.
IAS 38
Note 1: Summary of significant accounting policies (extract) paragraph 118
Intangible assets
Intangible assets are initially recognised at cost. Intangible assets that have indefinite useful lives are tested (b)
for impairment on an annual basis. Intangible assets that have finite useful lives are amortised over those
lives on a straight-line basis.
Patents and copyrights
These have all been acquired by the company. Costs relating to these assets are capitalised and amortised (b)
on a straight-line basis over the following periods:
Patent — packaging 5 years
Patent — tools 10 years
Copyright 10 years
Licence
The licence relating to television broadcasting rights is determined to be indefinite. (a)
Research and development
Research costs are expensed as incurred. Development costs are expensed except those that it is probable (a)
will generate future economic benefits, this being determined by an analysis of factors such as technical
feasibility and the existence of markets. Such costs are currently being amortised on a straight-line basis over
the following periods:
Tool design project 5 years (b)
Water cooling project 10 years
FIGURE 13.4 Illustrative disclosures required by paragraph 118(a) and (b) of IAS 38
Other disclosures required, where relevant, by paragraph 118 of IAS 38 are:

• the line item in the statement of profit or loss and other comprehensive income in which any
amortisation of intangible assets is included (paragraph 118(d))
• increases or decreases during the period resulting from revaluations under paragraphs 75, 85 and 86
and from impairment losses recognised or reversed directly in equity (paragraph 118(e)(iii))
• impairment losses reversed in profit or loss during the period (paragraph 118(e)(v)).
FIGURE 13.5 Illustrative disclosures required by paragraphs 118 and 122 of IAS 38
IAS 38
Note 11: Intangible assets paragraph 122
Details about the Company’s intangible assets are provided below. All intangibles are considered to have (a)
finite useful lives except for a patent held for a tool used in the manufacture of steel windmills. As this tool
is able to substantially lessen the cost of manufacturing windmills, and all entities manufacturing windmills
acquire the special tool from the company for use in their production process, the continued use of the
tool in the manufacturing process is considered to be infinite. Hence, the patent is considered to have an
indefinite life. The tool has a carrying amount of £155 000 [2013: £155 000].
Apart from the above, the main items constituting the intangible assets of the Company are:
Remaining
Carrying amount amortisation period (b)
2014 2013 2014 2013
£’000 £’000 years years
Patents and copyrights
Patent — packaging 31 45 7 8
Patent — tools 52 66 5 6
Copyright — manuals 15 24 3 4
Deferred development expenditure
Tool design 322 312 5 6
Packaging design 95 110 3 4
368 PART 2 Elements

IAS 38
Note 11: Intangible assets paragraph 122
Deferred paragraph 118

Patents and copyrights development expenditure
2014 2013 2014 2013
£’000 £’000 £’000 £’000
Balance at beginning of year, at cost 576 545 592 361 (c)
Accumulated amortisation 276 234 166 110
Carrying amount at beginning of year 300 311 426 251
Additions: (e)(i)
Acquisition of subsidiary — 22 — 54
Internal development — — 72 182
Acquired separately 10 15 — —
Disposals (15) — — — (e)(ii)
Amortisation (38) (32) (52) (44) (e)(vi)
Impairment — (10) — (12) (e)(iv)
Exchange differences 5 (6) 5 (5) (e)(vii)
Carrying amount at end of year 262 300 451 426
Intangible assets:
At cost 557 576 669 592 (c)
Accumulated amortisation 295 276 218 166
Carrying amount at end of year 262 300 451 426
Paragraph 122 of IAS 38 also requires the following disclosures, if relevant:

• for intangible assets acquired by way of a government grant and initially recognised at fair value
(paragraph 122(c)):
– the fair value initially recognised for these assets
– their carrying amount
– whether they are measured after recognition under the cost model or the revaluation model.
• the existence and carrying amounts of intangible assets whose title is restricted and the carrying
amounts of intangible assets pledged as security for liabilities (paragraph 122(d)).
• the amount of contractual commitments for the acquisition of intangible assets (paragraph 122(e)).
Paragraph 124 details further disclosures where intangible assets are carried at revalued amounts. An
example of this disclosure is contained in figure 13.6.
IAS 38
paragraph 124
Intangibles carried at revalued amounts

The company has recognised its Internet domain name as an intangible asset. The asset was recognised (a)(i)
initially at cost in 2012. The revaluation model was used to measure this asset from 1 January 2013. At the (a)(ii)
end of the reporting period, 31 December 2014, the carrying amount of this asset is £52 500. If the cost (a)(iii)
method had continued to be applied, the carrying amount would have been £33 600.
The revaluation surplus in relation to this asset is as follows:
2014 2013 (b)
Balance at beginning of year £48 000 £45 000
Increase 4 500 3 000
Balance at end of year £52 500 £48 000
There are no restrictions on the distribution of this balance to shareholders.
FIGURE 13.6 Disclosures required by paragraph 124 of IAS 38
Paragraph 126 requires disclosure of the aggregate amount of research and development expenditure
recognised as an expense during the period. Disclosures in paragraph 128 that are encouraged but not
required include a description of any fully amortised intangible asset that is still in use, and a brief descrip-
tion of significant intangible assets controlled by the entity but not recognised as assets because they did
not meet the recognition criteria in IAS 38.
An example of disclosure of intangible assets is in figure 13.7, which shows the intangible assets
disclosed by GSK in its 2014 annual report.

19 Other intangible assets
Computer Licences, Amortised Indefinite

software patents, etc. brands life brands Total
£m £m £m £m £m
Cost at 1 January 2013 1 501 10 604 412 2 184 14 701

Exchange adjustments (27) (143) — (37) (207)
Capitalised development costs 79 246 — — 325
Additions through business combinations — 191 7 — 198
Capitalised borrowing costs 5 1 — — 6
Other additions 99 141 — — 240
Disposals and asset write-offs (26) (346) — — (372)
Transfer (to)/from assets held for sale — (222) — 44 (178)
Cost at 31 December 2013 1 631 10 472 419 2 191 14 713

Exchange adjustments 11 52 3 (6) 60
Capitalised development costs — 242 — — 242
Capitalsed borrowing costs 6 3 — — 9
Other additions 179 108 — — 287
Reclassifications 12 — — — 12
Disposals and asset write-offs (21) (9) — — (30)
Transfer to assets held for sale — (587) — (30) (617)
Cost at 31 December 2014 1 818 10 281 422 2 155 14 676
Amortisation at 1 January 2013 (1 012) (2 473) (106) — (3 591)

Exchange adjustments 17 65 1 — 83
Charge for the year (128) (536) (18) — (682)
Disposals and asset write-offs 21 2 — — 23
Transfer to assets held for sale — 85 — — 85
Amortisation at 31 December 2013 (1 102) (2 857) (123) — (4 082)

Exchange adjustments (13) (63) — — (76)
Charge for the year (115) (578) (11) — (704)
Amortisation at 31 December 2014 (1 213) (3 492) (134) — (4 839)
Impairment at 1 January 2013 (39) (729) (129) (52) (949)

Exchange adjustments — 9 — 1 10
Impairment losses (6) (702) (11) (26) (745)
Impairment at 31 December 2013 (41) (1 090) (140) (77) (1 348)

Exchange adjustments 2 (18) — — (16)
Impairment losses (7) (131) (14) (5) (157)
Disposals and asset write-offs 4 — — — 4
Impairment at 31 December 2014 (42) (1 239) (154) (82) (1 517)
Total amortisation and impairment at 31 December 2013 (1 143) (3 947) (263) (77) (5 430)
Total amortisation and impairment at 31 December 2014 (1 255) (4 731) (288) (82) (6 356)
Net book value at 1 January 2013 450 7 402 177 2 132 10 161
Net book value at 31 December 2013 488 6 525 156 2 114 9 283
Net book value at 31 December 2014 563 5 550 134 2 073 8 320
FIGURE 13.7 Example of disclosure of intangible assets

Source: GSK (2014, p. 162).
370 PART 2 Elements

SUMMARY
Intangible assets are considered to be sufficiently different from other assets such as property, plant and
equipment for the standard setters to provide a separate standard. The reason for having such a standard is
that the nature of intangibles is such that there are particular measurement problems associated with these
assets that require specific accounting principles to be established. IAS 38 Intangible Assets is concerned
with the definition, recognition, measurement and disclosure of intangibles.
The characteristic of ‘identifiability’ is critical to the identification of intangibles, and is the same concept
that arises in IFRS 3 Business Combinations in relation to identifiable assets, liabilities and contingent liabilities
recognised by the acquirer. In considering the accounting for intangibles, it is important to consider the dif-
ferences in accounting depending on the source of the intangibles. Intangible assets acquired within a busi-
ness combination are easier to recognise than those internally generated by the entity. This is because within
a business combination the measurement issues are limited by the amount of the cost of the combination.
Amortisation of intangibles raises particular issues in terms of the useful lives of assets. The potential to
assess some intangible assets as having indefinite useful lives and hence not subject to amortisation makes
the decision on what is the useful life of an asset very significant. It is important to understand how to
make such a decision. Aspects of that decision process are required to be specifically disclosed.
DEMONSTRATION PROBLEM 13.1 Development outlays
This demonstration problem illustrates the application of the criteria in paragraph 57 of IAS 38, determining
when development outlays are capitalised or expensed.
Pretoria Ltd is a highly successful engineering company that manufactures filters for air conditioning systems.
Due to its dissatisfaction with the quality of the filters currently available, on 1 January 2014 it commenced
a project to design a more efficient filter. The following notes record the events relating to that project:
2014
January Paid £145 000 in salaries of company engineers and consultants who conducted basic tests
on available filters with varying modifications.
February Spent £165 000 on developing a new filter system, including the production of a basic
model. It became obvious that the model in its current form was not successful because the
material in the filter was not as effective as required.
March Acquired the fibres division of Durban Ltd for £330 000. The fair values of the tangible assets
of this division were: property, plant and equipment, £180 000; inventories, £60 000.
This business was acquired because one of the products it produced was a fibrous
compound, sold under the brand name Springbok, that Pretoria Ltd considered would be
excellent for including in the filtration process.
By buying the fibres division, Pretoria Ltd acquired the patent for this fibrous compound.
Pretoria Ltd valued the patent at £50 000 and the brand name at £40 000, using a number of
valuation techniques. The patent had a further 10-year life but was renewable on application.
Further costs of £54 000 were incurred on the new filter system during March.
April Spent a further £135 000 on revising the filtration process to incorporate the fibrous
compound. By the end of April, Pretoria Ltd was convinced that it now had a viable product
because preliminary tests showed that the filtration process was significantly better than any
other available on the market.
May Developed a prototype of the filtration component and proceeded to test it within a variety
of models of air conditioners. The company preferred to sell the filtration process to current
manufacturers of air conditioners if the process worked with currently available models.
If this proved not possible, the company would then consider developing its own brand
of air conditioners using the new filtration system. By the end of May, the filtration system
had proved successful on all but one of the currently available commercial models. Costs
incurred were £65 000.
June Various air conditioner manufacturers were invited to demonstrations of the filtration system.
Costs incurred were £25 000, including £12 000 for food and beverages for the prospective
clients. The feedback from a number of the companies was that they were prepared to
enter negotiations for acquiring the filters from Pretoria Ltd. The company now believed it
had a successful model and commenced planning the production of the filters. Ongoing
costs of £45 000 to refine the filtration system, particularly in the light of comments by the
manufacturers, were incurred in the latter part of June.

Required
Explain the accounting for the various outlays incurred by Pretoria Ltd.
Solution
The main problem in accounting for the costs is determining at what point of time costs can be capital-
ised. This is resolved by applying the criteria in paragraph 57 of IAS 38:
• Technical feasibility. At the end of April, the company believed that the filtration process was
technically feasible.
• Intention to complete and sell. At the end of April, the company was not yet sure that the system was
adaptable to currently available models of air conditioners. If it wasn’t adaptable, the company
would have to test whether development of its own brand of air conditioners would be a commercial
proposition. Hence, it was not until the end of May that the company was convinced it could
complete the project and had a product that it could sell.
• Ability to use or sell. By the end of May, the company had a product that it believed it had the ability
to sell. Being a filter manufacturer, it knew the current costs of competing products and so could
make an informed decision about the potential for the commercial sale of its own filter.
• Existence of a market. The market comprised the air conditioning manufacturers. By selling to the
manufacturers, the company had the potential to generate probable future cash flows. This criterion
was met by the end of May.
• Availability of resources. From the beginning of the project, the company was not short of resources,
being a highly successful company in its own right.
• Ability to measure costs reliably. Costs are readily attributable to the project throughout its development.
On the basis of the above analysis, the criteria in paragraph 57 of IAS 38 were all met at the end of
May. Therefore, costs incurred before this point are expensed, and those incurred after this point are
capitalised. Hence, the following costs would be written off as incurred:
January £145 000

February 165 000
March 54 000
April 135 000
May 65 000
In acquiring the fibres division from Durban Ltd, Pretoria Ltd would pass the following entry:
Property, plant and equipment Dr 180 000

Inventories Dr 60 000
Brand Dr 40 000
Patent Dr 50 000
Cash Cr 330 000
(Acquisition of assets)
The patent would initially be depreciated over a 10-year useful life. However, this would need to be
reassessed upon application of the fibrous compound to the air conditioning filtration system. This alter-
native use may extend the expected useful life of the product, and hence of the patent. The brand name
would be depreciated over the same useful life of the patent, because it is expected that the brand has no
real value unless backed by the patent.
The company would then capitalise development costs of £45 000 in June.
The marketing costs incurred in June of £25 000 would be expensed because they are not part of the
development process.
1. What are the key characteristics of an intangible asset?
2. Explain what is meant by ‘identifiability’.
3. How do the principles for amortisation of intangible assets differ from those for depreciation of prop-
erty, plant and equipment?
372 PART 2 Elements

4. Explain what is meant by an ‘active market’.
5. How is the useful life of an intangible asset determined?
6. What intangibles can never be recognised if internally generated? Why?
7. Explain the difference between ‘research’ and ‘development’.
8. Explain when development outlays can be capitalised.
References
Christian Dior 2014, Annual Report, www.dior-finance.com.
GSK 2014, Annual Report, https://www.gsk.com/en-gb/investors/corporate-reporting/.
Jenkins, E., and Upton, W. 2001, ‘Internally generated intangible assets: Framing the discussion’, Australian
Accounting Review, vol. 11, no. 2, pp. 4–11.
Lev, B. 2001, Intangibles: management, measurement, and reporting, Brookings Institution Press, Washington,
DC.
Lev, B. 2002, ‘Where have all of Enron’s intangibles gone?’ Journal of Accounting and Public Policy, vol. 21,
no. 2, pp. 131–135.
Upton, W. S. 2001, Business and financial reporting, challenges from the new economy, Financial Accounting
Series No. 219-A, Financial Accounting Standards Board, Norwalk, CT, USA.
Exercise 13.1 USEFUL TRADEMARK LIFE

★ X Ltd holds a trademark that is well known within consumer circles and has enabled the company to be
a market leader in its area. The trademark has been held by the company for 9 years. The legal life of the
trademark is 5 years, but is renewable by the company at little cost to it.
Required
Discuss how the company should determine the useful life of the trademark, noting in particular what
form of evidence it should collect to justify its selection of useful life.
Exercise 13.2 BRANDS AND FORMULAS

★ Wayne Upton (2001, p. 71) in his discussion of the lives of intangible assets noted that the formula for
Coca-Cola has grown more valuable over time, not less, and that Sir David Tweedie, former chairman
of the IASB, joked that the brand name of his favourite Scotch whisky is older than the United States of
America — and, in Sir David’s view, the formula for Scotch whisky has contributed more to the sum of
human happiness.
Required
Outline the accounting for brands under IAS 38, and discuss the difficulties for standard setters in allowing
the recognition of all brands and formulas on the statement of financial position.
Exercise 13.3 RESEARCH AND DEVELOPMENT

★★ Because of the low level of rainfall in Simonstown, householders find it difficult to keep their gardens and
lawns sufficiently watered. As a result, many householders have installed bores that allow them to access
underground water suitable for using on the garden. This is a cheaper option than incurring excess water
bills by using the government-provided water system. One of the problems with much of the bore water
is that its heavy iron content leaves a brown stain on paths and garden edges. This can make homes look
unsightly and lower their value.
Noting this problem, Strand Laboratories believed that it should research the problem with the
goal of developing a filter system that could be attached to a bore and remove the effects of the iron
content in the water. This process, if developed, could be patented and filters sold through local retic-
ulation shops.
In 2011, Strand commenced its work on the problem, resulting in August 2015 in a patent for the
NoMoreIron filter process. Costs incurred in this process were as shown below.

2011–12 Research conducted to develop filter £125 000
2012–13 Research conducted to develop filter 132 000
2013–14 Design and construction of prototype 152 000
2014–15 Testing of models 51 000
2015–16 Fees for preparing patent application 12 000
2016–17 Research to modify design 34 000
2017–18 Legal fees to protect patent against cheap copies 15 000
Required
Discuss how the company should account for each of these outlays.
Exercise 13.4 RECOGNITION OF INTANGIBLES

★★ Soweto Ltd is unsure of how to obtain computer software. Four possibilities are:
1. Purchase computer software externally, including packages for payroll and general ledger.
2. Contract to independent programmers to develop specific software for the company’s own use.
3. Buy computer software to incorporate into a product that the company will develop.
4. Employ its own programmers to write software that the company will use.
Required
Discuss whether the accounting will differ depending on which method is chosen.

★★ Stellenbosch Laboratories Ltd manufactures and distributes a wide range of general pharmaceutical prod-
ucts. Selected audited data for the reporting period ended 31 December 2014 are as follows:
Gross profit £17 600 000

Profit before income tax 1 700 000
Income tax expense (500 000)
Profit for the period 1 200 000
Total assets:
Current 7 300 000
Non-current 11 500 000
The company uses a standard mark-up on cost.

From your audit files, you ascertain that total research and development expenditure for the year
amounted to £4 700 000. This amount is substantially higher than in previous years and has eroded the
profitability of the company. Mr Bosch, the company’s finance director, has asked for your firm’s advice on
whether it is acceptable accounting practice for the company to carry forward any of this expenditure to a
future accounting period.
Your audit files disclose that the main reason for the significant increase in research and development
costs was the introduction of a planned 5-year laboratory programme to attempt to find an antidote for
the common cold. Salaries and identifiable equipment costs associated with this programme amounted to
£2 350 000 for the current year.
The following additional items were included in research and development costs for the year:
(a) Costs to test a new tamper-proof dispenser pack for the company’s major selling line (20% of sales) of
antibiotic capsules — £760 000. The new packs are to be introduced in the 2013 financial year.
(b) Experimental costs to convert a line of headache powders to liquid form — £59 000. The company
hopes to phase out the powder form if the tests to convert to the stronger and better handling liquid
form prove successful.
(c) Quality control required by stringent company policy and by law on all items of production for the
year — £750 000.
(d) Costs of a time and motion study aimed at improving production efficiency by redesigning plant
layout of existing equipment — £50 000.
(e) Construction and testing of a new prototype machine for producing hypodermic needles — £200 000.
Testing has been successful to date and is nearing completion. Hypodermic needles accounted for
1% of the company’s sales in the current year, but it is expected that the company’s market share will
increase following introduction of this new machine.
Required
Respond to Mr Bosch’s question for each of these items.
374 PART 2 Elements

★★ Capetown Ltd has been involved in a project to develop an engine that runs on extracts from sugar cane. It
started the project in February 2014. Between the starting date and 30 June 2014, the end of the reporting
period for the company, Capetown Ltd spent £254 000 on the project. At 30 June 2014, there was no indi-
cation that the project would be commercially feasible, although the company had made significant pro-
gress and was sufficiently sure of future success that it was prepared to outlay more funds on the project.
After spending a further £120 000 during July and August, the company had built a prototype that
appeared to be successful. The prototype was demonstrated to a number of engineering companies during
September, and several of these companies expressed interest in the further development of the engine.
Convinced that it now had a product that it would be able to sell, Capetown Ltd spent a further £65 000
during October adjusting for the problems that the engineering firms had pointed out. On 1 November,
Capetown Ltd applied for a patent on the engine, incurring legal and administrative costs of £35 000. The
patent had an expected useful life of 5 years, but was renewable for a further 5 years upon application.
Between November and December 2014, Capetown Ltd spent an additional amount of £82 000 on
engineering and consulting costs to develop the project such that the engine was at manufacturing stage.
This resulted in changes in the overall design of the engine, and costs of £5000 were incurred to add minor
changes to the patent authority.
On 1 January 2015, Capetown Ltd invited tenders for the manufacture of the engine for commercial sale.
Required
Discuss how Capetown Ltd should account for these costs. Provide journal entries with an explanation of
why these are the appropriate entries.
Exercise 13.7 ACCOUNTING FOR BRANDS

★★★ Jon West Ltd is a leading company in the sale of frozen and canned fish produce. These products are sold
under two brand names. Fish caught in southern Australian waters are sold under the brand ‘Arctic Fresh’,
which is the brand the company developed when it commenced operations and which is still used today.
Fish caught in the northern oceans are sold under the brand name ‘Tropical Taste’, the brand developed by
Fishy Tales Ltd. Jon West Ltd acquired all the assets and liabilities of Fishy Tales Ltd a number of years ago
when it took over that company’s operations.
Jon West Ltd has always marketed itself as operating in an environmentally responsible manner, and is
an advocate of sustainable fishing. The public regards it as a dolphin-friendly company as a result of its pre-
vious campaigns to ensure dolphins are not affected by tuna fishing. The marketing manager of Jon West
Ltd has noted the efforts of a ship, the Steve Irwin, to disrupt and hopefully stop the efforts of Japanese
whalers in the southern oceans and the publicity that this has received. He has recommended to the board
of directors that Jon West Ltd strengthen its environmentally responsible image by guaranteeing to repair
any damage caused to the Steve Irwin as a result of attempts to disrupt the Japanese whalers. He believes
that this action will increase Jon West Ltd’s environmental reputation, adding to the company’s goodwill.
He has told the board that such a guarantee will have no effect on Jon West Ltd’s reported profitability. He
has explained that, if any damage to the Steve Irwin occurs, Jon West Ltd can capitalise the resulting repair
costs to the carrying amounts of its brands, as such costs will have been incurred basically for marketing
purposes. Accordingly, as the company’s net asset position will increase, and there will be no effect on the
statement of profit or loss and other comprehensive income, this will be a win–win situation for everyone.
Required
The chairman of the board knows that the marketing manager is very effective at selling ideas but knows
very little about accounting. The chairman has, therefore, asked you to provide him with a report advising
the board on how the proposal should be accounted for under International Financial Reporting Stand-
ards and how such a proposal would affect Jon West Ltd’s financial statements.

There is an extant accounting literature on intangibles, only is consistent with usefulness of reported numbers under capi-
a small fraction of which can be reviewed here. Wyatt (2008) talisation. Nevertheless, the negative relation could be indic-
offers a comprehensive review of the literature for the inter- ative of investor perception that the decision to capitalise is
ested reader. Broadly, the literature can be split into two opportunistic in nature and is adopted by weaker firms.
strands. The first is with respect to intangible assets that are Wyatt (2005) employs an Australian sample during 1993–
recognised on the balance sheet (other than goodwill — see 1997. During this period Australian GAAP allowed consider-
chapter 14). The second strand is with respect to assessing able flexibility for companies as to whether to capitalise
the adequacy of the expensing requirements that apply to internally generated intangibles. Wyatt (2005) examines several
most internally generated intangibles. hypotheses as to what drives the capitalisation decision. In par-
Starting with recognised intangibles, Aboody and Lev ticular she predicts that the degree to which a firm can capture
(1998) examine the value relevance of capitalised software future benefits positively influences the capitalisation decision.
development costs in a sample of 163 software companies Wyatt (2005) provides evidence that is consistent with this pre-
between 1987 and 1995. They argue that software firms diction using several proxies. This suggests that Australian firms
reporting under US GAAP (SFAS 86 (FASB, 1985) and now used the discretion to capitalise in line with underlying econ-
ASC 985-20) face considerable flexibility with the capitali- omic fundamentals rather than in an opportunistic fashion.
sation decision. As a result, about one fifth of sample firms IAS 38 axiomatically assumes that acquired intangibles
expensed the development cost in full in every year exam- always satisfy asset-recognition criteria. Nevertheless, to the
ined. They find that the annual amount capitalised is smaller extent that uncertainty about future benefits is an inherent
in bigger and more profitable firms, and is larger when the feature of intangibles, it is questionable if acquired intangi-
development costs (before capitalisation) are larger. They fur- bles should be initially capitalised. Amir and Livne (2005)
ther find that stock returns are positively related to changes in raise this point when they examine human-capital intangi-
annual amounts of capitalisation, but unrelated to the change bles. Specifically, they take advantage of a unique industry
in development expense recognised in the income statement. arrangement — the football industry — whereby clubs that
Because capitalising firms amortise the intangible asset, the sign up new players often pay a transfer fee to the player’s
amortisation figures may be informative, for example with former club. This fee normally corresponds to the talent and
respect to managers’ estimate of the useful life. Consistent with stature of the player. Nevertheless, as the form of the player
that, the authors find that changes in amortisation expense are and his fit with the new team and coach are far from being
negatively related to stock returns. Levels analysis also con- certain, it is not clear that they should be capitalised. Amir and
firms that stock prices are positively related to the amount of Livne (2005) examine the relation between measures of future
software development cost recognised on the balance sheet. benefits and transfer fees paid, employing financials of 58 UK
Collectively, this evidence suggests that investors regard capi- football clubs between 1990 and 2003. While they find a posi-
talised amounts as assets. Mohd (2005) extends this analysis tive association between current sales, operating profit and
by looking at differences in information asymmetry between operating cash flows on one hand and past transfer fees on the
capitalising and expensing firms. He employs bid–ask spreads other hand, it seems that the investments are not fully recover-
and trading volume as measures of information asymmetry. able. In addition, the useful life of transfer fees is found to be
Consistent with the view that investors better understand the shorter than the amortisation period used by the clubs. Amir
financials of capitalising firms, he finds evidence of lower and Livne (2005) also examine the relation between transfer
information asymmetry for capitalising firms. Hence, both fees paid and stock prices and establish it is positive. They
Aboody and Lev (1998) and Mohn (2005) are supportive of therefore conclude that market participants do regard fees paid
capitalisation of software development cost because they pro- as an asset. While the setting examined in Amir and Livne
vide more useful information to investors. (2005) is industry-specific, it nevertheless raises some doubt
Markarian et al. (2008) provide evidence from Italy about about the requirement to show purchased intangibles as assets.
capitalisation of R&D expenses prior to the adoption of IFRS® Turning to unrecognised intangibles, a number of studies
Standards in 2005. Domestic Italian rules were quite similar have criticised the immediate expensing rule that applies to
to the capitalisation rules set in IAS 38 for development cost. internally generated intangibles, mostly advertising and R&D.
Therefore this study is helpful in understanding how discretion Hirschey and Weygandt (1985) is one of the earlier studies
is used under IAS 38. This paper employs 130 firm-year observ- to suggest advertising and R&D should be capitalised. Specifi-
ations during 2001–2003. The degree of capitalisation is on cally, they examine the association between the ratio of market
average 10% of total R&D costs. The paper fails to find consis- value of equity to replacement cost of equity (a measure of
tent evidence as to the determinants of the amount capitalised, the premium of market price over book value of equity) and
although some evidence suggests that more profitable firms advertising and R&D expenses. Inconsistent with standard-
capitalise less. Cazavan-Jeny and Jeanjean (2006) focus on a setters’ view, the results indicate a positive relation, which is
French sample, also pre IFRS Standards. During 1993–2002 expected if investors regard these expenditures as assets.
domestic French rules allowed considerable flexibility to man- Lev and Sougiannis (1996) advance a method for esti-
agers with respect to the capitalisation decision. Their sample mating the amortised cost of intangible R&D assets. They
consists of 197 firms and 770 firm-year observations, with employ more than 11,600 observations to estimate economic
250 observations under capitalisation. Unlike Aboody and amortisation rates that subsequently were used to estimate the
Lev (1998) they find that (1) capitalised amounts are nega- hypothetical amount to be recognised as an R&D asset in bal-
tively related to stock prices, and (2) changes in capitalised ance sheet. They also calculate the difference between reported
amounts are negatively related to stock returns. This evidence earnings (and equity) and capitalisation-with-amortisation
376 PART 2 Elements

adjusted earnings (and equity). Lev and Sougiannis (1996)
find that these differences are positively associated with stock
References
prices, especially for high R&D-intensity firms. A stock returns Aboody, D., and Lev, B. 1998. The value relevance of
analysis modestly supports the levels analysis. This evidence intangibles: The case of software capitalization. Journal of
collectively suggests that investors pay attention to these Accounting Research, 161–191.
differences, which in turn indicates that for R&D-intensive Amir, E., Guan, Y., and Livne, G. 2007. The association of
firms investors adjust reported numbers as if R&D expense is R&D and capital expenditures with subsequent earnings
capitalised. variability. Journal of Business Finance & Accounting, 34
Lev and Zarowin (1999) take the charge against expensing (1 and 2), 222–246.
of R&D a step further. They look at the ability of earnings Amir, E., and Livne, G. 2005. Accounting, valuation and
and changes in earnings to explain stock returns over a duration of football player contracts. Journal of Business
period of 20 years. In addition to the changes analysis they Finance & Accounting, 32(3–4), 549–586.
look at the ability of earnings and book value of equity to Barth, M. E., Clement, M. B., Foster, G., and. Kasznik, R.
explain stock prices (levels analysis) over the same period. 1998. Brand values and capital market valuation. Review of
They provide evidence that suggests that (1) the usefulness Accounting Studies, 3(1), 41–68.
of accounting numbers has declined over the period exam- Bonacchi, M., Kolev, K., and Lev, B. 2014. Customer
ined and (2) at the same time there has been an increase in franchise—A hidden, yet crucial asset. Contemporary
the rate of change businesses have faced. The central claim Accounting Research, 32(3), 1024–1049.
of the Lev and Zarowin’s (1999) paper is that the changes Cazavan-Jeny, A., and Jeanjean, T. 2006. The negative impact
in business environment are attributable to the role of R&D of R&D capitalization: A value relevance approach.
and technology. To support this assertion they show that European Accounting Review, 15(1), 37–61.
firms that increase (decrease) their R&D intensity over time Financial Accounting Standards Board. 1985. Accounting
exhibit lower (higher) usefulness of their financial reports. for the Costs of Computer Software to Be Sold, Leased, or
They then argue that the expensing rule may have contrib- Otherwise Marketed. SFAS 86. Stamford, CT.
uted to the decline in usefulness, although in this paper they Hirschey, M., and Weygandt, J. J. 1985. Amortization policy
do not furnish direct evidence pertaining to this claim. for advertising and research and development expenditures.
Not all studies agree that R&D should be capitalised. Journal of Accounting Research, 326–335.
Kothari et al. (2002) show that the variability of future profits Kothari, S. P., Laguerre, T. E., and Leone, A. J. 2002.
is increasing with R&D expense, and more so than capital Capitalization versus expensing: Evidence on the
expenditure (CAPEX). This is consistent with standard set- uncertainty of future earnings from capital expenditures
ters’ view that the uncertainty surrounding future benefits versus R&D outlays. Review of Accounting Studies, 7(4),
is high in the case of R&D. Amir et al. (2007) nevertheless 355–382.
argue, and provide evidence to that effect, that the risk in Lev, B., and Sougiannis, T. 1996. The capitalization,
CAPEX can exceed that of R&D in several industries. The evi- amortization, and value-relevance of R&D. Journal of
dence provided in Amir et al. (2007) is intriguing because it Accounting and Economics, 21(1), 107–138.
challenges the view that CAPEX should always be capitalised. Lev, B., and Zarowin, P. 1999. The Boundaries of financial
Further research has been conducted also with respect to reporting and how to extend them. Journal of Accounting
other intangibles that existing accounting rules disallow their Research, 37(2), 353–385.
capitalisation. For example, Barth et al. (2008) employ brand Livne, G., Simpson, A., and Talmor, E. 2011. Do customer
estimates reported by Financial World that, in turn, are based acquisition cost, retention and usage matter to firm
on valuation methodology developed by Interbrand Ltd. The performance and valuation? Journal of Business Finance &
authors find evidence supporting the view that unrecognised Accounting, 38(3), 334–63.
brands are regarded as assets by market participants. Livne Markarian, G., Pozza, L., and Prencipe, A. 2008.
et al. (2011) examine the valuation role of customer acquisi- Capitalization of R&D costs and earnings management:
tion cost, a major expense in several service-based firms. Evidence from Italian listed companies. The International
They provide evidence from the wireless industry that these Journal of Accounting, 43(3), 246–267.
expenses are positively related to customer retention and Mohd, E. 2005. Accounting for software development costs
future operating profit. This suggests that such expenses meet and information asymmetry. The Accounting Review, 80(4),
asset recognition criteria. Bonacchi et al. (2014) extend this 1211–1231.
research by looking at subscription-based enterprises. They Wyatt, A. 2005. Accounting recognition of intangible assets:
develop a valuation model for customer equity using 576 Theory and evidence on economic determinants. The
firm-year observations and find that it is positively related Accounting Review, 80(3), 967–1003.
to stock prices. Since internally generated customer relation- Wyatt, A. 2008. What financial and non-financial
ships cannot be capitalised, the evidence in Livne et al. (2011) information on intangibles is value-relevant? A review
and Bonacchi et al. (2014) calls for a change in existing rules of the evidence. Accounting and Business Research, 38(3),
regarding customer relationships. 217–256.

14 Business combinations
ACCOUNTING IFRS 3 Business Combinations
STANDARDS
IN FOCUS

OBJECTIVES
1 understand the nature of a business combination and its various forms
2 explain the basic steps in the acquisition method of accounting for a business combination
3 account for a business combination in the records of the acquirer
4 recognise and measure the assets acquired and liabilities assumed in the business combination
5 understand the nature of and the accounting for goodwill and gain from bargain purchase
6 account for shares acquired in the acquiree
7 prepare the accounting records of the acquiree
8 account for subsequent adjustments to the initial accounting for a business combination
9 provide the disclosures required under IFRS 3.
CHAPTER 14 Business combinations 379

LO1 14.1 THE NATURE OF A BUSINESS COMBINATION
The accounting standard relevant for accounting for business combinations is IFRS 3 Business Combinations
issued by the International Accounting Standards Board (IASB®) in January 2008.
A business combination is defined in Appendix A to IFRS 3 as:
A transaction or other event in which an acquirer obtains control of one or more businesses.
The meaning of control is the same as in IFRS 10 Consolidated Financial Statements. Control exists when
an investor is exposed, or has rights, to variable returns from its involvement with the investee and has the
ability to affect those returns through its power over the investee.
The term business is defined in Appendix A as:
An integrated set of activities and assets that is capable of being conducted and managed for the purpose of
providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other
owners, members or participants.
The purpose of defining a business is to distinguish between the acquisition of a group of assets that
does not constitute a business and the acquisition of a business.
Combining two or more separate businesses requires the combination of the assets and liabilities of the
acquirer with those acquired from the acquiree(s). This can occur in a number of ways. For example, if A
Ltd is to be combined with B Ltd, the following possibilities might arise:
1. A Ltd acquires all the assets and liabilities of B Ltd.
B Ltd continues as a company, holding shares in A Ltd.
2. A Ltd acquires all the assets and liabilities of B Ltd.
B Ltd liquidates.
3. C Ltd is formed to acquire all the assets and liabilities of A Ltd and B Ltd.
A Ltd and B Ltd liquidate.
4. A Ltd acquires a group of net assets of B Ltd, the group of net assets constituting a business, such as a
division, branch or segment, of B Ltd.
B Ltd continues to operate as a company.
These possibilities are covered in this chapter.
Entity Entity
A B
Sale of mining division

to entity A
Issue of shares
to entity B
FIGURE 14.1 Identification of a business combination
The most obvious way in which control can be achieved is through one entity acquiring sufficient shares
of another entity on the open market to have a controlling interest. Accounting for that form of business
combination requires the application of the principles discussed in this chapter, but the application fur-
ther involves the preparation of consolidated financial statements. Accounting for these forms of business
combinations is discussed in chapters 20 to 24.
A business combination could also occur without any exchange of assets or equity between the entities
involved in the exchange. For example, a business combination could occur where two entities merged
under a contract. The shareholders of the two entities could agree to adjust the rights of each of their
shareholdings so that they receive a specified share of the profits of both the combined entities. As a result
of the contract, both entities would be under the control of a single management group.
There are many other forms of business combinations that can occur, such as A Ltd acquiring the assets
only of B Ltd, and B Ltd paying off its liabilities and then liquidating. Alternatively, A Ltd may acquire all
of B Ltd’s assets and some of its liabilities, followed by B Ltd settlings its remaining liabilities before liq-
uidating. The three approaches identified in figure 14.2 cover most of the arrangements that are likely to
occur in practice.
IFRS 3 applies to all business combinations except those listed in paragraph 2 of the standard, namely:
• Where the business combination results in the formation of a joint venture. Such a business combination is
accounted for under IFRS 11 Joint Arrangements.
380 PART 2 Elements

• Where the business combination involves entities or businesses under common control. This occurs where
all of the combining entities are controlled by the same party or parties both before and after the
combination, and where control is not transitory. For example, P Ltd owns 100% of S Ltd’s issued
share capital. If P Ltd formed a new wholly owned entity, X Ltd, that acquired all of S Ltd’s equity,
then this would simply constitute an internal reconstruction. All of the combining entities would be
controlled by P Ltd both before and after the reconstruction.
FIGURE 14.2 General forms of business combinations
Alternative 1
A Ltd acquires net assets of B Ltd B Ltd continues, holding shares in A Ltd
A Ltd: B Ltd:
• Receipt of assets and liabilities of B Ltd • Sale of assets and liabilities to A Ltd
• Consideration transferred, e.g. shares, cash or • Gain or loss on sale
other consideration • Receipt of consideration transferred, e.g. shares,
cash or other consideration
Alternative 2
A Ltd acquires net assets of B Ltd B Ltd liquidates
A Ltd: B Ltd:
• As for alternative 1 above, A Ltd • Liquidation account, including gain/loss on
liquidation
• Receipt of purchase consideration
• Distribution of consideration to appropriate
parties, including shareholders via the
Shareholders’ Distribution account
Alternative 3
C Ltd formed A Ltd and B Ltd liquidate
C Ltd: A Ltd and B Ltd:
• Formation of C Ltd with issue of shares • As for alternative 2 above, B Ltd
• Acquisition of assets and liabilities of A Ltd and
B Ltd
• Payment for net assets of A Ltd and B Ltd via
cash outlays or issue of shares in C Ltd
LO2 14.2 ACCOUNTING FOR A BUSINESS

COMBINATION — BASIC PRINCIPLES
The required method of accounting for a business combination under paragraph 4 of IFRS 3 is the acquisi-
tion method. The four key steps in this method are noted in paragraph 5 of the standard:
1. Identify the acquirer.
2. Determine the acquisition date.
3. Recognise and measure the identifiable assets acquired, the liabilities assumed, and any non-controlling
interest in the acquiree.
4. Recognise and measure goodwill or a gain from a bargain purchase.
The acquisition date is the date that the acquirer obtains control of the acquiree. IFRS 3 deals with the
acquisition itself and also with the subsequent measurement and accounting for assets and liabilities rec-
ognised initially at acquisition date.
14.2.1 Identifying the acquirer [step 1]

Paragraph 7 of IFRS 3 states that the acquirer is ‘the entity that obtains control of another entity, i.e.
the acquiree’.
The key criterion, then, in identifying an acquirer is that of control. This term is the same as that used in
IFRS 10 Consolidated Financial Statements for identifying a parent–subsidiary relationship (see chapter 20).
It is often straightforward to identify the acquirer. For example, entity A might acquire shares in entity B.
In other situations, identification of an acquirer requires judgement. Consider the situation where entity
A combines with entity B. To effect the combination, a new company (entity C) is formed, which issues
shares to acquire all the shares of both entities A and B. The subsequent organisational structure is as

Entity C
100% 100%
Entity A Entity B
FIGURE 14.3 Example of entity combination and

subsequent organisational structure
As entity C is created solely to formalise the organisation structure, it is not the acquirer, even though it
is the legal parent of both of the other entities. Paragraph B18 of Appendix B to IFRS 3 states that one of
the entities that existed before the combination must be identified as the acquirer. Entity C is not a party
to the decisions associated with creating the business combination, it is just a vehicle used to facilitate the
combination. If entity A is identified as the acquirer, then entity B’s assets and liabilities are measured at
fair value at acquisition date.
Paragraphs B14–B18 of Appendix B to IFRS 3 provide some indicators to assist in assessing which entity
is the acquirer:
• What are the relative voting rights in the combined entity after the business combination? The acquirer is
usually the entity whose owners have the largest portion of the voting rights in the combined entity.
As noted in paragraph B19, in a reverse acquisition, entity X may issue its shares to acquire the shares
of entity Y. However, because of the greater number of X shares given to the former Y shareholders
relative to those held by the shareholders in entity X before the combination, the former shareholders
in entity Y may have the majority of shares in entity X and be able to determine the operating and
financial policies of the combined entities.
• Is there a large minority voting interest in the combined entity? The acquirer is usually the entity that has
the largest minority voting interest in an entity that has a widely dispersed ownership.
• What is the composition of the governing body of the combined entity? The acquirer is usually the combining
entity whose owners have the ability to elect or appoint or to remove a majority of the members of the
governing body of the combined entity.
• What is the composition of the senior management that governs the combined entity subsequent to the
combination? This is an important indicator given that the criterion for identification of an acquirer
is that of control. If X and Y combine, is the senior management group of the combined entity
dominated by former senior managers of X or Y?
• What are the terms of the exchange of equity interests? Has one of the combining entities paid a premium
over the pre-combination fair value of one of the combining entities, an amount paid in order to gain
control?
• Which entity is the larger? This could be measured by reference to the fair value of each of the
combining entities, or relative revenues or profits. In a takeover, it is normally the larger company that
takes over the smaller company (that is, the larger company is the acquirer).
• Which entity initiated the exchange? Normally the entity that is the acquirer is the one that undertakes
action to take over the acquiree.
Determining the controlling entity is the key to identification of the acquirer. However, doing so may
not be straightforward in many business combinations, and the accountant might be required to make a
reasoned judgement based on the circumstances.
Paragraph 6 requires an acquirer to be identified in every business combination, even though it may be
argued that it is not always possible to do so. In the case of a ‘true’ merger, neither party would claim to
be dominant.
It can also prove difficult to identify an acquirer under a combination achieved by contract alone. Such
a combination may not involve the exchange of readily measurable consideration.
The need to identify the acquirer stems from the need to measure the acquiree’s assets at fair value, but
not those of the acquirer.
14.2.2 Determining the acquisition date [step 2]

The acquisition date is defined in Appendix A to IFRS 3 as:
[t]he date on which the acquirer obtains control of the acquiree.
382 PART 2 Elements

Other dates, such as the date that the contract is signed or the date on which the assets are delivered may
be important issues for management, but they do not necessarily reflect the acquisition date. As noted in
paragraph 9 of IFRS 3, on the closing date of the combination, the acquirer legally transfers the consider-
ation — cash or shares — and acquires the assets and assumes the liabilities of the acquiree. However, in
some cases this may not be the acquisition date.
The definition of acquisition date then relates to the point in time when the net assets of the acquiree
become the net assets of the acquirer — in essence, the date on which the acquirer can recognise the net
assets acquired in its own records.
Identifying the acquisition date is important because:
• The identifiable assets acquired and liabilities assumed by the acquirer are measured at their fair values
on the acquisition date. If markets are volatile then the date could affect the fair value.
• The consideration paid by the acquirer is determined as the sum of the fair values of assets given,
equity issued and/or liabilities undertaken in exchange for the net assets or shares of another entity.
Share prices can fluctuate daily, so the choice of date can affect the measure of fair value.
• The acquirer may acquire only some of the shares of the acquiree. The owners of the balance of the
shares of the acquiree are called the non-controlling interest. This non-controlling interest is measured
at fair value at acquisition date.
• The acquirer may have previously held an equity interest in the acquiree prior to obtaining control of
the acquiree. For example, entity X may have previously acquired 20% of the shares of entity Y, and
now acquires the remaining 80% giving it control of entity Y. The acquisition date is the date when
entity X acquired the 80% interest. The 20% share holding will be recorded as an asset in the records
of entity X. At acquisition date, the fair value of this investment is measured.
The effect of determining the acquisition date is that the financial position of the combined entity
at acquisition date should report the assets and liabilities of the acquiree at that date, and any profits
reported as a result of the acquiree’s operations within the business combination should reflect profits
earned after the acquisition date.
LO3 14.3 ACCOUNTING IN THE RECORDS OF THE ACQUIRER

Where the acquirer purchases assets and assumes liabilities of another entity, it has to consider:
(a) the recognition and measurement of the identifiable assets acquired and the liabilities assumed (step 3
of the acquisition method)
(b) the recognition and measurement of goodwill or a gain from a bargain purchase (step 4 of the acqui-
sition method).
Chapters 20 to 24 deal with the preparation of consolidated financial statements for business combina-
tions where the acquirer purchases the shares of the acquiree. The only aspect of such business combina-
tions that will be covered in this chapter is the recognition and measurement of the investment by the
acquirer (see section 14.6).
LO4 14.4 RECOGNITION AND MEASUREMENT OF ASSETS

ACQUIRED AND LIABILITIES ASSUMED [STEP 3]
14.4.1 Recognition
Paragraph 10 of IFRS 3 states:
As of the acquisition date, the acquirer shall recognise, separately from goodwill, the identifiable assets acquired,
the liabilities assumed and any non-controlling interest in the acquiree. Recognition of identifiable assets
acquired and liabilities assumed is subject to the conditions specified in paragraphs 11 and 12.
Paragraph 4.38 of the Conceptual Framework specifies two recognition criteria for assets and liabilities,
stating that recognition occurs if:
• it is probable that any future economic benefit will flow to or from the entity
• the item has a cost or value that can be reliably measured.
The probability criterion does not really apply in the context of a business combination because the use
of fair values automatically incorporates the probabilities of future economic benefits into the valuation.
For example, an asset whose future expected cash flows were regarded as risky would have a lower fair value.
Paragraph 10 requires the recognition of any non-controlling interest in the acquiree. Non-controlling
interests are discussed in chapter 23.
In paragraphs 11 and 12 of IFRS 3, there are two conditions that have to be met prior to the recognition
of assets and liabilities acquired in the business combination:
Firstly, at the acquisition date, the assets and liabilities recognised by the acquirer must meet the defini-
tions of assets and liabilities in the Conceptual Framework. Any expected future costs cannot be included in
the calculation of assets acquired and liabilities assumed.

Secondly, the item acquired or assumed must be part of the business acquired rather than the result of a
separate transaction.
The first of these conditions can have implications for the treatment of contingent liabilities. If the liability
is contingent upon a future event, such as the outcome of legal action against the acquiree, then nothing needs
to be done. If the liability has been treated as contingent because the future outflows are not regarded as ‘prob-
able’ or because the amounts cannot be measured with sufficient reliability, then it is necessary to attach a fair
value, even though it would have been a breach of IAS 37 Provisions, Contingent Liabilities and Contingent Assets
for the acquiree to have recognised the liability in its financial statements before the combination.
The second condition applies substance over form. For example, suppose the acquiree had a claim out-
standing against the acquirer before the acquisition date. If the acquirer agrees to settle the claim as part of
the combination and part of the consideration includes a sum in settlement of the claim then it would be
necessary to account for the acquisition as two transactions and the sum paid in settlement would have to
be separated out from the consideration.
Paragraph 13 of IFRS 3 notes that a possible result of applying the principles of IFRS 3 may be the recog-
nition of assets and liabilities as a result of the business combination that were not previously recognised by
the acquiree. For example, internally generated intangibles that were not recognised by the acquiree because
of the requirements of IAS 38 Intangible Assets may have to be recognised by the acquirer at fair value.
Paragraph 15 of IFRS 3 requires that the acquirer classifies or designates assets and liabilities on the
basis of the contractual terms, economic conditions, its operating or accounting policies and other perti-
nent conditions that exist at acquisition date. This could, for example, affect the classification of financial
assets at fair value or at amortised cost.
As a part of the illustrative examples accompanying IFRS 3, the IASB provided examples of items
acquired in a business combination that would meet the definition of an intangible asset (see figure 14.4).
CLASS BASIS
Marketing-related intangible assets
Trademarks, trade names, service marks, collective marks and certification marks Contractual
Trade dress (unique colour, shape or package design) Contractual
Newspaper mastheads Contractual
Internet domain names Contractual
Non-competition agreements Contractual
Customer-related intangible assets
Customer lists Non-contractual
Order or production backlog Contractual
Customer contracts and related customer relationships Contractual
Non-contractual customer relationships Non-contractual
Artistic-related intangible assets
Plays, operas and ballets Contractual
Books, magazines, newspapers and other literary works Contractual
Musical works such as compositions, song lyrics and advertising jingles Contractual
Pictures and photographs Contractual
Video and audiovisual material, including motion pictures or films, music videos Contractual
and television programs
Contract-based intangible assets
Licensing, royalty and standstill agreements Contractual
Advertising, construction, management, service or supply contracts Contractual
Lease agreements (whether the acquiree is the lessee or lessor) Contractual
Construction permits Contractual
Franchise agreements Contractual
Operating and broadcasting rights Contractual
Servicing contracts such as mortgage servicing contracts Contractual
Employment contracts Contractual
Use rights, such as drilling, water, air, timber cutting and route authorities Contractual
Technology-based intangible assets
Patented technology Contractual
Computer software and mask works Contractual
Unpatented technology Non-contractual
Databases including title plants Non-contractual
Trade secrets such as secret formulas, processes and recipes Contractual
FIGURE 14.4 Intangible assets, IFRS 3 Illustrative Examples
384 PART 2 Elements

14.4.2 Measurement
Paragraph 18 requires an acquirer to measure the identifiable assets acquired and the liabilities assumed at
their fair values on acquisition date.
Fair value is defined in Appendix A to IFRS 3 as follows:
the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between
Fair value is discussed in detail in chapter 3.
Paragraph BC198 of the Basis for Conclusions on IFRS 3 argues that fair values are relevant, comparable
and understandable.
LO5 14.5 GOODWILL AND GAIN ON BARGAIN

PURCHASE [STEP 4]
The acquirer shall recognise goodwill as of the acquisition date measured as the excess of (a) over (b) below:
(a) the aggregate of:
(i) the consideration transferred measured in accordance with this IFRS, which generally requires acquisition-
date fair value (see paragraph 37);
(ii) the amount of any non-controlling interest in the acquiree measured in accordance with this IFRS; and
(iii) in a business combination achieved in stages (see paragraphs 41 and 42), the acquisition-date fair value
of the acquirer’s previously held equity interest in the acquiree.
(b) the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed meas-
ured in accordance with this IFRS.
In relation to parts (a)(ii) and (iii) in paragraph 32, these will affect calculations only where the acquirer
obtains control by acquiring shares in the acquiree. This is discussed in chapters 20 to 24. This means that for
business combinations discussed in this chapter, goodwill is determined by comparing the consideration
transferred by the acquirer with the net fair value of the identifiable assets and liabilities acquired.
The net fair value of the identifiable assets and liabilities acquired is determined as step 3. The first part
of step 4 is then the measurement of consideration transferred.
14.5.1 Consideration transferred

According to paragraph 37, the consideration transferred:
• is measured at fair value at acquisition date
• is calculated as the sum of the acquisition-date fair values of the assets transferred by the acquirer, the
liabilities incurred by the acquirer to former owners of the acquiree, and the equity interest issued by
the acquirer.
In a specific exchange, the consideration transferred to the acquiree could include just one form of con-
sideration, such as cash, but could equally well consist of a number of forms such as cash, other assets,
shares and contingent consideration. These are considered in the following pages.
Cash or other monetary assets
The fair value is the amount of cash or cash equivalent dispersed. The amount is usually readily determi-
nable. One problem that may occur arises when the settlement is deferred to a time after the acquisition
date. For a deferred payment, the fair value to the acquirer is the amount the entity would have to borrow
to settle the debt immediately. The discount rate used is the entity’s incremental borrowing rate.
Use of cash, including a deferred payment, to acquire net assets results in the acquirer recording the
following form of entry at the acquisition date:
Net assets Dr xxx

Cash Cr xxx
Payable to Acquiree Cr xxx
(Acquisition of net assets with partially deferred payment)
When the deferred payment is made to the acquiree, the interest component needs to be recognised:
Payable to Acquiree Dr xxx

Interest Expense Dr xxx
Cash Cr xxx
(Payment of deferred amount)

Non-monetary assets
Non-monetary assets are assets such as property, plant and equipment, investments, licences and patents.
Chapter 3 discusses how fair values are determined.
The acquirer is effectively selling the non-monetary asset to the acquiree. Hence, it is earning income
equal to the fair value on the sale of the asset. Where the carrying amount of the asset in the records of the
acquirer is different from fair value, a gain or loss on the asset is recognised at acquisition date. This principle
is explained in paragraph 38 of IFRS 3: ‘the acquirer shall remeasure the transferred assets or liabilities to
their fair values as of the acquisition date and recognise the resulting gains or losses, if any, in profit or loss’.
Use of a non-monetary asset such as plant as part of the consideration to acquire net assets results in the
acquirer recording the following entries (assume a cost of plant of $180, a carrying amount of $150 and
fair value of $155):
Plant Cr 25
Gain Cr 5
(Remeasurement as part of consideration transferred in a business
combination)
Net Assets Acquired Dr xxx

Plant Cr 155
Other Consideration Payable Cr xxx
(Acquisition of net assets)
The acquirer recognises a gain on the non-current asset and the asset is then included in the considera-
tion transferred at fair value.
Equity instruments
If an acquirer issues its own shares as consideration, it needs to determine the fair value of those shares at
the acquisition date. For listed entities, reference is made to the quoted prices of the shares. As noted in
paragraph BC342 of the Basis for Conclusions on IFRS 3, ‘equity instruments issued as consideration in a
business combination should be measured at their fair values on the acquisition date’.
Liabilities assumed
The fair values of liabilities assumed are best measured by the present values of expected future cash out-
flows. Future losses or other costs expected to be incurred as a result of the combination are not liabilities
of the acquirer and are therefore not included in the calculation of the fair value of consideration paid.
Costs of issuing debt and equity instruments
Paragraph 53 of IFRS 3 indicates costs to issue debt and equity instruments are accounted for in accord-
ance with IAS 32 Financial Instruments: Presentation and IFRS 9 Financial Instruments. In issuing equity
instruments such as shares as part of the consideration paid, transaction costs such as stamp duties, profes-
sional advisers’ fees, underwriting costs and brokerage fees may be incurred. Paragraph 35 of IAS 32 states
that these outlays should be treated as a reduction in the share capital of the entity as such costs reduce the
proceeds from the equity issue, net of any related income tax benefit. Hence, if costs of $1000 are incurred
in issuing shares as part of the consideration paid, the journal entry in the records of the acquirer is:

Cash Cr 1 000
(Costs of issuing equity instruments)
Similarly, the costs of arranging and issuing financial liabilities are an integral part of the liability issue
transaction. These costs are included in the initial measurement of the liability. Financial liabilities are dis-
cussed further in chapter 7.
Contingent consideration
Appendix A to IFRS 3 provides the following definition of contingent consideration:
Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of
an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are
met. However, contingent consideration also may give the acquirer the right to the return of previously trans-
ferred consideration if specified conditions are met.
Consider two examples of contingencies. The first is where, because the future income of the acquirer
is regarded as uncertain, the agreement contains a clause that requires the acquirer to provide additional
consideration to the acquiree if the income of the acquirer is not equal to or exceeds a specified amount
386 PART 2 Elements

over some specified period. The second situation is where the acquirer issues shares to the acquiree and
the acquiree is concerned that the issue of these shares may make the market price of the acquirer’s shares
decline over time. Therefore, the acquirer may offer additional cash or shares if the market price falls below
a specified amount over a specified period of time.
According to paragraph 39 of IFRS 3, consistent with other measurements in transferred consideration,
the acquirer shall recognise the acquisition-date fair values of contingent consideration as part of the con-
sideration transferred.
14.5.2 Acquisition-related costs

In addition to the consideration transferred by the acquirer to the acquiree, a further item to be considered
in determining the cost of the business combination is the costs directly attributable to the combination,
which includes costs such as ‘finder’s fees; advisory, legal, accounting, valuation and other professional or
consulting fees; [and] general administrative costs, including the costs of maintaining an internal acquisi-
tions department’ (IFRS 3 paragraph 53).
In IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets, directly attributable costs are con-
sidered as a part of the cost of acquisition and capitalised into the cost of the asset acquired. In contrast,
the acquisition-related costs associated with a business combination are accounted for as expenses in the
periods in which they are incurred and the services are received. The key reasons given for this approach
are provided in paragraph BC366 of the Basis for Conclusions on IFRS 3:
• Acquisition-related costs are not part of the fair value exchange between the buyer and seller.
• They are separate transactions for which the buyer pays the fair value for the services received.
• These amounts do not generally represent assets of the acquirer at acquisition date because the benefits
obtained are consumed as the services are received.
The IFRS 3 accounting for these outlays is a result of the decision to record the identifiable assets
acquired and liabilities assumed at fair value. In contrast, under IAS 16 and IAS 38, the assets acquired are
initially recorded at cost.
ILLUSTRATIVE EXAMPLE 14.1 Consideration transferred in a business combination
The trial balance below represents the financial position of Whiting Ltd at 1 January 2016.
WHITING LTD
Trial Balance
as at 1 January 2016
Debit Credit
Share capital
Preference — 6000 fully paid shares $ 6 000
Ordinary — 30 000 fully paid shares 30 000
Equipment $42 000
Accumulated depreciation – equipment 10 000
Inventory 18 000
Accounts receivable 16 000
Patents 3 500
Debentures 4 000
$79 500 $79 500
At this date, the business of Whiting Ltd is acquired by Salmon Ltd, with Whiting Ltd going into liq-
uidation. The terms of acquisition are as follows:
1. Salmon Ltd is to take over all the assets of Whiting Ltd as well as the accounts payable of Whiting Ltd.
2. Costs of liquidation of $350 are to be paid by Whiting Ltd with funds supplied by Salmon Ltd.
3. Preference shareholders of Whiting Ltd are to receive two fully paid preference shares in Salmon Ltd
for every three shares held or, alternatively, $1 per share in cash payable at acquisition date.
4. Ordinary shareholders of Whiting Ltd are to receive two fully paid ordinary shares in Salmon Ltd for
every share held or, alternatively, $2.50 in cash, payable half at the acquisition date and half on 31
December 2016.
5. Debenture holders of Whiting Ltd are to be paid in cash out of funds provided by Salmon Ltd. These
debentures have a fair value of $102 per $100 debenture.
6. All shares being issued by Salmon Ltd have a fair value of $1.10 per share. Holders of 3000 preference
shares and 5000 ordinary shares elect to receive the cash.

7. Costs of issuing and registering the shares issued by Salmon Ltd amount to $40 for the preference
shares and $100 for the ordinary shares.
8. Costs associated with the business combination and incurred by Salmon Ltd were $1000.
The calculation of the consideration transferred in the business combination to Salmon Ltd is shown
in figure 14.5. The incremental borrowing rate for Salmon Ltd is 10% p.a.
Consideration transferred:
Fair value
Cash: Costs of liquidation $ 350
Preference shareholders (3000 × $1.00) 3 000
Ordinary shareholders
– payable immediately (1/2 × 5000 × $2.50) 6 250
– payable later (1/2 × 5000 × $2.50 × 0.909091)* 5 682
Debentures, including premium ($4000 × 1.02) 4 080 $ 19 362
Shares: Preference shareholders (2000 × $1.10) 2 200
Ordinary shareholders (50 000 × $1.10) 55 000 57 200
Consideration transferred $ 76 562
* $5682 is the cash payable in 1 year’s time discounted at 10% p.a.
FIGURE 14.5 Consideration transferred in the business combination

In acquiring the net assets of Whiting Ltd, Salmon Ltd passes the journal entries shown in figure 14.6.
2016
Jan. 1 Net Assets Acquired Dr 76 562
Consideration Payable Cr 19 362
Share Capital – Preference Cr 2 200
Share Capital – Ordinary Cr 55 000
(Acquisition of the net assets of Whiting Ltd)
Consideration Payable Dr 13 680
Cash Cr 13 680
(Payment of cash consideration to Whiting Ltd:
$19 362 less $5682 payable later)
Share Capital – Ordinary Dr 100

Share Capital – Preference Dr 40
Cash Cr 140
(Share issue costs)
Acquisition-Related Expenses Dr 1 000

Cash Cr 1 000
(Acquisition-related expenses)
Dec. 31 Consideration Payable Dr 5 682

Cash Cr 6 250
(Balance of consideration paid)
FIGURE 14.6 Journal entries in the acquirer’s records
14.5.3 Goodwill
As noted at the beginning of section 14.5, goodwill is the excess of the consideration transferred over the net
fair value of the identifiable assets acquired and liabilities assumed.
Goodwill = Consideration transferred

less
Acquirer’s interest in the net fair value of the acquiree’s
identifiable assets and liabilities
Goodwill is accounted for as an asset and is defined in Appendix A to IFRS 3 as:

An asset representing the future economic benefits arising from other assets acquired in a business combination
that are not individually identified and separately recognised.
388 PART 2 Elements

The criterion of ‘being individually identified’ relates to the characteristic of ‘identifiability’ as used in IAS
38 Intangible Assets to distinguish intangible assets from goodwill. Note paragraph 11 of IAS 38 in this regard:
The definition of an intangible asset requires an intangible asset to be identifiable to distinguish it from goodwill.
Goodwill recognised in a business combination is an asset representing future economic benefits arising from
other assets acquired in a business combination that are not individually identified and separately recognised.
The future economic benefits may result from synergy between the identifiable assets acquired or from assets
that, individually, do not qualify for recognition in the financial statements.
In order to be identifiable, an asset must be capable of being separated or divided from the entity, or
arise from contractual or other legal rights. The notion of being ‘separately recognised’ is also then a part
of the criterion of ‘identifiability’. This criterion is discussed further in chapter 13.
Goodwill is then a residual, after the acquirer’s interest in the identifiable tangible assets, intangible
assets, and liabilities of the acquiree is recognised.
The components of goodwill
Johnson and Petrone (1998, p. 295) identified six components of goodwill:
1. Excess of the fair values over the book values of the acquiree’s recognised assets. In a business acquisition, as
assets acquired are measured at fair value, these excesses should not exist. Subsequent to the acquisi-
tion, the acquiree’s goodwill could include such excesses where assets are measured at cost.
2. Fair values of other net assets not recognised by the acquiree. The assets of concern here are those tangible
assets which are incapable of reliable measurement by the acquiree, and non-physical assets that do not
meet the identifiability criteria for intangible assets.
3. Fair value of the ‘going concern’ element of the acquiree’s existing business. This represents the ability of the
acquiree to earn a higher return on an assembled collection of net assets than would be expected from
those net assets operating separately. This reflects synergies of the assets, as well as factors relating to
market imperfections such as an ability of an entity to earn a monopoly profit, or where there are barri-
ers to competitors entering a particular market.
4. Fair value from combining the acquirer’s and acquiree’s businesses and net assets. This stems from the synergies
that result from the combination, the value of which is unique to each combination.
5. Overvaluation of the consideration paid by the acquirer. This relates to errors in valuing the consideration
paid by the acquirer, and may arise particularly where shares are issued as consideration with differences
in prices for small parcels of shares as opposed to controlling parcels of shares. There could also be
overvaluation of the fair values of the assets acquired. This component could then relate to all errors in
measuring the fair values in the business combination.
6. Overpayment (or underpayment) by the acquirer. This may occur if the price is driven up in the course of
bidding; conversely, goodwill could be understated if the acquiree’s net assets were obtained through a
distress or fire sale.
In paragraph BC130 of the Basis for Conclusions on IFRS 3, the IASB recognised that components 1
and 2 are not conceptually part of goodwill. Johnson and Petrone (1998, p. 295) and the IASB (paragraph
BC131) recognised that components 5 and 6 in the above list also are not conceptually part of goodwill,
but rather relate to measurement errors. The two components that are seen as part of goodwill are compo-
nents 3 and 4, described by Johnson and Petrone (p. 296) as ‘going-concern goodwill’ and ‘combination
goodwill’ respectively, with the combination of the components being referred to as ‘core goodwill’. This is
represented diagrammatically in figure 14.7.
Going-concern Combination
goodwill goodwill
Core goodwill
FIGURE 14.7 Core goodwill

Source: Data derived from Johnson and Petrone (1998).
It is this ‘core goodwill’ that the IASB is concerned with in determining how to account for goodwill.
The IASB in paragraph BC137 of the Basis for Conclusions on IFRS 3 notes how IFRS 3 tries to avoid
subsuming the first, second and fifth components into the amount calculated as goodwill by requiring an
acquirer to make every effort to:
• measure the consideration accurately (eliminating or reducing component 5)
• recognise the identifiable net assets acquired at their fair values rather than their carrying amounts
(eliminating or reducing component 1)
• recognise all acquired intangible assets (reducing component 2).

Is goodwill an asset?
IFRS 3 accounts for goodwill as an asset, although it is debatable whether it meets the definition of an
asset as set out in the Conceptual Framework.
The problem with goodwill is that it is a unique asset. It arises as a residual. As Leo, Hoggett and Radford
(1995, pp. 44–7) noted, the key difference between identifiable net assets and goodwill is measurement:
The difference between the measurement method used for goodwill and that for measurement of all other
assets of the business is whether the method involves determining the value of the business as a whole or part
thereof.
The authors defined unidentifiable assets (p. 46) as those assets that meet the recognition criteria and
cannot be measured without measuring the total net assets of a business entity. The existence of goodwill
depends on the measurement of the entity as a whole. In recognising this, the IASB argued in paragraph
BC323 of the Basis for Conclusions on IFRS 3:
control of core goodwill is provided by means of the acquirer’s power to direct the policies and management of
the acquiree. Therefore, both the IASB and the FASB concluded that core goodwill meets the conceptual defini-
tion of an asset.
Accounting for goodwill

As noted earlier, goodwill is calculated as the excess of the consideration transferred in the business
combination over the acquirer’s interest in the net fair value of the identifiable assets acquired and
liabilities assumed from the acquiree. Hence, to calculate goodwill as a part of the acquisition analysis
it is necessary to calculate the consideration transferred and the net fair value of the identifiable assets
acquired and liabilities assumed. A comparison of these two amounts determines the existence of
goodwill. The acquirer then recognises goodwill as an asset in the same way as for all other identifiable
assets acquired.
ILLUSTRATIVE EXAMPLE 14.2 Acquisition analysis
Using the figures from illustrative example 14.1, assume that Salmon Ltd assesses the fair values of the
identifiable assets and liabilities of Whiting Ltd to be as follows:
Equipment $36 000

Inventory 20 000
Patents 10 000
To determine the entries to be passed by the acquirer, prepare an acquisition analysis that compares
the consideration transferred with the net fair value of the identifiable assets, liabilities and contingent
liabilities acquired. The analysis for this example is shown in figure 14.8.
Acquisition analysis
Net fair value of identifiable assets acquired and liabilities assumed:
Equipment $36 000
Inventory 20 000
Patents 10 000
75 000
Net fair value $67 000
Consideration transferred:
This was calculated in figure 14.5 as $76 562.
Goodwill acquired:
Net fair value acquired = $67 000
Consideration transferred = $76 562
Goodwill = $76 562 − $67 000
= $9 562
FIGURE 14.8 Acquisition analysis by the acquirer
390 PART 2 Elements

The journal entries for Salmon Ltd at acquisition date are as shown in figure 14.9.
Equipment Dr 36 000
Inventory Dr 20 000
Accounts Receivable Dr 9 000
Patents Dr 10 000
Goodwill Dr 9 562
(Acquisition of the assets and liabilities of Whiting Ltd)
Consideration Payable Dr 13 680

Cash Cr 13 680
(Payment of cash consideration)

Cash Cr 1 000
(Acquisition-related costs)
Share Capital – Ordinary Dr 100

Share Capital – Preference Dr 40
Cash Cr 140
(Share issue costs)
FIGURE 14.9 Journal entries of the acquirer, including recognition of goodwill, at acquisition date
14.5.4 Accounting for a gain on a bargain purchase

Where the acquirer’s interest in the net fair value of the acquiree’s identifiable assets and liabilities is
greater than the consideration transferred, the difference is called a gain on a bargain purchase. In equa-
tion format, it can be represented as follows:
Gain on bargain purchase = Acquirer’s interest in the net fair value of the acquiree’s
identifiable assets and liabilities
less
Consideration transferred
The existence of a bargain purchase is considered by the standard setters (paragraph BC371) as an anom-
alous transaction as parties to the business combination do not knowingly sell assets at amounts lower
than their fair value. However, because the acquirer has excellent negotiation skills, or because the acquiree
has made a sale for other than economic reasons or is forced to sell owing to specific circumstances such
as cash flow problems, such situations do arise.
The standard setters adopt the view that most business combinations are an exchange of equal amounts,
given markets in which the parties to the business combinations are informed and willing participants in
the transaction. Therefore, the existence of a bargain purchase is expected to be an unusual or rare event.
Paragraph 36 of IFRS 3 requires that before a gain is recognised, the acquirer must reassess whether it
has correctly:
• identified all the assets acquired and liabilities assumed
• measured at fair value all the assets acquired and liabilities assumed
• measured the consideration transferred.
The objective here is to ensure that all the measurements at acquisition date reflect all the information
that is available at that date.
Note that one effect of recognising a bargain purchase is that there is no recognition of goodwill. A gain
on bargain purchase and goodwill cannot be recognised in the same business combination.

ILLUSTRATIVE EXAMPLE 14.3 Gain on bargain purchase
Using the information regarding the consideration transferred in a business combination from illustrative
examples 14.1 and 14.2, assume the fair values of the identifiable assets and liabilities of Whiting Ltd
are assessed to be:
Equipment $45 000

Inventory 25 000
Patents 11 000
90 000
$82 000
The acquisition analysis now shows:
Net fair value of assets and liabilities acquired = $82 000

Gain on bargain purchase = $82 000 − $76 562
= $5438
Assuming that the reassessment process did not result in any changes to the fair values calculated, the
first journal entry in Salmon Ltd to record the acquisition of the net assets of Whiting Ltd is:
Equipment Dr 45 000
Inventory Dr 25 000
Patents Dr 11 000
Gain (Profit or Loss) Cr 5 438
(Acquisition of assets and liabilities acquired from Whiting Ltd,
and the gain on bargain purchase)
LO6 14.6 SHARES ACQUIRED IN THE ACQUIREE

Where an entity acquires shares in another entity, rather than the net assets of that entity, the measurement
of the initial investment in these financial assets is in accordance with IFRS 9 Financial Instruments at fair
value plus transaction costs.
Accounting for financial assets is covered in chapter 7.
LO7 14.7 ACCOUNTING IN THE RECORDS OF THE ACQUIREE

Where the acquirer purchases the acquiree’s assets and liabilities, the acquiree may continue in existence
or may liquidate. The acquiree accounts affected by the business combination will differ according to the
actions of the acquiree.
14.7.1 Acquiree does not liquidate

In the situation where the acquiree disposes of a business, the journal entries required in the records
of the acquiree are shown in figure 14.10. Under IAS 16 Property, Plant and Equipment, when an item of
property, plant and equipment is sold, gains or losses are recognised in the statement of profit or loss
and other comprehensive income. Similarly, on the sale of a business, the acquiree recognises a gain
or loss.
392 PART 2 Elements

Receivable from Acquirer Dr xxx
Liability A Dr xxx
Liability B Dr xxx
Liability C Dr xxx
Asset A Cr xxx
Asset B Cr xxx
Asset C Cr xxx
Gain on Sale of Operation Cr xxx
(Sale of operation)
Shares in Acquirer Dr xxx

Cash Dr xxx
Receivable from Acquirer Cr xxx
(Receipt of consideration from acquirer)
FIGURE 14.10 Journal entries of acquiree on sale of business
14.7.2 Acquiree liquidates

The entries required in the records of the acquiree when it sells all its net assets to the acquirer are shown
in figure 14.11. The accounts of the acquiree are transferred to two accounts, the Liquidation account and
the Shareholders’ Distribution account.
To the Liquidation account are transferred:
• all assets taken over by the acquirer, including cash if relevant, as well as any assets not taken over and
which have a zero value, including goodwill
• all liabilities taken over
• the expenses of liquidation if paid by the acquiree
• additional expenses to be paid by the acquiree but not previously recognised by the acquiree
• consideration from the acquirer as proceeds on sale of net assets
• all reserves, including retained earnings.
The balance of the Liquidation account is then transferred to the Shareholders’ Distribution account.
FIGURE 14.11 Journal entries of acquiree on liquidation after sale of net assets
Liquidation Dr xxx
Asset A Cr xxx
Asset B Cr xxx
Asset C Cr xxx
(Transfer of all assets acquired by acquirer, at their carrying
amounts)
Liability A Dr xxx
Liability B Dr xxx
Liability C Dr xxx
Liquidation Cr xxx
(Transfer of all liabilities assumed by the acquirer)
Liquidation Dr xxx
Cash Cr xxx
(Liquidation and other expenses not recognised previously, if paid
by the acquiree)
Receivable from Acquirer Dr xxx
Liquidation Cr xxx
(Consideration for net assets sold)
Cash Dr xxx
Shares in Acquirer Dr xxx
Receivable from Acquirer Cr xxx
(Receipt of consideration)
Other Reserves Dr xxx
Retained Earnings Dr xxx
Liquidation Cr xxx
(Transfer of reserves)
(continued)

Liquidation Dr xxx
Shareholders’ Distribution Cr xxx
(Transfer of balance of liquidation)
Share Capital Dr xxx

Shareholders’ Distribution Cr xxx
(Transfer of share capital)
Shareholders’ Distribution Dr xxx

Cash Cr xxx
Shares in Acquirer Cr xxx
(Distribution of consideration to shareholders)
To the Shareholders’ Distribution account are transferred:

• the balance of share capital
• the balance of the Liquidation account
• the portion of the consideration received from the acquirer that is distributed to the shareholders.
Some of the consideration received by the acquiree may be used to pay for liabilities not assumed by
the acquirer, and for liquidation expenses.
ILLUSTRATIVE EXAMPLE 14.4 Entries in the acquiree’s records
Using the information from illustrative example 14.1, the entries in the records of Whiting Ltd are
FIGURE 14.12 Liquidation of acquiree
Liquidation Dr 69 500
Accumulated Depreciation – Equipment Dr 10 000
Equipment Cr 42 000
Inventory Cr 18 000
Accounts Receivable Cr 16 000
Patents Cr 3 500
(Assets taken over)
Accounts Payable Dr 8 000

Liquidation Cr 8 000
(Liabilities taken over)
Liquidation Dr 350
Liquidation Expenses Payable Cr 350
(Liquidation expenses payable by acquiree)
Liquidation Dr 80
Debenture Holders Payable Cr 80
(Premium expense on debentures to be paid on redemption)
Receivable from Salmon Ltd Dr 76 562

(Consideration receivable)
Cash Dr 13 680
Shares in Salmon Ltd Dr 57 200
Receivable from Salmon Ltd Cr 70 880
(Receipt of consideration from acquirer)

(Transfer of retained earnings)
Liquidation Dr 36 132
Shareholders’ Distribution Cr 36 132
(Balance of Liquidation account transferred to
Shareholders’ Distribution)
394 PART 2 Elements

Share Capital – Ordinary Dr 30 000
Share Capital – Preference Dr 6 000
Shareholders’ Distribution Cr 36 000
(Transfer of share capital)
Debentures Dr 4 000
Debenture Holders Payable Cr 4 000
(Transfer of debentures to payable account)
Liquidation Expenses Payable Dr 350
Debenture Holders Payable Dr 4 080
Cash Cr 4 430
(Payment of liabilities)
Shareholders’ Distribution Dr 72 132

Cash Cr 9 250
Shares in Salmon Ltd Cr 57 200
Receivable from Salmon Ltd Cr 5 682
(Payment to shareholders)
14.7.3 Acquirer buys only shares in the acquiree

When the acquirer buys only shares in the acquiree, there are no entries in the records of the acquiree
because the transaction is between the acquirer and the shareholders of the acquiree entity. The acquiree
itself is not involved.
LO8 14.8 SUBSEQUENT ADJUSTMENTS TO THE INITIAL

ACCOUNTING FOR A BUSINESS COMBINATION
Three areas where adjustments may need to be made subsequent to the initial accounting after acquisition
date are:
• goodwill
• contingent liabilities
• contingent consideration.
Goodwill
Having recognised goodwill arising in the business combination, the subsequent accounting is directed
from other accounting standards:
• goodwill is not subject to amortisation but is subject to an annual impairment test as detailed in IAS
36 Impairment of Assets (see chapter 15).
• goodwill cannot be revalued because IAS 38 Intangible Assets does not allow the recognition of
internally generated goodwill.
Contingent liabilities
Having recognised any contingent liabilities of the acquiree as liabilities, the acquirer must then determine
a subsequent measurement for the liability. The liability is initially recognised at fair value. Subsequent to
acquisition date, according to paragraph 56 of IFRS 3, the liability is measured as the higher of:
(a) the amount that would be recognised in accordance with IAS 37; and
(b) the amount initially recognised less, if appropriate, cumulative amortisation recognised in accordance with
IAS 18 Revenue.
Under IAS 37 paragraph 36, the liability would be measured at the best estimate of the expenditure
required to settle the present obligation at the end of the reporting period. This would be used, for
example, where a liability was recognised in relation to a court case. However, the IASB was also concerned
about contingent liabilities such as guarantees or other financial liabilities. Under IAS 39 paragraph 47,
the subsequent measurement of financial liabilities requires preparers to use the higher of the IAS 37
measurements and the amount initially recognised subject to amortisation in line with IAS 18. In order
for IFRS 3 to be consistent with IAS 39, the measurement method to be used in subsequent accounting for
contingent liabilities was made the same as that in IAS 39.
Contingent consideration
At acquisition date, the contingent consideration is measured at fair value, and is classified either as equity
(e.g. the requirement for the acquirer to issue more shares subject to subsequent events) or as a liability

(e.g. the requirement to provide more cash subject to subsequent events). Subsequent to the business com-
bination, paragraph 54 of IFRS 3 requires the accounting for contingent consideration to be in accordance
with the accounting standard that would normally apply to these accounts. However, IFRS 3 provides
guidance on the measures to be used.
Where the contingent consideration is classified as equity, no remeasurement is required, and the subse-
quent settlement is accounted for within equity (IFRS 3 paragraph 58(a)). This means that if extra equity
instruments are issued they are effectively issued for no consideration and there is no change to share capital.
Where the contingent consideration is a financial liability, it will be accounted for under IAS 39 and
measured at fair value with movements being accounted for in accordance with that standard. If it is a
liability not within the scope of IAS 39, it is accounted for in accordance with IAS 37. So, if there were
changes in the amount of an expected cash outflow, the liability would be adjusted and an amount recog-
nised in profit or loss.
It should be noted that the subsequent accounting for contingent consideration is to treat it as a post-
acquisition event; that is, not affecting the measurements made at acquisition date. Hence, any subsequent
adjustments do not affect the goodwill calculated at acquisition date.
ILLUSTRATIVE EXAMPLE 14.5 Comprehensive example
Labrador Ltd’s major business is in the pet food industry. It makes a number of canned pet foods,
mainly for cats and dogs, as well as having a very promising line in dry dog food. It has been interested
for some time in the operations of Pelican Ltd, an entity that deals with the processing of grain products
for a number of other industries including flour-processing, health foods and, in more recent times, the
production of grain products for feeding birds. Given its interest in the pet food industry and its desire
to stay as one of the leaders in this area, Labrador Ltd began negotiations with Pelican Ltd to acquire its
birdseed product division.
Negotiations began in July 2015. After months of discussion between the relevant parties of both
companies, an agreement was reached on 15 February 2016 for Labrador Ltd to acquire the birdseed
division. The agreement document was taken to the board of directors of Pelican Ltd who ratified the
agreement on 1 March 2016. The net assets were exchanged on this date.
The net assets of the birdseed division at 1 March 2016, showing the carrying amounts at that date
and the fair values as estimated by Labrador Ltd from documentation supplied by Pelican Ltd, were as
shown below:
Carrying amount Fair value

Plant and equipment $ 160 000 $ 167 000
Land 70 000 75 000
Motor vehicles 30 000 32 000
Inventory 24 000 28 000
Total assets 302 000 318 000
Bank overdraft 55 000 55 000
Total liabilities 90 000 90 000
Net assets $ 212 000 $ 228 000
Details of the consideration Labrador Ltd agreed to provide in exchange for the net assets of the division
are described below:
• 100 000 shares in Labrador Ltd — movements in the share price were as follows:
1 July 2015 $1.00

1 October 2015 1.10
1 January 2016 1.15
1 February 2016 1.30
15 February 2016 1.32
16 February 2016 1.45
1 March 2016 1.50
• Because of doubts as to whether it could sustain a share price of at least $1.50, Labrador Ltd agreed to
supply cash to the value of any decrease in the share price below $1.50 for the 100 000 shares issued,
this guarantee of the share price lasting until 31 July. Labrador Ltd believed that there was a 90% chance
that the share price would remain at $1.50 or higher and a 10% chance that it would fall to $1.48.
• Cash of $40 000, half to be paid on the date of acquisition and half in 1 year’s time.
396 PART 2 Elements

• Supply of a patent relating to the manufacture of packing material. This has a fair value of $60 000
but has not been recognised in the records of Labrador Ltd because it resulted from an internally
generated research project.
• Pelican Ltd was currently being sued for damages relating to a claim by a bird breeder who had bought
some seed from the company, and claimed that this resulted in the death of some prime breeding
pigeons. Labrador Ltd agreed to pay any resulting damages in relation to the court case. The expected
damages were $40 000. Lawyers estimated that there was only a 20% chance of losing the case.
Labrador Ltd supplied the cash on the acquisition date as well as surrendering the patent. The shares
were issued on 5 March, and the costs of issuing the shares amounted to $1000. The incremental bor-
rowing rate for Labrador Ltd is 10% p.a. Acquisition-related costs paid by Labrador Ltd in relation to the
acquisition amounted to $5000.
On 31 July the share price of Labrador Ltd’s shares was $1.52.
Required
Prepare the journal entries in the records of the acquirer.
Solution
Net fair value of assets acquired and liabilities assumed
Plant and equipment $ 167 000
Land 75 000
Motor vehicles 32 000
Inventory 28 000
318 000
Bank overdraft 55 000
Provision for damages (20% × $40 000) 8 000
98 000
$ 220 000
Purchase consideration:
Shares: 100 000 × $1.50 $ 150 000
Guarantee: 10% ($1.50 − $1.48) × 100 000 200
Cash: Payable now 20 000
Deferred ($20 000 × 0.909 091) 18 182
Patent 60 000
$ 248 382
Goodwill ($248 382 − $220 000) $ 28 382
The journal entries of the acquirer, Labrador Ltd, are shown in figure 14.13.
FIGURE 14.13 Journal entries of the acquirer
2016
March 1 Plant and Equipment Dr 167 000
Land Dr 75 000
Motor Vehicles Dr 32 000
Inventory Dr 28 000
Goodwill Dr 28 382
Bank Overdraft Cr 55 000
Provision for Damages Cr 8 000
Provision for Loss in Value of Shares Cr 200
Cash Cr 20 000
Gain on Sale of Patent Cr 60 000
(Acquisition of birdseed division from Pelican Ltd)
(continued)


Cash Cr 5 000
March 5 Share Capital Dr 1 000

Cash Cr 1 000
(Costs of issuing shares)
July 31 Provision for Loss in Value of Shares Dr 200

Gain Cr 200
(Contingency not having to be paid)
LO9 14.9 DISCLOSURE — BUSINESS COMBINATIONS

Paragraphs 59–63 of IFRS 3 contain information on disclosures required in relation to business combi-
nations. To meet these disclosure requirements it is necessary to apply Appendix B of IFRS 3, which is an
integral part of IFRS 3 containing application guidance.
Paragraph 59 requires entities to disclose information about the nature and financial effect of business
combinations occurring during the current reporting period, or after the end of the reporting period but
before the financial statements are authorised for issue. Paragraphs B64–B66 contain information to assist
preparers to meet the disclosure objective in paragraph 59.
Note the qualitative information required to be disclosed under paragraph B64. In particular, note B64(d)
which requires disclosure of the primary reasons for the business combination as well as a description of
how the acquirer obtained control of the acquiree. This information should assist users to evaluate the
success of the business combination and judge the ability of management to make investment decisions.
Also note that paragraph B64(e) requires disclosure of ‘a qualitative description of the factors that make up
goodwill recognised, such as expected synergies from combining operations of the acquiree and the acquirer,
intangible assets that do not qualify for separate recognition or other factors’. Goodwill is not to be consid-
ered just a residual calculation. As explained in section 14.5.3, core goodwill can consist of elements such as
combination goodwill and going-concern goodwill. An understanding of where the synergies exist will assist
management in managing the earnings from goodwill as well as in any later impairment tests of goodwill
(see chapter 15 for more details concerning impairment testing). Unrecognised intangible assets may also be
included in goodwill (see chapter 13 for information on accounting for intangible assets in a business combination).
Paragraph 61 of IFRS 3 requires the disclosure of information to assist in the evaluation of the financial
effects of adjustments recognised in the current period that relate to business combinations occurring in pre-
vious periods. Paragraph B67 details disclosures required in meet the information objective in paragraph 61.
An example of the required disclosures is provided in figure 14.14.
FIGURE 14.14 Disclosures required by Labrador Ltd under IFRS 3
IFRS 3
26. Business combinations paragraph
Acquisition of division from Pelican Ltd

During the current reporting period, the company acquired the birdseed division of B64(a)
Pelican Ltd. The acquisition date was 1 March 2016. The company has not had to B64(b)
dispose of any operations as a result of this combination. The primary reason for the B64(d)
business combination was to gain synergies in terms of the sales outlets for products
sold by both entities.
The consideration transferred to Pelican Ltd was $248 382. The components of the cost B64(f)
were:
Shares in the company $150 000
Cash paid and payable 38 182
Patent for packaging 60 000
Guarantee relating to the maintenance of the company’s share price 200 B64(g)(i)
The contingent consideration — the guarantee — was measured at acquisition date at B64(g)(ii)
$200 being based on an analysis of probable movements in share prices and budgeted
information on future sales. The company issued 100 000 shares, determining a fair B64(f)(iv)
value of $1.50 based on the current market price of the company at 1 March 2016 as
reported by the stock exchange.
398 PART 2 Elements

The assets acquired and liabilities assumed from Pelican Ltd were, as at 1 March 2016: B64(i)

Plant and equipment $160 000 $ 167 000
Land 70 000 75 000
Inventory 24 000 28 000
302 000 318 000
90 000 90 000
Contingent liability acquired 8 000 8 000
98 000
Net assets acquired $ 220 000
Goodwill of $28 382 was recognised in the acquisition, the extra consideration being B64(e)
paid due to the excellent reputation and customer following relating to the quality of
the birdseed products.
An adjustment of $2000 was made to the fair value of the plant and equipment and B67(a)
goodwill subsequent to the acquisition due to the provisional nature of the fair value
of some of the specialised equipment determined at acquisition date.
The contingent liability acquired related to a court case involving a claim from a B64(j)
customer that certain bird food was of poor quality. If the court case were lost, which
is not expected, the damages could be $40 000. A present obligation is regarded as
existing at the end of the reporting period.
Subsequent to the end of the reporting period, the provision in relation to the B64(g)(iii)
company’s guarantee in relation to maintenance of the share price expired. No extra
payment was required, as the share price had been maintained.
Acquisition-related costs amounted to $5 000, all of which was recognised as an B64(m)
expense against the line item ‘operating expenses’. Share issue costs of $1000 were
treated as a reduction in share capital.
Acquisition of shares in Cages Ltd
On 1 August 2015, the company acquired 100% of the shares in Cages Ltd, a B64(a),(b),(c)
company involved mainly in manufacturing bird cages, for $100 000. The primary B64(d)
reason for acquiring the company was to expand the variety of products sold to B64(f)
customers in the same industry. The consideration paid was cash.
The assets and liabilities of Cages Ltd at acquisition date were: B64(i)

Plant and equipment $ 82 000 $ 88 000
Vehicles 22 000 20 000
Cash 12 000 12 000
124 000 127 000
Net assets $ 92 000 $ 95 000
Goodwill of $5000 was acquired, attributable to a quality, well-trained workforce. B64(e)

The consolidated revenue for the consolidated group is $952 000. If the business B64(q)
combinations occurring during the year had occurred on 1 July 2015 instead of
during the year, it is estimated that consolidated revenue would have been $985 000.
The consolidated profit under the same assumption would have been $322 000
instead of $299 000.
(continued)

27. Goodwill
2016 2015
Gross amount at beginning of period $ 20 600 $ 19 600 B67(d)(i)
Accumulated impairment losses 500 300
20 100 19 300
Goodwill acquired 35 380 3 000 B67(d)(ii)
55 480 22 300
Adjustments — tax assets recognised — 2 000 B67(d)(iii)
20 300
Impairment losses for current period — 200 B67(d)(iv)
Carrying amount at end of period $ 55 480 $ 20 100
Consisting of: B67(d)(viii)

Gross amount at end of period $ 55 980 $ 20 600
Accumulated impairment losses 500 500
$ 55 480 $ 20 100
SUMMARY
IFRS 3 was issued in January 2008 on completion of a major project on business combinations undertaken
by the IASB. IFRS 3 specifies accounting standards that have implications not only for the exchanges of assets
between entities but also for the accounting for subsidiaries and associated entities. The standard specifies
how an acquirer accounts for the assets and liabilities acquired as well as the measurement of the consider-
ation transferred. In making these calculations, the acquirer must determine the acquisition date as all fair
value measurements are made at acquisition date. The standard interacts with other standards such as IAS
38 Intangible Assets and IAS 37 Provisions, Contingent Liabilities and Contingent Assets because the acquirer has
to recognise intangible assets and liabilities acquired in a business combination. The nature and calculation
of goodwill is also covered in this accounting standard, as is the treatment of a gain on a bargain purchase.
Entities commonly trade with each other, exchanging one set of assets for another. When a grouping of
assets constitutes a business, the accounting for the exchange transaction is determined by IFRS 3. IFRS 3
requires the application of the acquisition method under which the accountant must be able to identify
which of the entities involved in the combination is the acquirer. The identifiable assets and liabilities
acquired are measured at fair value at the acquisition date.
Goodwill or the gain on a bargain purchase is determined as a residual which, for the business com-
binations considered in this chapter, is generally determined by comparing the consideration transferred
and the net fair value of the identifiable assets and liabilities acquired. Where the acquirer acquires the
shares in the acquiree and where the acquirer already holds some shares in the acquiree at the acquisition
date, the determination of goodwill is more involved. Understanding the nature of goodwill is essential
to understanding how to account for it. With the existence of the accounting standard on impairment of
assets, goodwill is not required to be amortised. Where a bargain purchase arises, the gain is recognised in
current period income.
DEMONSTRATION PROBLEM 14.1 Acquisition analyses
On 1 January 2016, Trevally Ltd concluded agreements to take over the operations of Mackerel Ltd and
to acquire the rest of the shares of Perch Ltd. The statements of financial position of the three companies
as at that date were:
Trevally Ltd Mackerel Ltd Perch Ltd
Cash $ 20 000 $ 1 000 $ 12 500
Accounts receivable 35 000 19 000 30 000
Inventory 52 000 26 500 40 000
Property, plant and equipment (net) 280 500 149 500 107 500
Shares in Perch Ltd (15 000 shares) 19 000 — —
Debentures in Hangi Ltd 45 000 18 000 —
$ 451 500 $ 214 000 $ 190 000
400 PART 2 Elements

Trevally Ltd Mackerel Ltd Perch Ltd
Accounts payable $ 78 000 $ 76 000 $ 27 500
Loan payable — 40 000 —
$10 debentures — nominal value — — 50 000
Share capital — issued at $1 300 000 80 000 70 000
Retained earnings 73 500 18 000 42 500
$ 451 500 $ 214 000 $ 190 000
Mackerel Ltd included in the notes to its accounts a contingent liability relating to a guarantee for a
loan. Although a present obligation existed, a liability was not recognised by Mackerel Ltd because of
the difficulty of measuring the ultimate amount to be paid.
The details of the acquisition agreements are as follows.
Mackerel Ltd
Trevally Ltd is to acquire all the assets (except cash) and all the liabilities of Mackerel Ltd. In exchange
for every four shares in Mackerel Ltd, shareholders are to receive three shares in Trevally Ltd and $1.00
in cash. Each share in Trevally Ltd has a fair value of $1.80. Trevally Ltd is to pay additional cash to
Mackerel Ltd to cover the total liquidation expenses of Mackerel Ltd which are expected to amount to
$6000. The cash already held by Mackerel Ltd is to go towards the liquidation costs. The assets of
Mackerel Ltd are all recorded in Mackerel Ltd’s records at cost (depreciated if applicable). The fair values
of Mackerel Ltd’s assets are:
Receivables $ 17 500
Inventory 32 000
Property, plant and equipment 165 500
Debentures in Hangi Ltd 19 000
Mackerel Ltd had been undertaking research into new manufacturing machinery, and had expensed
a total of $10 000 research costs. Trevally Ltd determined that the fair value of this in-process research
was $2000 at acquisition date. The contingent liability relating to the guarantee was considered to have
a fair value of $1500.
External accounting advice and valuers’ fees amounted to $3000.
Perch Ltd
Trevally Ltd is to acquire the remaining issued capital of Perch Ltd. In exchange, the shareholders in
Perch Ltd are to receive four shares in Trevally Ltd for every five shares held in Perch Ltd. The shares
already held in Perch Ltd are valued at $21 600. They have been measured at fair value with movements
in fair value being recognised in profit or loss.
The legal costs incurred by Trevally Ltd in issuing its shares to Mackerel Ltd and Perch Ltd amounted
to $1300 and $800 respectively.
Required
Prepare the acquisition analyses and journal entries necessary to record the acquisition of both Mackerel
Ltd and Perch Ltd in the records of Trevally Ltd.
Solution
Prepare acquisition analyses and journal entries
The first step is to analyse the nature of the business combination, in particular what happens to each
entity involved in the transactions. In this example, Trevally Ltd is the acquirer. It acquires assets and
liabilities of Mackerel Ltd, probably with the latter entity going into liquidation. With Perch Ltd, Trevally
Ltd acquires only shares in that entity; hence, the transaction is between Trevally Ltd and the share-
holders of Perch Ltd and not with Perch Ltd.
Considering the combination between Trevally Ltd and Mackerel Ltd, the first step is to prepare an
acquisition analysis. This involves looking at the two sides of the transaction, determining the fair value
of the identifiable assets acquired and liabilities assumed and calculating the consideration transferred.
The difference between these two amounts will be goodwill or gain on bargain purchase.
1. Acquisition analysis — Trevally Ltd and Mackerel Ltd
Trevally Ltd acquired all the assets except cash, and assumed all the liabilities of Mackerel Ltd. These
assets and liabilities are now measured at fair value.

Accounts receivable $ 17 500
Inventory 32 000
Property, plant and equipment 165 500
Debentures in Hangi Ltd 19 000
In-process research 2 000
236 000
Provision for guarantee 1 500
Loan payable 40 000
117 500
Net fair value $ 118 500
The consideration transferred is the purchase consideration payable to Mackerel Ltd and is measured as
the sum of the fair values of shares issued, liabilities undertaken and assets given up by the acquirer. In
this example, Trevally Ltd issues shares and gives up cash. The share price is the fair value of the shares
at the acquisition date.
Shares: Share capital of Mackerel Ltd $80 000
Shares issued by Trevally Ltd (3/4) 60 000 × $1.80 $ 108 000
Cash: 80 000/4 × $1.00 20 000
Liquidation costs 6 000
Less: Held by Mackerel Ltd (1 000) 25 000
Consideration transferred $ 133 000
The consideration transferred is then compared with the net fair value of the identifiable assets and
liabilities acquired to determine whether goodwill or a gain arises. In this case the consideration trans-
ferred is greater; hence, goodwill has been acquired.
Goodwill = $133 000 − $118 500 = $14 500
2. Acquisition analysis — Trevally Ltd and Perch Ltd

In this situation, Trevally Ltd acquires the shares in the acquiree rather than the actual assets and lia-
bilities. Note that Trevally Ltd can gain control over the net assets of another entity by either buying
the actual net assets or by acquiring a controlling interest in the entity that holds those net assets. The
acquisition of the shares as an asset is not a business combination. However, by acquiring the shares, a
business combination may have occurred, and a set of consolidated financial statements is prepared for
the combined businesses using the principles of IFRS 3.
Cost of shares acquired

Share capital of Perch Ltd $ 70 000
Already held by Trevally Ltd 15 000
To acquire $ 55 000
Trevally Ltd to issue 55 000 × 4/5 × $1.80 = $ 79 200
The shares already held by Trevally Ltd in Perch Ltd are recorded at $19 000 at acquisition date. The fair
value is $21 600. The investment is revalued at acquisition date to fair value, and the difference between
these two amounts, $2600, is recorded as a gain.
The general journal entries in Trevally Ltd can then be read from the acquisition analysis. Note that
when shares are issued the relevant account is ‘Share Capital’.
402 PART 2 Elements

Inventory Dr 32 000
Property, Plant and Equipment Dr 165 500
Debentures in Hangi Ltd Dr 19 000
In-process Research Dr 2 000
Goodwill Dr 14 500
Loan Payable Cr 40 000
Provision for Guarantee Cr 1 500
Payable to Mackerel Ltd Cr 25 000
(Acquisition of net assets of Mackerel Ltd)
Payable to Mackerel Ltd Dr 25 000
Cash Cr 25 000
(Payment of consideration transferred)
Acquisition-Related Expenses Dr 3000
Cash Cr 3000
Shares in Perch Ltd Dr 2 600
Gain on Revaluation of Investment Cr 2 600
(Revaluation of investment to fair value)
Shares in Perch Ltd Dr 79 200
(Purchase of remaining shares in Perch Ltd)
Cash Cr 2 100
(Share issue costs incurred)
Note that the costs of share issue reduce the Share Capital account which shows the net proceeds from
share issues.
DEMONSTRATION PROBLEM 14.2 Acquisition and liquidation
On 1 July 2016, Smetana Ltd and Bay Ltd sign an agreement whereby the operations of Bay Ltd are to
be taken over by Smetana Ltd. Bay Ltd will liquidate after the transfer is complete. The statements of
financial position of the two companies on that day were as shown below.
Smetana Ltd Bay Ltd

Cash $ 50 000 $ 20 000
Inventory 46 000 29 000
Land 65 000 —
Accumulated depreciation — plant and equipment (60 000) (40 000)
Patents 10 000 —
Shares in Cape Ltd — 26 000
Debentures in Brett Ltd (nominal value) 10 000 —
$ 376 000 $ 258 000
Accounts payable $ 62 000 $ 31 000

10% debentures (face value) 100 000 30 000
Contributed equity:
Ordinary shares of $1, fully paid 100 000 —
A class shares of $2, fully paid — 40 000
B class shares of $1, fully paid 60 000
$376 000 $258 000

Smetana Ltd is to acquire all the assets of Bay Ltd (except for cash). The assets of Bay Ltd are recorded at
their fair values except for:

Inventory $ 29 000 $ 39 200
Shares in Cape Ltd 26 000 22 500
In exchange, the A class shareholders of Bay Ltd are to receive one 7% debenture in Smetana Ltd,
redeemable on 1 July 2016, for every share held in Bay Ltd. The fair value of each debenture is $3.50.
Smetana Ltd will also provide one of its patents to be held jointly by the A class shareholders of Bay Ltd
and for which they will receive future royalties. The patent is carried at $4000 in the records of Smetana
Ltd, but is considered to have a fair value of $5000.
The B class shareholders of Bay Ltd are to receive two shares in Smetana Ltd for every three shares
held in Bay Ltd. The fair value of each Smetana Ltd share is $2.70. Costs to issue these shares amount
to $900. Additionally, Smetana Ltd is to provide Bay Ltd with sufficient cash, additional to that already
held, to enable Bay Ltd to pay its liabilities. The outstanding debentures are to be redeemed at a 10%
premium. Annual leave entitlements of $16 200 outstanding at 1 July 2016 and expected liquidation
costs of $5000 have not been recognised by Bay Ltd. Costs incurred in arranging the business combina-
tion amounted to $1600.
Required
(a) Prepare the journal entries in the records of Smetana Ltd to record the acquisition of Bay Ltd.
(b) Prepare the Liquidation, Liquidator’s Cash and Shareholders’ Distribution ledger accounts in the
records of Bay Ltd.
Solution
1. Prepare the journal entries of Smetana Ltd
The nature of the transaction in this question is that the acquirer, Smetana Ltd, is acquiring the opera-
tions (assets and liabilities) of Bay Ltd with the acquiree going into liquidation.
The first step is to prepare the acquisition analysis, which is a comparison of the fair value of the iden-
tifiable assets acquired and liabilities assumed with the consideration transferred.
Acquisition analysis — Smetana Ltd and Bay Ltd
Note that all the assets acquired and the liabilities assumed by the acquirer are measured at fair value.
Accounts receivable $ 56 000

Inventory 39 200
Plant and equipment 155 000
Shares in Cape Ltd 22 500
$272 700
The consideration transferred is measured by calculating the fair value of the assets given up, liabilities
undertaken and shares issued by the acquirer. In this example, the acquirer issues shares and debentures
in itself, gives up a patent and provides cash.
Purchase consideration
Shareholders
Debentures: A shares of Bay Ltd 20 000
Debentures in Smetana (1/1) 20 000 × $3.50 $ 70 000
Shares: B shares of Bay Ltd 60 000
Shares in Smetana (2/3) 40 000 × $2.70 108 000
Patent 5 000
Creditors 30 000
Cash: Debentures issued 3 000
Plus premium (10%) 33 000
404 PART 2 Elements

Mortgage loan 21 500
Liquidation costs 5 000
Annual leave 16 200
Total cash required 106 700
Less: Already held (20 000) $ 86 700
Total consideration transferred 269 700
Because the total consideration transferred is less than the net fair value of the identifiable assets and liabil-
ities acquired, the acquirer has to assess the measurements undertaken in the acquisition analysis. Having
been assured that all relevant assets and liabilities have been included and that the fair values are reliable,
the difference is then accounted for as a bargain purchase, and is included in current period income.
Gain on bargain purchase [$272 700 − $269 700] $3 000
The general journal entries can then be read from the acquisition analysis. Note that when shares are
issued the relevant account is ‘Share Capital’.
In relation to the patent, prior to accounting for the business combination, the acquirer remeasures
the asset to fair value.
Patent Dr 1000
Gain Cr 1000
(Remeasurement to fair value as part of consideration
transferred on business combination)

Inventory Dr 39 200
Property, Plant and Equipment Dr 155 000
Shares in Cape Ltd Dr 22 500
Payable to Bay Ltd Cr 156 700
Patent Cr 5 000
Gain on Bargain Purchase Cr 3 000
(Acquisition of Bay Ltd)
Payable to Bay Ltd Dr 156 700

7% Debentures Cr 70 000
Cash Cr 86 700
(Payment of consideration)

Cash Cr 1600
Share Capital Dr 900

Cash Cr 900
(Payment of share issue costs)
Note that the costs of share issue reduce the share capital issued with the Share Capital account then
showing the net proceeds from share issues.
2. Prepare the ledger accounts of Bay Ltd
The Liquidation account effectively records the sale of the assets and the receipt of the purchase consideration.
• All items being sold by the acquiree — whether assets or a package of assets and liabilities — are
taken at their carrying amount to the Liquidation account.
• Any amounts arising during the liquidation process and not previously recorded by the acquiree
are also taken to the Liquidation account. In this example, there are three such items: premium on
debentures, annual leave payable and liquidation costs. The relevant amounts are debited to the
Liquidation account and liabilities are raised in relation to these items.
• Any reserves recognised by the acquiree — in this example it is retained earnings — are taken to the
Liquidation account.
• The consideration transferred is credited to the Liquidation account, with the recognition of assets
received, namely cash, patent, shares in Smetana Ltd and debentures in Smetana Ltd.

The balance of the Liquidation account is transferred to the Shareholders’ Distribution account.
Liquidation
Receivables 56 000 Retained Earnings 75 500
Inventory 29 000 Accumulated Depreciation 40 000
Plant and Equipment 167 000 Receivable from Smetana Ltd 269 700
Shares in Cape Ltd 26 000
Debentures – Premium 3 000
Annual Leave Payable 16 200
Liquidation Costs Payable 5 000
Shareholders’ Distribution 83 000
385 200 385 200
The cash received via the consideration transferred and the balance originally held by the acquiree is
used to pay the liabilities of the acquiree, including liabilities such as liquidation costs payable raised
during the liquidation process.
Liquidator’s Cash
Opening balance 20 000 Accounts Payable 31 000
Receivable from Smetana Ltd 86 700 Debentures 33 000
Mortgage Loan 21 500
Liquidation Costs Payable 5 000
Annual Leave Payable 16 200
106 700 106 700
The capital balances of the acquiree, in this example the capital relating to both A and B shares issued by
the acquiree, are taken to the credit side of the Shareholders’ Distribution account. The assets to be distrib-
uted to the former shareholders of the acquiree are transferred to the debit side of the account. In this case
they consist of the debentures and shares in Smetana Ltd and the patent, all these having been received as
part of the consideration transferred from the acquirer. The account balances when the balance transferred
from the Liquidation account is included. At this stage, all accounts of the acquiree are closed.
Shareholders’ Distribution
Debentures in Smetana Ltd 70 000 Share Capital – A Shares 40 000
Shares in Smetana Ltd 108 000 Share Capital – B Shares 60 000
Patent 5 000 Liquidation 83 000
183 000 183 000
1. What is meant by a ‘business combination’?
2. Discuss the importance of identifying the acquisition date.
3. What is meant by ‘contingent consideration’ and how is it accounted for?
4. Explain the key components of ‘core’ goodwill.
5. What recognition criteria are applied to assets acquired and liabilities assumed in a business combination?
6. How is an acquirer identified?
7. Explain the key steps in the acquisition method.
8. How is the consideration transferred calculated?
9. If an acquiree liquidates, what are the key accounts raised by the acquiree and which accounts are
transferred to these accounts?
10. How is a gain on bargain purchase accounted for?
11. Why is it important to identify an acquirer in a business combination?
References
Johnson, L. T., & Petrone, K. R. 1998, ‘Is goodwill an asset?’, Accounting Horizons, vol. 12, no. 3, pp. 293–303.
Leo, K. J., Hoggett, J. R., and Radford, J. 1995, Accounting for identifiable intangibles and goodwill, Australian
Society of Certified Practising Accountants, Melbourne.
406 PART 2 Elements

Exercise 14.1 ACCOUNTING BY THE ACQUIRER

★ On 1 July 2016, New Ltd acquired the following assets and liabilities from Day Ltd:

Land $ 300 000 $350 000
Plant (cost $400 000) 280 000 290 000
Inventory 80 000 85 000
Cash 15 000 15 000
Accounts payable (20 000) (20 000)
Loans (80 000) (80 000)
In exchange for these assets and liabilities, New Ltd issued 100 000 shares that had been issued for $1.20
per share but at 1 July 2016 had a fair value of $6.50 per share.
Required
1. Prepare the journal entries in the records of New Ltd to account for the acquisition of the assets and
liabilities of Day Ltd.
2. Prepare the journal entries assuming that the fair value of New Ltd shares was $6 per share.
Exercise 14.2 ACQUISITION OF SHARES IN ACQUIREE

★ On 1 January 2016, Desert Ltd acquired all the issued shares of Island Ltd. At this date the equity of Island
Ltd consisted of:
Share capital — 100 000 shares issued at $5 per share $500 000
In exchange for these shares, Desert Ltd agreed to pay the former shareholders of Island Ltd two shares
in Desert Ltd, these having a fair value of $4 per share, plus $1.50 cash for each share held in Island Ltd.
The costs of issuing the shares were $800.
Required
Prepare the journal entries in the records of Desert Ltd to record these events.
Exercise 14.3 DETERMINING THE FAIR VALUE OF EQUITY ISSUED BY THE ACQUIRER
★ On 1 December 2016, Trout Ltd acquired all the assets and liabilities of Dory Ltd, with Trout Ltd issuing
100 000 shares to acquire them. The fair values of Dory Ltd’s assets and liabilities at this date were:
Cash $ 50 000
Furniture and fittings 20 000
Plant 125 000
Annual leave payable 2 000
The financial year for Trout Ltd is January to December.

Required
1. Prepare the journal entries for Trout Ltd to record the business combination at 1 December 2016, as-
suming the fair value of each Trout Ltd share at acquisition date is $1.90. Prepare any note disclosures
for Trout Ltd at 31 December 2016 in relation to the business combination.
2. Assume the fair value of each Trout Ltd share at acquisition date is $1.90. At acquisition date, the ac-
quirer could only determine a provisional fair value for the plant. On 1 March 2017, Trout Ltd received
the final value from the independent appraisal, the fair value at acquisition date being $131 000. As-
suming the plant had a further 5-year life from the acquisition date, explain how Trout Ltd will account
for the business combination both at acquisition date and in the financial statements for 2017.
3. Prepare the journal entries for Trout Ltd to record the business combination at 1 December 2016, as-
suming the fair value of each Trout Ltd share at acquisition date is $1.70.

Exercise 14.4 IDENTIFYING THE ACQUIRER
★★ White Ltd has been negotiating with Cloud Ltd for several months, and agreements have finally been
reached for the two companies to combine. In considering the accounting for the combined entities, man-
agement realises that, in applying IFRS 3, an acquirer must be identified. However, there is debate among
the accounting staff as to which entity is the acquirer.
Required
1. What factors/indicators should management consider in determining which entity is the acquirer?
2. Why is it necessary to identify an acquirer? In particular, what differences in accounting would arise if
White Ltd or Cloud Ltd were identified as the acquirer?
Exercise 14.5 CONSIDERATION TRANSFERRED

★★ On 1 September 2016, the directors of Monkfish Ltd approached the directors of Cod Ltd with the fol-
lowing proposal for the acquisition of the issued shares of Cod Ltd, conditional on acceptance by 90% of
the shareholders of Cod Ltd by 30 November 2016:
• Two fully paid ordinary shares in Monkfish Ltd plus $3.10 cash for every preference share in Cod Ltd,
payable at acquisition date.
• Three fully paid ordinary shares in Monkfish Ltd plus $1.20 cash for every ordinary share in Cod Ltd.
Half the cash is payable at acquisition, and the other half in 1 year’s time.
By 30 November, 90% of the ordinary shareholders and all of the preference shareholders of Cod Ltd
had accepted the offer. The directors of Monkfish Ltd decided not to acquire the remaining ordinary shares.
Share transfer forms covering the transfer were dated 30 November 2016, and showed a price per Monkfish
Ltd ordinary share of $4.20. Monkfish Ltd’s incremental borrowing rate is 8% p.a.
The statement of financial position of Cod Ltd at 30 November 2016 was as follows:
COD LTD
Statement of Financial Position
as at 30 November 2016
Current assets $ 120 000

Non-current assets
Land and buildings $203 000
Plant and equipment 168 000
Less: Accumulated depreciation (45 000)
Shares in other companies listed on stock exchange at cost
(market $190 000) 30 000
Government bonds, at cost 50 000
Total non-current assets 406 000
Total assets 526 000
Current liabilities 30 000
Net assets $ 496 000
Equity
Share capital
80 000 ordinary shares fully paid $160 000
50 000 6% preference shares fully paid 100 000 $ 260 000
Total equity $ 496 000
Monkfish Ltd then appointed a new board of directors of Cod Ltd. This board took office on 1 December
2016 and immediately:
• revalued the asset Shares in Other Companies to its market value (assume no tax effect)
• used the surplus so created to make a bonus issue of $32 000 to ordinary shareholders, each
shareholder being allocated two ordinary shares for every ten ordinary shares held.
Required
Prepare all journal entries (in general form) to record the transactions in the records of (a) Monkfish Ltd
and (b) Cod Ltd.
408 PART 2 Elements

Exercise 14.6 ACCOUNTING FOR BUSINESS COMBINATION BY ACQUIRER, LIQUIDATION ACCOUNTS
★★ OF ACQUIREE
On 1 July 2016, two companies — New Starfish Ltd and Tuna Ltd — sign an agreement whereby the oper-
ations of Tuna Ltd are to be taken over by New Starfish Ltd. Tuna Ltd is to liquidate after the transfer is
complete. The statements of financial position of the two companies on that day were as follows:
New Starfish Ltd Tuna Ltd

Cash $ 50 000 $ 20 000
Inventory 56 000 29 000
Land 65 000 —
Accumulated depreciation — plant and equipment (60 000) (40 000)
Shares in Sefton Ltd — 26 000
Debentures in Akaroa Ltd (face value) 10 000 —
$376 000 $258 000

10% debentures (face value) 100 000 30 000
Share capital:
Ordinary shares of $1, fully paid 100 000 —
A class shares of $2, fully paid — 40 000
B class shares of $1, fully paid 60 000
$376 000 $258 000
Acquisition of Tuna Ltd

New Starfish Ltd is to acquire all of the assets of Tuna Ltd (except for cash). The assets of Tuna Ltd are
recorded at their fair values except for the following:

Inventory $ 29 000 $ 39 200
Shares in Sefton Ltd 26 000 22 500
In exchange, the A class shareholders of Tuna Ltd are to receive one 7% debenture in New Starfish Ltd,
redeemable on 1 July 2018, for every share held in Tuna Ltd. The fair value of each debenture is $3.50. The
B class shareholders of Tuna Ltd are to receive two shares in New Starfish Ltd for every three shares held
in Tuna Ltd. The fair value of each New Starfish Ltd share is $2.70. Costs to issue these shares will amount
to $900.
Additionally, New Starfish Ltd is to provide Tuna Ltd with sufficient cash, additional to that already held,
to enable Tuna Ltd to pay its liabilities. The outstanding debentures are to be redeemed at a 10% premium.
Annual leave entitlements of $16 200 outstanding at 1 July 2016 and expected liquidation costs of $5000
have not been recognised by Tuna Ltd. Costs associated with undertaking the acquisition amounted to $1600.
Required
1. Prepare the acquisition analysis and journal entries in the books of New Starfish Ltd to record the acqui-
sition of Tuna Ltd.
2. Prepare the Liquidation, Liquidator’s Cash, and Shareholders’ Distribution ledger accounts in the re-
cords of Tuna Ltd.
Exercise 14.7 ACCOUNTING FOR BUSINESS COMBINATION BY ACQUIRER, JOURNAL ENTRIES FOR LIQUIDATION
★★ OF ACQUIREE
Ling Ltd and Steenbras Ltd are small family-owned companies engaged in vegetable growing and distri-
bution. The Spencer family owns the shares in Steenbras Ltd and the Rokocoko family owns the shares in
Ling Ltd. The head of the Spencer family wishes to retire but his two sons are not interested in carrying
on the family business. Accordingly, on 1 July 2016, Ling Ltd is to take over the operations of Steenbras
Ltd, which will then liquidate. Ling Ltd is asset-rich but has limited overdraft facilities so the following
arrangement has been made.

Ling Ltd is to acquire all of the assets, except cash, delivery trucks and motor vehicles, of Steenbras Ltd
and will assume all of the liabilities except accounts payable. In return, Ling Ltd is to give the shareholders
of Steenbras Ltd a block of vacant land, two delivery vehicles and sufficient additional cash to enable the
company to pay off the accounts payable and the liquidation costs of $1500. The land and vehicles had
the following values at 30 June 2016:

Freehold land $ 50 000 $120 000
Delivery trucks 30 000 28 000
On the liquidation of Steenbras Ltd, Mr Spencer is to receive the land and the motor vehicles and his
two sons are to receive the delivery trucks.
The statements of financial position of the two companies as at 30 June 2016 were as follows:
Ling Ltd Steenbras Ltd

Cash $ 3 500 $ 2 000
Freehold land 250 000 100 000
Buildings (net) 25 000 30 000
Cultivation equipment (net) 65 000 46 000
Irrigation equipment 16 000 22 000
Delivery trucks 45 000 36 000
$ 454 500 $ 283 000
Loan — Bank of NZ 150 000 80 000
Loan — Trevally Bros 35 000 35 000
Loan — Long Cloud 70 000 52 500
Share capital — 100 000 shares 100 000 —
— 60 000 shares — 60 000
Reserves 28 500 —
$454 500 $283 000
All the assets of Steenbras Ltd are recorded at fair value, with the exception of:
Fair value
Freehold land $120 000
Buildings 40 000
Cultivation equipment 40 000
Motor vehicle 34 000
Required
1. Prepare the acquisition analysis and the journal entries to record the acquisition of Steenbras Ltd’s op-
erations in the records of Ling Ltd.
2. Prepare the journal entries to record the liquidation of Steenbras Ltd.
3. Prepare the statement of financial position of Ling Ltd after the business combination, including any
notes relating to the business combination.
Exercise 14.8 ACCOUNTING FOR BUSINESS COMBINATION BY ACQUIRER

★★ Sweetlip Ltd and Warehou Ltd are two family-owned flax-producing companies in New Zealand. Sweetlip
Ltd is owned by the Wood family and the Bradbury family owns Warehou Ltd. The Wood family has
only one son and he is engaged to be married to the daughter of the Bradbury family. Because the son
is currently managing Warehou Ltd, it is proposed that, after the wedding, he should manage both
410 PART 2 Elements

companies. As a result, it is agreed by the two families that Sweetlip Ltd should take over the net assets
of Warehou Ltd.
The statement of financial position of Warehou Ltd immediately before the takeover is as follows:

Cash $ 20 000 $ 20 000
Land 620 000 840 000
Buildings (net) 530 000 550 000
Farm equipment (net) $ 360 000 $364 000
Irrigation equipment (net) 220 000 225 000
Vehicles (net) 160 000 172 000
$ 2 050 000
Accounts payable $ 80 000 80 000
Loan — Trevally Bank 480 000 480 000
$ 2 050 000
The takeover agreement specified the following details:

• Sweetlip Ltd is to acquire all the assets of Warehou Ltd except for cash, and one of the vehicles (having
a carrying amount of $45 000 and a fair value of $48 000), and assume all the liabilities except for
the loan from the Trevally Bank. Warehou Ltd is then to go into liquidation. The vehicle is to be
transferred to Mr and Mrs Bradbury.
• Sweetlip Ltd is to supply sufficient cash to enable the debt to the Trevally Bank to be paid off and
to cover the liquidation costs of $5500. It will also give $150 000 to be distributed to Mr and Mrs
Bradbury to help pay the costs of the wedding.
• Sweetlip Ltd is also to give a piece of its own prime land to Warehou Ltd to be distributed to
Mr and Mrs Bradbury, this eventually being available to be given to any offspring of the
forthcoming marriage. The piece of land in question has a carrying amount of $80 000 and a fair
value of $220 000.
• Sweetlip Ltd is to issue 100 000 shares, these having a fair value of $14 per share, to be distributed
via Warehou Ltd to the soon-to-be-married-daughter of Mr and Mrs Bradbury, who is currently a
shareholder in Warehou Ltd.
The takeover proceeded as per the agreement, with Sweetlip Ltd incurring incidental acquisition costs of
$25 000 and $18 000 share issue costs.
Required
Prepare the acquisition analysis and the journal entries to record the acquisition of Warehou Ltd in the
records of Sweetlip Ltd.
Exercise 14.9 ACCOUNTING FOR ACQUISITIONS OF A BUSINESS AND SHARES IN ANOTHER ENTITY
★★★ Tailor Ltd is seeking to expand its share of the pet care market and has negotiated to acquire the operations
of Flathead Ltd and the shares of Octopus Ltd.
At 1 July 2016, the trial balances of the three companies were:
Tailor Ltd Flathead Ltd Octopus Ltd

Cash $ 145 000 $ 5 200 $ 84 000
Inventory 56 000 30 000 25 400
Shares in listed companies 16 000 22 000 7 000
Land and buildings (net) 70 000 40 000 36 000
Plant and equipment (net) 130 000 105 000 25 000
Goodwill (net) 6 000 5 000 5 600
$ 457 000 $ 228 500 $ 195 000

Tailor Ltd Flathead Ltd Octopus Ltd
Accounts payable $ 65 000 $ 40 000 $ 29 000
Debentures 50 000 0 100 000
Mortgage loan 100 000 30 000 0
Contributed equity:
Ordinary shares of $1, fully paid 200 000 150 000 60 000
Other reserves 15 000 6 500 2 500
Retained earnings (30/6/16) 27 000 2 000 2 000
$ 457 000 $ 228 500 $ 195 000
Flathead Ltd
Tailor Ltd is to acquire all assets (except cash and shares in listed companies) of Flathead Ltd. Acquisition-related
costs are expected to be $7600. The net assets of Flathead Ltd are recorded at fair value except for the following:
Inventory $ 30 000 $ 26 000
Land and buildings 40 000 80 000
Shares in listed companies 22 000 18 000
Accounts payable (40 000) (49 100)
Accrued leave 0 (29 700)
In exchange, the shareholders of Flathead Ltd are to receive, for every three Flathead Ltd shares held,
one Tailor Ltd share worth $2.50 each. Costs to issue these shares are $950. Additionally, Tailor Ltd will
transfer to Flathead Ltd its ‘Shares in listed companies’ asset, which has a fair value of $15 000. These
shares, together with those already owned by Flathead Ltd, will be sold and the proceeds distributed to the
Flathead Ltd shareholders. Assume that the shares were sold for their fair values.
Tailor Ltd will also give Flathead Ltd sufficient additional cash to enable Flathead Ltd to pay all its
creditors. Flathead Ltd will then liquidate. Liquidation costs are estimated to be $8700.
Octopus Ltd
Tailor Ltd is to acquire all the issued shares of Octopus Ltd. In exchange, the shareholders of Octopus Ltd
are to receive one Tailor Ltd share, worth $2.50, and $1.50 cash for every two Octopus Ltd shares held.
Required
1. Prepare the acquisition analysis and journal entries to record the acquisitions in the records of Tailor Ltd.
2. Prepare the Liquidation account and Shareholders’ Distribution account for Flathead Ltd.
3. Explain in detail why, if Flathead Ltd has recorded a goodwill asset of $5000, Tailor Ltd calculates the
goodwill acquired via an acquisition analysis. Why does Tailor Ltd not determine a fair value for the
goodwill asset and record that figure as it has done for other assets acquired from Flathead Ltd?
4. If Tailor Ltd subsequently receives a dividend cheque for $1500 from Octopus Ltd, paid from retained
earnings earned before its acquisition of the shares in Octopus Ltd, how should Tailor Ltd account for
that cheque? Why?
5. Shortly after the business combination, the liquidator of Flathead Ltd receives a valid claim of $25 000
from a creditor. As Tailor Ltd has agreed to provide sufficient cash to pay all the liabilities of Flathead
Ltd at acquisition date, the liquidator requests and receives a cheque for $25 000 from Tailor Ltd. How
should Tailor Ltd record this payment? Why?
Exercise 14.10 ACQUISITION OF TWO BUSINESSES

★★★ Queenfish Ltd is a manufacturer of specialised industrial machinery seeking to diversify its operations.
After protracted negotiations, the directors decided to purchase the assets and liabilities of Blackfish Ltd
and the spare parts retail division of Hoklo Ltd.
At 30 June 2016 the statements of financial position of the three entities were as follows:
Queenfish Ltd Blackfish Ltd Hoklo Ltd

Land and buildings (net) $ 60 000 $ 25 000 $ 40 000
Plant and machinery (net) 100 000 36 000 76 000
Office equipment (net) 16 000 4 000 6 000
Shares in listed companies 24 000 15 000 20 800
Debentures in listed companies 20 000 — —
Inventory 150 000 54 000 30 200
412 PART 2 Elements

Queenfish Ltd Blackfish Ltd Hoklo Ltd
Cash $ 59 000 $ 11 000 $ 9 000
Goodwill — 7 000 —
$ 464 000 $ 178 000 $ 224 000
Accounts payable 26 000 14 000 27 000
Current tax liability 21 000 6 000 7 000
Provision for leave 36 000 10 000 17 500
Bank loan 83 000 16 000 43 500
Debentures 60 000 50 000 —
Share capital (issued at $1, fully paid) 200 000 60 000 90 000
$ 464 000 $ 178 000 $ 224 000
The acquisition agreement details are as follows:

Blackfish Ltd
Queenfish Ltd is to acquire all the assets (other than cash) and liabilities (other than debentures, provi-
sions and tax liabilities) of Blackfish Ltd for the following purchase consideration:
• Shareholders in Blackfish Ltd are to receive three shares in Queenfish Ltd, credited as fully paid, in
exchange for every four shares held. The shares in Queenfish Ltd are to be issued at their fair value of
$3 per share. Costs of share issue amounted to $2000.
• Queenfish Ltd is to provide sufficient cash which, when added to the cash already held, will enable
Blackfish Ltd to pay out the current tax liability and provision for leave, to redeem the debentures at a
premium of 5%, and to pay its liquidation expenses of $2500.
The fair values of the assets and liabilities of Blackfish Ltd are equal to their carrying amounts with the
exception of the following:
Fair value
Land and buildings $60 000
Plant and machinery 50 000
Incidental costs associated with the acquisition amount to $2500.

Hoklo Ltd
Queenfish Ltd is to acquire the spare parts retail business of Hoklo Ltd. The following information is avail-
able concerning that business, relative to the whole of Hoklo Ltd:
Total amount Spare parts division

Carrying amount Carrying amount Fair value
Land and buildings (net) $40 000 $20 000 $30 000
Plant and machinery (net) 76 000 32 000 34 500
Office equipment (net) 6 000 2 000 2 500
Inventory 30 200 12 000 12 000
Provision for leave 17 500 7 000 7 000
The divisional net assets are to be acquired for $10 000 cash, plus 11 000 ordinary shares in Queenfish Ltd
issued at their fair value of $3, plus the land and buildings that have been purchased from Blackfish Ltd.
Incidental costs associated with the acquisition are $1000.
Required
1. Prepare the acquisition analysis for the acquisition transactions of Queenfish Ltd.
2. Prepare the liquidation account for Blackfish Ltd.
3. Prepare the journal entries for the acquisition transactions in the records of Queenfish Ltd and Hoklo Ltd.

One of the interesting questions about business combina- as future profits owing to higher depreciation. The opposite
tions is whether earnings management plays a role in the is also true since goodwill is not amortised. Shalev et al.
acquisition price. One context where earnings may play a (2013) explore how managerial compensation affects this
role is when the acquisition is funded by stock-for-stock price allocation. They examine 320 acquisitions between
swap. Here managers of the acquiring firm may attempt to 2001 and 2008 and test for the association between a
inflate earnings to increase the price of their stock. This, in CEO’s cash bonus (which is typically based on accounting
turn, can produce a more favourable exchange ratio for the numbers) and the percentage of the purchase price that is
acquiring firm’s shareholders. Erickson and Wang (1999) allocated to goodwill and intangibles with indefinite life.
examine this question for 55 stock-for-stock mergers that Shalev et al. (2013) provide evidence that suggests that
took place between 1985 and 1990. Earnings management greater bonus intensity is positively associated with the
is captured by abnormal accruals and is shown to increase percentage of purchase price that is allocated to goodwill
in the quarters preceding the merger announcement, but and intangibles with indefinite life. This is consistent with
decrease following the announcement. To enhance the managers of acquiring firms using discretion to allocate a
strength of the conclusion that earnings management is greater fraction of the purchase price to assets that are not
present mostly in stock-for stock acquisitions, the authors subject to depreciation and amortisation which, in turn,
also analyse 64 cash deals, but do not find similar results. boosts future profits.
Louis (2004) extends this line of inquiry to mergers between Since goodwill is the difference between price paid and fair
1992 and 2000 comprising 236 stock swaps and 137 cash value of net assets acquired it is not clear what its economic
deals. He finds that stock-swap acquirers experienced nega- meaning is. Furthermore, insofar as goodwill is manipu-
tive abnormal returns in the 2 years prior to the merger lated, it is interesting to see if it has any predictive value and
announcement. This poor performance may have exerted whether its power to predict future performance is moder-
pressure on managers to manipulate earnings. Consistent ated by managerial discretion. These questions are addressed
with this, Louis (2004) finds strong evidence of greater by Lee (2011). Lee (2011) first establishes that goodwill is
earnings management in the quarter preceding the merger positively related to 1 year ahead operating cash flows. This
announcement in stock acquirers than cash acquirers. provides support to the view that goodwill is an asset.
Additionally, he finds that abnormal stock returns in the Importantly, this relation is not found to be sensitive to the
3 years following the merger are negatively related to the degree of managerial discretion.
measure of abnormal accruals in the quarter preceding the The above-mentioned studies are based on US samples;
announcement. This is consistent with successful earnings not much academic research has been conducted into
management by managers of stock swap-acquirers. More- IFRS 3. One of the few studies to do so is Glaum et al.
over, the evidence suggests that market participants do not (2013) who examine the degree of compliance with the
fully understand the effect of pre-merger announcement disclosure requirements of IFRS 3 and IAS 36, the latter
earnings management. governing goodwill impairment rules. They examine compli-
As business combinations represent a major corporate ance in a sample of 357 European firms involved in acqui-
event, investors would benefit from additional disclosures sitions in 2005 — the year when IFRS became mandatory in
that could help them form expectations about future perfor- the EU. Glaum et al. (2013) develop a 100-item disclosure
mance. Shalev (2009) assembles a sample of 297 acquiring checklist that is based on the requirements of the two stand-
firms involved in 1019 acquisitions between 1 July 2001 to ards. Compliance is found to vary across countries, indus-
31 December 2004 to examine what determines the level of tries and auditor type. For example, Switzerland shows the
disclosure. He posits that acquirers that are more confident highest level of compliance and Austria the lowest. Compa-
about the acquisition outcome would tend to be more forth- nies audited by big audit firms tend to comply more than
coming in their disclosures. He finds that disclosure levels companies audited by smaller auditors. Glaum et al. (2013)
are negatively related to the amount of goodwill recognised. further find from a multivariate analysis that compliance
This is consistent with goodwill capturing overpayment increases with the size of recorded goodwill. A second study
and hence bad news that acquirers would like to withhold. of IFRS 3 is Hamberg et al. (2011) who examine IFRS 3
Acquirers that provide more disclosure also tend to report adoption in a sample of Swedish firms. They find that
higher ROA in the year of acquisition and the following year. goodwill-intensive firms experience higher stock returns
Consistent with Shalev’s (2009) hypothesis, these acquirers than no-goodwill firms upon adoption of IFRS 3. It is not
also experience positive abnormal stock returns in the year clear, however, if investors correctly interpret goodwill as a
following the filing of the annual report for the acquisition signal of better performance.
year.
Another question is whether earnings management plays
a role in the allocation of the purchase consideration to net
assets and goodwill. Under IFRS® Standards, the purchase con-
References
sideration is allocated to goodwill after the fair value of net Erickson, M., and Wang, S. W. 1999. Earnings management
assets acquired is determined. This implies a one-to-one substi- by acquiring firms in stock for stock mergers. Journal of
tution effect between fair value adjustments and goodwill. For Accounting and Economics, 27(2), 149–176.
example, allocating purchase consideration to higher fair Glaum, M., Schmidt, P., Street, D. L., and Vogel, S. 2013.
value of depreciable assets would reduce goodwill as well Compliance with IFRS 3- and IAS 36-required disclosures
414 PART 2 Elements

across 17 European countries: Company- and country-level Louis, H. 2004. Earnings management and the market
determinants. Accounting and Business Research, 43(3), performance of acquiring firms. Journal of Financial
163–204. Economics, 74(1), 121–148.
Hamberg, M., Paananen, M., and Novak, J. 2011. The Shalev, R. 2009. The information content of business
adoption of IFRS 3: The effects of managerial discretion combination disclosure level. The Accounting Review, 84(1),
and stock market reactions. European Accounting Review, 239–270.
20(2), 263–288. Shalev, R., Zhang, I. X., and Zhang, Y. 2013. CEO
Lee, C. 2011. The effect of SFAS 142 on the ability of goodwill compensation and fair value accounting: Evidence from
to predict future cash flows. Journal of Accounting and Public purchase price allocation. Journal of Accounting Research,
Policy, 30(3), 236–255. 51(4), 819–854.

15 Impairment of assets
ACCOUNTING IAS 36 Impairment of Assets
STANDARDS
IN FOCUS

OBJECTIVES
1 understand the purpose of the impairment test for assets
2 understand when to undertake an impairment test
3 explain how to undertake an impairment test for an individual asset
4 identify a cash-generating unit, and account for an impairment loss for a cash-generating
unit — not including goodwill
5 account for the impairment of goodwill
6 account for reversals of impairment losses
7 apply the disclosure requirements of IAS 36.
CHAPTER 15 Impairment of assets 417

LO1 15.1 INTRODUCTION TO IAS 36
Chapters 11 and 13 discuss the measurement and recognition criteria for property, plant and equipment,
and intangibles. These assets are measured at cost or revalued amount and, for each asset, the cost or
revalued amount is allocated over its useful life. The exception is where intangible assets have indefinite
useful lives, in which case no amortisation is charged. In the statement of financial position at the end of
a reporting period, the assets are reported at cost or revalued amount less the accumulated depreciation/
amortisation. Because there are many judgements in the depreciation/amortisation process — estimates
of useful life, residual values and the pattern of benefits — the question to be asked at the end of the
reporting period is whether the carrying amounts of the assets in the statement of financial position over-
state the worth of the assets. In other words, can an entity expect to recover in future periods the carrying
amounts of an entity’s assets? Recovery can be from future use of the asset and/or from the eventual dis-
posal of the asset. The entity has an impairment loss in relation to an asset if the expected recovery is less
than the carrying amount of that asset. Paragraph 6 of IAS 36 Impairment of Assets defines an impairment
loss as follows:
An impairment loss is the amount by which the carrying amount of an asset or a cash-generating unit exceeds
its recoverable amount.
This chapter examines the impairment test for assets. The accounting standard covering impairment is
IAS 36 Impairment of Assets. The standard was issued initially by the International Accounting Standards
Board (IASB®) in July 1998 and amended on numerous occasions, including an amendment in 2013.
Under IAS 36, an entity is required to conduct impairment tests for its assets to see whether it has
incurred any impairment losses. The purpose of the impairment test is to ensure that assets are not carried
at amounts that exceed their recoverable amounts or, more simply, that assets are not overstated.
Key questions in relation to the impairment test are:
• How does the test work?
• Is the test the same for all assets?
• Should the test apply to individual assets or to groups of assets? If to groups, which groups?
• Is the accounting treatment the same for assets measured at cost and for those measured at revalued
amount?
• When should the test be carried out? Should it be done annually, every 3 years or some other time?
• Can the results of the impairment test be reversed; that is, if an asset is written down because it is
impaired, can later events lead to the reversal of that write-down?
15.1.1 Scope of IAS 36

Paragraph 2 of IAS 36 notes that the standard does not apply to all assets; that is, not all assets are subject
to impairment testing. Assets to which IAS 36 does not apply are:
• inventories — IAS 2 Inventories
• assets arising from construction contracts — IAS 11 Construction Contracts
• deferred tax assets — IAS 12 Income Taxes
• assets arising from employee benefits — IAS 19 Employee Benefits
• financial assets — IAS 39 Financial Instruments: Recognition and Measurement
• investment properties measured at fair value — IAS 40 Investment Property
• biological assets measured at fair value less costs to sell — IAS 41 Agriculture
• deferred acquisition costs and intangible assets relating to insurance contracts — IFRS 4 Insurance
Contracts
• non-current assets or disposal groups classified as held for sale — IFRS 5 Non-current Assets Held for
Sale and Discontinued Operations.
The accounting standards listed contain the principles for recognition and measurement of the par-
ticular assets covered by those standards. Note that in some of these standards the assets are required to be
recorded at fair value, or fair value less costs of disposal. Fair value is discussed in detail in chapter 3. Where
assets are recorded at fair value, there is no need to test for recoverability of the carrying amount of the
asset. Under IAS 2, inventory is recorded at the lower of cost and net realisable value. As net realisable
value is defined in terms of estimated selling price, IAS 2 has an inbuilt impairment test requiring inven-
tory to be written down when the cost is effectively greater than the recoverable amount.
LO2 15.2 WHEN TO UNDERTAKE AN IMPAIRMENT TEST

As noted earlier, the purpose of the impairment test is to ensure that disclosed assets do not have carrying
amounts in excess of their recoverable amounts. However, under IAS 36 it is not necessary at the end of
each reporting period to test each asset in order to determine whether it is impaired. The only assets that
need to be tested at the end of the reporting period are those where there is any indication that an asset
may be impaired (see paragraph 9 of IAS 36). An entity therefore must determine by looking at various
418 PART 2 Elements

sources of information whether there is sufficient evidence to suspect that an asset may be impaired. If
there is no such evidence, then an entity can assume that impairment has not occurred.
For most assets, the need for an impairment test can be assessed by analysing sources of evidence.
However, there are some assets for which an impairment test must be undertaken every year. Paragraph 10
identifies these assets:
• intangible assets with indefinite useful lives
• intangible assets not yet available for use
• goodwill acquired in a business combination.
The reason for singling out these assets for automatic impairment testing is that the carrying amounts
of these assets are considered to be more uncertain than those of other assets. None of these assets are
subject to an annual amortisation charge, and so there is no ongoing reduction in the carrying amounts of
the assets. As the assets are not being reduced via amortisation, it is considered essential that the carrying
amounts be tested against the recoverable amounts.
Another important reason for remeasuring assets and testing for impairment relates to the concept of
depreciation adopted by the IASB. As noted in chapter 11, depreciation is viewed as a process of allocation
rather than as a valuation process, even when an asset is measured at a revalued amount. Therefore, the
carrying amount of an asset reflects the unallocated measure of the asset rather than the benefits to be
derived from the asset in the future. The impairment test relates to the assessment of recoverability of the
asset, which is not a feature of the depreciation allocation process.
15.2.1 Collecting evidence of impairment

The purpose of the impairment test is to determine whether the carrying amount of an asset exceeds its
recoverable amount. The recoverable amount will be discussed in more detail below, but it is essentially
the higher of the asset’s fair value and the net present value of the cash flows that will be generated by that
asset. Time and effort can be saved by establishing whichever of the two figures is the easier to determine.
If that figure exceeds the carrying value then the asset cannot be impaired and the other figure is unneces-
sary. For example, an entity owns property with a carrying value of $10 million. Management believes that
the fair value is ‘at least’ $12 million. The value of the cash flows associated with the property is irrelevant
and so there is no need to establish it.
IAS 36 requires management to consider sources of evidence that might indicate the possibility of
impairment. Evidence can come from internal and external sources.
External sources of information
Paragraph 12 of IAS 36 lists four sources of information relating to the external environment in which the
entity operates:
1. Asset’s value. Might the asset’s value have declined more than would normally be expected during the
period? For example, are revenues from the products made using the asset declining? Are observable
market prices for similar assets declining on the open market?
2. Entity’s environment/market. Have significant adverse changes occurred or will they occur in the techno-
logical, market, economic or legal environment in which the entity operates, or in the market to which
the asset is dedicated? For example, a competitor may have developed a product or technology that is
likely to cause or has caused a significant and permanent reduction in the entity’s market share.
3. Interest rates. Have market interest rates or market rates of return increased during the period? If so, then
discounting future cash flows at this higher rate will reduce their net present value.
4. Market capitalisation. Is the carrying amount of the net assets of the entity greater than the market capit-
alisation of the entity?
Internal sources of information
Paragraph 12 of IAS 36 lists three sources of information based on events within the entity itself:
1. Obsolescence or physical damage. Does an analysis of the asset reveal physical damage or obsolescence?
2. Changed use within the entity. Is the asset expected to be used differently within the entity? For example,
the asset may become idle; there may be a restructure in the entity that changes the use of the asset;
there may be plans to sell the asset; or the useful life of an intangible may be changed from indefinite
to finite.
3. Economic performance of the asset. Do internal reports indicate that the economic performance of the
asset is worse than expected? Evidence of this consists of:
– actual cash flows for maintenance or operating the asset may be significantly higher than expected
– actual cash inflows or profits may be lower than expected
– expected cash flows for maintenance of operations may have increased, or expected profits may be
lower.
In analysing the information from the above sources, paragraph 15 of IAS 36 notes that materiality must
be taken into account. For example, an increase in short-term interest rates that is not expected to persist
would have very little impact on net present values.

In its notes to the 2014 consolidated financial statements, Nokia provided details of the factors that
trigger an impairment review for the entity (see figure 15.1).
Assessment of the recoverability of long-lived assets, intangible assets and goodwill

The Group assesses the carrying value of goodwill annually or more frequently if events or changes in
circumstances indicate that such carrying value may not be recoverable. The carrying value of identifiable
intangible assets and long-lived assets is assessed if events or changes in circumstances indicate that such
carrying value may not be recoverable. Factors that trigger an impairment review include, but are not
limited to, underperformance relative to historical or projected future results, significant changes in the
manner of the use of the acquired assets or the strategy for the overall business, and significant negative
industry or economic trends.
FIGURE 15.1 Indicators of impairment for Nokia Corporation

LO3 15.3 IMPAIRMENT TEST FOR AN INDIVIDUAL ASSET

The impairment test involves comparing the carrying amount of an asset with its recoverable amount. To
understand the nature of this test, it is necessary to understand a number of definitions given in paragraph
6 of IAS 36:
The recoverable amount of an asset or a cash-generating unit is the higher of its fair value less costs of disposal
and its value in use.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transac-
tion between market participants at the measurement date. (See IFRS 13 Fair Value Measurement.)
Costs of disposal are incremental costs directly attributable to the disposal of an asset or cash-generating unit,
excluding finance costs and income tax expense.
Value in use is the present value of the future cash flows expected to be derived from an asset or cash-generating unit.
Note the phrase ‘an asset or cash-generating unit’ in the above definitions. The discussion in this section
focuses on an individual asset, and it is assumed that, for the asset being tested for impairment, there are
specific cash flows that can be associated with the asset. Cash-generating units are discussed in section 15.4.
From the definition of recoverable amount, there are two possible amounts against which the carrying
amount can be tested for impairment: (1) fair value less costs of disposal and (2) value in use. Although
the definition of recoverable amount refers to the ‘higher’ of these two amounts, an impairment occurs
if the carrying amount exceeds recoverable amount (paragraph 8). However, it is not always necessary to
measure both amounts when testing for impairment. If either one of these amounts is greater than car-
rying amount, the asset is not impaired (paragraph 19). Where there are active markets, determining fair
value less costs of disposal is probably easier than calculating value in use. However, where the carrying
amount exceeds the fair value less costs of disposal, it is necessary to calculate the value in use. Figure 15.2
is a diagrammatic representation of the impairment test.
Step 1: Determine Recoverable amount
equal to the higher of
Fair value less

and Value in use
costs of disposal
Step 2: Compare Recoverable amount Carrying amount

and
If recoverable amount < carrying amount, an impairment loss has occurred.

If recoverable amount > carrying amount, no further action is required.
FIGURE 15.2 The impairment test
420 PART 2 Elements

In calculating either fair value less costs of disposal or value in use, paragraph 23 of IAS 36 notes that
in ‘some cases, estimates, averages and computational shortcuts may provide reasonable approxima-
tions’, rather than an entity having to perform in-depth calculations annually. It is also possible to use
the most recent detailed calculation of recoverable amount made in a preceding year (paragraph 24)
in the case of an intangible asset with an indefinite useful life. The latter is possible if all the following
criteria are met:
• for the intangible asset, if tested as part of a cash-generating unit (see section 15.4), the other assets and
liabilities in the unit have not changed significantly
• in the preceding year’s calculation, the difference between the carrying amount and recoverable
amount was substantial
• an analysis of all evidence relating to events affecting the asset suggests that the likelihood of the
recoverable amount being less than carrying amount is remote.
15.3.1 Calculating fair value less costs of disposal

There are two parts to the determination of fair value less costs of disposal, namely fair value and costs of
disposal. Fair value is measured in accordance with IFRS 13 Fair Value Measurement and is discussed in detail
in chapter 3. Fair value is defined as an exit price and can be measured using a number of valuation tech-
niques using various observable or unobservable inputs.
Paragraph 28 of IAS 36 provides the following examples of costs of disposal: legal costs, stamp duty
and similar transaction taxes, costs of removing the asset, and direct incremental costs to bring the asset
into condition for sale. The costs must be directly associated with either the sale of the asset or getting the
asset ready for sale. Any costs arising after the sale of the asset, even if arising as a result of the sale, are not
regarded as costs of disposal.
Paragraph 5 of IAS 36 provides guidance where an asset is measured at a revalued amount (i.e. fair
value). Fair value as a measure does not include a consideration of disposal costs. Hence, if an asset’s
fair value is equal to its market value, the difference between fair value and fair value less costs of dis-
posal is the disposal costs of the asset. If the disposal costs are immaterial, then there is no significant
difference between fair value and fair value less costs of disposal. If the fair value is up to date then
the asset could only be impaired if the disposal costs were material. When that is the case, the entity
will have to determine the asset’s value in use because the asset will not be impaired if its value in use
exceeds its carrying value.
Figure 15.3 describes how Nokia calculated the fair value less costs of disposal of one of its cash-generating
units. Note that the purpose of the calculation was to determine a disposal price.
Carrying value of the HERE cash-generating unit

The recoverable amount of the HERE CGU is determined using the fair value less costs of disposal
method. Estimation and judgment are required in determining the components of the recoverable
amount calculation, including the discount rate, the terminal growth rate, estimated revenue growth
rates, profit margins, costs of disposal and the cost level of operational and capital investment. The
discount rate reflects current assessments of the time value of money, relevant market risk premiums,
and industry comparisons. Risk premiums reflect risks and uncertainties for which the future cash
flow estimates have not been adjusted. Terminal values are based on the expected life of products
and forecasted life cycle, and forecasted cash flows over that period. In 2014, the Group recorded
an impairment loss of EUR 1209 million to reduce the carrying amount of the HERE CGU to its
recoverable amount. The remaining carrying amount of the HERE goodwill is EUR 2273 million. As the
carrying amount of the HERE CGU has been written down to its recoverable amount, any increase in
the discount rate, any decrease in the terminal growth rate, or any material change in other valuation
assumptions could result in further impairment.
FIGURE 15.3 Calculation of fair value less costs of disposal

15.3.2 Calculating value in use

Value in use is the present value of future cash flows relating to the asset being measured. These should
be discounted at an appropriate rate that takes account of the risks inherent in future cash flows from the
asset. Paragraph 53A of IAS 36 Impairment of Assets notes that fair value differs from value in use because
of factors that are likely to be specific to the entity:
(a) additional value derived from the grouping of assets (such as the creation of a portfolio of investment prop-
erties in different locations);
(b) synergies between the asset being measured and other assets;

(c) legal rights or legal restrictions that are specific only to the current owner of the asset; and
(d) tax benefits or tax burdens that are specific to the current owner of the asset.
Determining future cash flows

Paragraphs 33–54 of IAS 36 provide guidance in measuring future cash flows. Some important guide-
lines are:
• Cash flow projections should be based on management’s best estimate of the range of economic
conditions that will exist over the remaining useful life of the asset. These should be modified by
an analysis of past cash flows and management’s success in the past in predicting future cash flows
accurately. Where external evidence is available, this should be given greater weight than simple
reliance on management’s expectations.
• Cash flow projections should be based on the most recent financial budgets and forecasts. These
projections should cover a maximum period of 5 years unless a longer period can be justified. For
most entities, a detailed analysis of future operations rarely extends beyond 5 years.
• Expectations concerning growth rate should be realistic and in line with observable rates. The cash
inflows should include those from continuing use of the asset over its expected useful life as well as
those expected to be received on disposal of the asset. Further, any cash outflows necessary to achieve the
projected inflows must be taken into account.
• Projected cash flows must be estimated for the asset in its current condition (paragraph 44).
Where there is an expected restructuring of the entity in future periods, or where there are
possibilities for improving or enhancing the performance of the asset by subsequent expenditure,
projections of cash flows will not take these possible events into consideration. Such enhancements
can only be taken into consideration once the entity is committed to the restructure. Day-to-day
servicing costs are included in the outflows used to measure value in use, as are the costs of major
inspections.
• Cash flows relating to financing activities or income tax are not included in the calculations of future cash
flows. As the discount rate is based on a pre-tax basis, the future cash flows must also be on a pre-tax
basis.
• In assessing cash flows from disposal, the expected disposal price will take into account specific future
price increases/decreases, and be based on an analysis of prices prevailing at the date of the estimate
for similar assets in conditions similar to those expected for the asset under consideration at the end
of its useful life.
• Appendix A to IAS 36, described as an ‘integral part of the standard’, contains guidance on the use of
present value techniques in measuring value in use. Essentially, expected values may be used when
probabilities can be estimated.
Determining the discount rate

Paragraph 55 of IAS 36 notes that the discount rate should:
• reflect the time value of money
• reflect the risks specific to the asset for which the future cash flow estimates have not been adjusted.
The rate may be determined by viewing rates used for similar assets in the market, or from the weighted
average cost of capital of a listed entity that has a single asset, or portfolio of assets, similar to the asset
under review (paragraph 56).
Figure 15.4 contains information provided in Note 19 to the financial statements in the 2014 annual
report of Amcor Ltd. Note in particular the information provided about the calculation of the recoverable
amount using value-in-use calculations.
FIGURE 15.4 Calculation of value in use
(b) Impairment tests for goodwill

For the purpose of impairment testing, goodwill acquired in a business combination is allocated to cash generating units
or groups of cash generating units (CGUs) according to the level at which management monitors goodwill. The goodwill
amounts allocated below are tested annually or semi-annually if there are indicators of impairment, by comparison with the
recoverable amount of each CGU or group of CGU’s assets. Recoverable amounts for CGUs are measured at the higher of
fair value less costs of disposal and value in use. Value in use is calculated from cash flow projections for five years using
data from the consolidated entity’s latest internal forecasts. The key assumptions for the value in use calculations are those
regarding discount rates, growth rates and expected changes in margins. The forecasts used in the value in use calculations
are management’s estimates in determining income, expenses, capital expenditure and cash flows for each asset and CGU.
Changes in selling prices and direct costs are based on past experience and management’s expectation of future changes
in the markets in which the consolidated entity operates. Cash flows beyond the five year period are extrapolated using
estimated growth rates. The following table presents a summary of the goodwill allocation and the key assumptions used in
determining the recoverable amount of each CGU:
422 PART 2 Elements

Pre-Tax
Goodwill Allocation Discount Rate Growth Rate
2014 2013 2014 2013 2014 2013
CGU $ million $ million % % % %
Continuing Operations
Rigid Plastics
Rigid Plastics 712.7 725.2 11.8 12.2 11 —
Flexibles
Flexibles Europe & Americas 515.3 500.1 7.6 7.6 — —
Tobacco Packaging 321.0 303.7 7.6 7.6 — —
Flexibles Asia Pacific 246.2 192.4 9.6 9.9 3.0 3.0
Discontinued Operations
Australasia and Packaging Distribution
Australasia — 85.6 — 9.1 — —
Packaging Distribution — 116.6 — 8.9 — 3.0
1 795.2 1 923.6
The discount rate used in performing the value in use calculations reflects the consolidated entity’s weighted average cost
of capital, as adjusted for specific risks relating to each geographical region in which the CGUs operate. The pre-tax discount
rates are disclosed above. The growth rate represents the average rate applied to extrapolate CGU cash flows beyond the
five year forecast period. These growth rates are determined with regard to the long-term performance of each CGU in their
respective market and are not expected to exceed the long-term average growth rates in the applicable market.
Source: Amcor Ltd (2014, p. 115).
15.3.3 Recognition and measurement of an impairment

loss for an individual asset
Paragraphs 58–64 of IAS 36 provide the principles for recognition and measurement of an impairment loss
for an individual asset. If the recoverable amount of an asset is less than its carrying amount, an impair-
ment loss occurs, and the asset must be written down from its carrying amount to the recoverable amount.
Where an asset is measured using the cost model, according to paragraph 60 of IAS 36 an impairment
loss is recognised immediately in profit or loss. In relation to the other side of the accounting entry to the
loss, reference should be made to paragraph 73(d) of IAS 16 Property, Plant and Equipment. According to
this paragraph, for items of property, plant and equipment ‘the gross carrying amount and the accumulated
depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period’
should be disclosed. When impairment occurs, there is no need to write off any existing accumulated depre-
ciation or create a separate accumulated impairment account. The impairment write-down can be included
in accumulated depreciation, preferably referred to as ‘Accumulated Depreciation and Impairment Losses’.
Hence, if an asset having a carrying amount of $100 (original cost $160) has a recoverable amount of
$90, the appropriate journal entry to account for the impairment loss is:
Impairment Loss Dr 10
Accumulated Depreciation and Impairment Losses Cr 10
(Impairment loss on asset)
Where an asset is measured using the revaluation model (i.e. at fair value), according to paragraph 60 of
IAS 36 any impairment loss is treated as a revaluation increase and accounted for as set out in IAS 16. If
an asset at the end of an accounting period has a carrying amount of $100, being previously calculated as
fair value of $120 less accumulated depreciation of $20, and the asset’s recoverable amount (and possibly
its fair value) at the end of the period is determined to be $90, the accounting entry is:
Asset Cr 20
(Write-down of asset)
Loss – Downward Revaluation of Asset (P/L) Dr 10

Asset Cr 10
(Revaluation of asset)

If the revalued asset had a previous revaluation increase of $20, giving rise to a revaluation surplus of
$14 and a deferred tax liability (using a tax rate of 30%) of $6, then the entry to write the asset down to a
recoverable amount of $90 requires an adjustment directly against the revaluation surplus:
Asset Revaluation Surplus Dr 7
Deferred Tax Liability Dr 3
Asset Cr 30
(Write-down of asset to recoverable amount)
Regardless of whether the cost model or the revaluation model is used, once the impairment loss
is recognised, any subsequent depreciation/amortisation is based on the new recoverable amount. In
accordance with paragraph 63 of IAS 36, the depreciation charge is that necessary to allocate the asset’s
revised carrying amount (the recoverable amount) less its residual value (if any) on a systematic basis
over its remaining useful life, which may have to be reviewed in light of the circumstances leading to
the impairment.
It is possible that the recoverable amount is negative owing to large expected future cash outflows
relating to the asset, so the impairment loss could be greater than the carrying amount of the asset.
According to paragraph 62 of IAS 16, a liability for the excess should be raised only if another standard
requires it.
Figure 15.5 contains information disclosed in Note 10 to the 2014 financial statements of Nokia Corpo-
ration relating to its impairment of specific assets.
FIGURE 15.5 Impairment of assets
10. Impairment
Impairment charges by asset category are:
EURm 2014 2013 2012
Continuing operations
Goodwill 1 209 — —
Other intangible assets — — 8
Property, plant and equipment — 12 23
Investments in associated companies — — 8
Available-for-sale investments 15 8 31
Total 1 224 20 70
Goodwill
Goodwill impairment assessment for the HERE CGU was carried out at September 30, 2014. The previous
assessment date was October 1, 2013. The assessment date was brought forward to September 30, 2014 due
to an adjustment to the HERE strategy and the related new long-range plan, which incorporates the slower
than expected increase in net sales directly to consumers, and the Group’s plans to curtail its investment in
certain higher-risk and longer-term growth opportunities. This represented a triggering event resulting in an
interim impairment test to assess if events or changes in circumstances indicate that the carrying amount of
HERE goodwill may not be recoverable. The goodwill impairment assessment for the HERE CGU was rolled
forward to October 1, 2014 to align with the annual assessment date. The goodwill impairment assessment
for the Nokia Networks Radio Access Networks group of CGUs in Mobile Broadband and Global Services
group of CGUs was carried out at November 30, 2014 (November 30 in 2013).
The carrying value of goodwill allocated to each of the Group’s CGUs at each of the respective years’
impairment testing dates is:
EURm 2014 2013
HERE (1) 2 273 3 219

Global Services 106 91
Radio Access Networks in Mobile Broadband 96 88
Devices & Services (Discontinued operations) — 1 417
(1)The carrying value of goodwill after the 2014 impairment charge.
424 PART 2 Elements

The recoverable amounts of the Group’s CGUs were determined using the fair value less costs of
disposal method. In the absence of observable market prices, the recoverable amounts were estimated
based on an income approach, specifically a discounted cash flow model. The valuation method
is in line with previous years, with the exception that the cash flow forecast period is five years in
comparison with ten years previously. The cash flow projections used in calculating the recoverable
amounts are based on financial plans approved by management covering an explicit forecast period of
five years and reflect the price that would be received to sell the CGU in an orderly transaction between
market participants at the measurement date. The level of fair value hierarchy within which the fair value
measurement is categorized is level 3. Refer to Note 19, Fair value of financial instruments for the fair
value hierarchy.
The recoverable amount of the HERE CGU at September 30, 2014 was EUR 2,031 million, which
resulted in an impairment charge of EUR 1,209 million. The impairment charge is the result of an
evaluation of the projected financial performance and net cash flows of the HERE CGU and was
allocated entirely against the carrying value of HERE goodwill. The evaluation incorporates the
slower than expected increase in net sales directly to consumers, and the Group’s plans to curtail
its investment in certain higher-risk and longer-term growth opportunities. It also reflects the current
assessment of risks related to the growth opportunities that management plans to continue pursuing,
as well as the related terminal value growth assumptions. After consideration of all relevant factors,
management reduced the net sales projections for the HERE CGU, particularly in the latter years of the
valuation. The HERE CGU corresponds to the HERE operating and reportable segment. Refer to Note 2,
Segment information.
The key assumptions applied in the impairment testing analysis for each CGU are:
2014 2013 2014 2013 2014 2013

Radio Access Networks Global
group of CGUs in Services group
Key assumption % HERE CGU Mobile Broadband of CGUs
Terminal growth rate (1) 1.2 1.7 2.6 1.5 1.6 0.5
Post-tax discount rate 11.0 10.6 9.4 10.8 9.1 10.1
(1)Based
on a five-year forecast period (ten-year forecast period in 2013).
Terminal growth rates reflect long-term average growth rates for the industry and economies in which the
CGUs operate. The discount rates reflect current assessments of the time value of money and relevant
market risk premiums. Risk premiums reflect risks and uncertainties for which the future cash flow
estimates have not been adjusted. Other key variables in future cash flow projections include assumptions
on estimated sales growth, gross margin and operating margin. All cash flow projections are consistent
with external sources of information, wherever possible.
Management has determined the recoverable amount of the HERE CGU to be most sensitive to changes
in both the discount rate and the terminal growth rate. As the carrying value of the HERE CGU has been
written down to its recoverable amount, any increase in the discount rate or any decrease in the terminal
growth rate would result in further impairment. Management’s estimates of the overall automotive volumes
and market share, customer adoption of the new location-based platform and related service offerings, and
assumptions regarding industry pricing are the main drivers for the HERE net cash flow projections. The
Group’s cash flow forecasts reflect the current strategic views that license fee-based models will remain
important in both the near and long term. Management expects that when license fee-based models are
augmented with software and services, transactions fees will grow in the future as more customers demand
complete, end-to-end location solutions and as cloud computing and cloud-based services gain greater
market acceptance. Actual short- and long-term performance could vary from management’s forecasts and
impact future estimates of recoverable amount.
Management has determined the discount rate and the terminal growth rate to be the key assumptions for
the Nokia Networks Radio Access Networks group of CGUs and the Global Services group of CGUs. The
recoverable amounts calculated based on the sensitized assumptions do not indicate impairment in 2014
or 2013. Further, no reasonably possible changes in other key assumptions on which the Group has based
its determination of the recoverable amounts would result in impairment in 2014 or 2013.
In 2013, the recoverable amount of the Devices & Services CGU was determined using the fair value less
costs of disposal method, based on the agreed purchase price, excluding any consideration attributable to
patents or patent applications.
(continued)

Other intangible assets

In 2012, Nokia Networks recognized an impairment charge of EUR 8 million on intangible assets
attributable to the decision to transition certain operations into maintenance mode. These charges were
recorded in Other operating expenses.
Property, plant and equipment
In 2013, Nokia Networks recognized an impairment charge of EUR 6 million (EUR 23 million in 2012)
following the remeasurement of the Optical Networks disposal group at fair value less cost of disposal. In
2013, the Group recognized impairment losses of EUR 6 million relating to certain properties attributable
to Group Common Functions.
Investments in associated companies
In 2012, the Group recognized an impairment charge of EUR 8 million to adjust the Group’s investment
in associated companies to the recoverable amount. These charges were recorded in Other operating
expenses and included in Group Common Functions.
Available-for-sale investments
The Group recognized an impairment charge of EUR 15 million (EUR 8 million in 2013 and EUR 31
million in 2012) as certain equity and interest-bearing securities held as available-for-sale suffered a
significant or prolonged decline in fair value. These charges are recorded in Other expenses and Financial
income and expenses.
LO4 15.4 CASH-GENERATING UNITS — EXCLUDING

GOODWILL
The discussion above (section 15.3) focuses on individual assets and whether they have been impaired. The
impairment test in such cases involves the determination of recoverable amount, and this requires the
measurement of fair value less costs of disposal and value in use of the asset being tested for impairment.
However, for some assets, fair value less costs of disposal may be determinable, because the asset is sepa-
rable and a market for that asset exists, but it may be impossible to determine the value in use. Value in
use requires determining the expected cash flows to be received from an asset.
Some assets do not individually generate cash flows because the cash flows generated are the result of a
combination of several assets. For example, a machine in a factory works in conjunction with the rest of
the assets in the factory to produce sellable goods. For such assets, if the carrying amount exceeds the fair
value less costs of disposal, some other measure relating to value in use must be used.
Paragraph 66 of IAS 36 requires that, where there is any indication an asset may be impaired, if possible
the recoverable amount should be estimated for the individual asset.
However, if this is not possible, the entity should ‘determine the recoverable amount of the cash-generating
unit to which the asset belongs’. In other words, the impairment test is applied to a cash-generating unit
rather than to an individual asset. Paragraph 6 contains the following definition of a cash-generating unit:
A cash-generating unit is the smallest identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or groups of assets.
15.4.1 Identifying a cash-generating unit

The identification of a cash-generating unit requires judgement. As is stated in the definition, the key is to
determine the ‘smallest identifiable group of assets’, and this group must create ‘independent’ cash flows
from continuing use. Guidelines given in paragraphs 67–73 of IAS 36 include the following:
• Consider how management monitors the entity’s operations, such as by product lines, businesses,
individual locations, districts or regional areas.
• Consider how management makes decisions about continuing or disposing of the entity’s assets and
operations.
• If an active market exists for the output of a group of assets, this group constitutes a cash-generating unit.
• Even if some of the output of a group is used internally, if the output could be sold externally, then
these prices can be used to measure the value in use of the group of assets.
• Cash-generating units should be identified consistently from period to period for the same group of assets.
For example, an entity owns eight shops, spread across the same city. Head office sets selling prices and
designs shop layout. All inventory is purchased centrally. Factors that would indicate that each store is a
cash generating unit include the following:
• Does management monitor the profitability of each store separately?
• Does the location of the store suggest that each will have its own unique customer base?
426 PART 2 Elements

Or consider a steel mill that manufactures a particular grade of steel that is transferred to another fac-
tory owned by the entity. If the steel could be sold on the open market (even if all output is transferred
internally) then the mill is likely to be a separate cash-generating unit. If there is no external market then
the mill and the factory may have to be combined into a single cash-generating unit.
The identification of cash-generating units can be a little arbitrary. That leaves scope for the identifica-
tion of cash-generating units in such a way that assets that are likely to decrease in value are combined
with others that are likely to increase, so that impairment losses are unlikely to be recognised.
One alternative to the cash-generating unit is the segment concept as in IFRS 8 Operating Segments.
Although determination of segments is also arbitrary, an accounting standard covers the identification
of segments, which should improve the comparability across entities, and the identified segments are
reported to the public. Note, however, that IAS 36 allows a segment to be used as the cash-generating unit
only if the segment equates to the smallest identifiable group of assets that generate independent cash
flows. Figure 15.6 shows how in Lafarge Malaysia Berhad Note 15 to its 2014 financial statements reported
the company’s allocation of goodwill to its cash-generating units.
Goodwill acquired in a business combination is allocated, at acquisition, to the cash-generating unit

(“CGU”) that is expected to benefit from that business combination. Before recognition of any impairment
losses, the carrying amount of goodwill has been allocated to the following business segments as
independent CGUs:
Group
2014 2013
RM’000 RM’000
Cement 1 149 458 1 151 285

Aggregates and concrete 54 219 54 219
1 203 677 1 205 504
FIGURE 15.6 Allocation of goodwill to cash-generating units

Source: Lafarge Malaysia Berhad (2014, p. 98).
15.4.2 Impairment loss for a cash-generating unit —

excluding goodwill
An impairment loss occurs when the carrying amount of the assets of a cash-generating unit exceeds their
recoverable amount.
Determining the impairment loss
In determining the carrying amount of the assets, all those assets that are directly attributable to the cash-
generating unit and that contribute to generating the cash flows used in measuring recoverable amount must
be included. There must be consistency between what is being measured for recoverable amount — namely
cash flows relating to a group of assets — and the measurement of the carrying amount of those assets.
The principles for determining the recoverable amount of a cash-generating unit are the same as those
previously described for an individual asset (section 15.3). However, note that paragraph 76(b) of IAS 36
requires that the carrying amount of a cash-generating unit does not include the carrying amount of any
recognised liability. This is because, as stated in paragraph 43(b), the calculation of the future cash flows of
the cash-generating unit does not include cash outflows that relate to obligations that have been recognised
as liabilities, such as payables and provisions.
Accounting for an impairment loss in a cash-generating unit
If an impairment loss is recognised in a cash-generating unit that has not recorded any goodwill, paragraph
104 of IAS 36 states that the impairment loss should be allocated to reduce the carrying amount of the
assets of the unit by allocating the impairment loss pro rata based on the carrying amount of each asset in
the unit. The reduction in each carrying amount relates to each specific asset, and should be treated as an
impairment of each asset, even though the impairment loss was based on an analysis of a cash-generating
unit. The loss is accounted for in the same way as that for an individual asset as described in section 15.3,
with losses relating to an asset measured at cost being recognised immediately in profit or loss.
Paragraph 105 of IAS 36 places some restrictions on an entity’s ability to write down assets as a result of
the allocation of the impairment loss across the carrying amounts of the assets of the cash-generating unit.
For each asset, the carrying amount should not be reduced below the highest of:
(a) its fair value less costs of disposal (if measurable);
(b) its value in use (if determinable); and
(c) zero.

If there is an amount of impairment loss allocated to an asset, but a part of it would reduce the asset
below, say, its fair value less costs of disposal, then that part is allocated across the other assets in the
cash-generating unit on a pro rata basis (see illustrative example 15.1). However, as paragraph 106 notes,
if the recoverable amount of each of the assets cannot be estimated without undue costs or effort, then an
arbitrary allocation of the impairment loss between the assets of the unit will suffice because all the assets
of a cash-generating unit work together.
ILLUSTRATIVE EXAMPLE 15.1 Impairment of a cash-generating unit
A cash-generating unit has been assessed for impairment and it has been determined that the unit has
incurred an impairment loss of $12 000. The carrying amounts of the assets and the allocation of the
impairment loss on a proportional basis are as shown below.
Carrying Allocation of Net carrying

amount Proportion impairment loss amount
Buildings $ 500 000 5/12 $ 5 000 $495 000
Equipment 300 000 3/12 3 000 297 000
Land 250 000 2.5/12 2 500 247 500
Fittings 150 000 1.5/12 1 500 148 500
$ 1 200 000 $12 000
However, if the fair value less costs of disposal of the buildings was $497 000, then this is the max-
imum to which these assets could be reduced. Hence, the balance of the allocated impairment loss to
buildings of $2000 (i.e. $5000 − [$500 000 − $497 000]) has to be allocated across the other assets:
Carrying Allocation of Net carrying

amount Proportion impairment loss amount
Buildings $497 000
Equipment $297 000 297/693 $ 857 296 143
Land 247 500 247.5/693 714 246 786
Fittings 148 500 148.5/693 429 148 071
$693 000 $2 000
The journal entry to reflect the recognition of the impairment loss is:
Impairment Loss Dr 12 000

Losses – Buildings Cr 3 000
Losses – Equipment Cr 3 857
Land Cr 3 214
Losses – Fittings Cr 1 929
Corporate assets
One problem that arises when dividing an entity into separate cash-generating units is dealing with cor-
porate assets. Corporate assets, such as the headquarters building or the information technology support
centre, are integral to all cash-generating units generating cash flows but do not by themselves inde-
pendently generate cash flows. Paragraph 102 of IAS 36 sets out how corporate assets should be dealt with
in determining impairment losses for an entity:
Step 1: If any corporate assets can be allocated on a reasonable and consistent basis to cash-generating
units, then this should be done. Each unit is then, where appropriate, tested for an impairment
loss. Where a loss occurs in a cash-generating unit, the loss is allocated pro rata across the assets
including the portion of the corporate asset allocated to the unit.
Step 2: If some corporate assets cannot be allocated across the cash-generating units, the entity:
• compares the carrying amount of each unit being tested (excluding the unallocated corporate
asset) with its recoverable amount and recognises any impairment loss by allocating the loss
across the assets of the unit
428 PART 2 Elements

• identifies the smallest cash-generating unit that includes the unit under review and to which a
portion of the unallocated corporate asset can be allocated on a reasonable and consistent basis
• compares the carrying amount of the larger cash-generating unit, including the portion of the
corporate asset, with its allocated amount. Any impairment loss is then allocated across the
assets of the larger cash-generating unit.
Illustrative example 15.2 provides the accounting for corporate assets.
ILLUSTRATIVE EXAMPLE 15.2 Accounting for corporate assets
Singapore Engineering has two cash generating units, A and B. The assets of the two units are as follows:
Unit A Unit B
Plant $ 500 $ 400
Land 300 220
Singapore Engineering has two corporate assets: the headquarters building and a research centre. The
headquarters is assumed to be used equally by both units. The carrying amount of the research centre
cannot be allocated on a reasonable basis to the two units. The headquarters building has a carrying
amount of $160. The research centre’s assets consist of furniture of $100 and equipment of $160. Nei-
ther of the corporate assets produces cash flows for Singapore Engineering.
The recoverable amounts of the two cash-generating units are:
Unit A $ 900
Unit B $ 665
The first step is to calculate the impairment losses for each of the cash generating units. To do this, the
carrying amount of the headquarters building is allocated equally between the two units as it is used
equally by those units. Impairment losses are then as follows:
Unit A Unit B
Plant $ 500 $ 400
Land 300 220
Headquarters building 80 80
880 700
Recoverable amount 900 665
Impairment loss $ 0 $ 35
The impairment loss of $35 for Unit B is then allocated across all non-excluded assets in that unit:
Carrying Proportion Adjusted
amount of loss Loss carrying amount
Plant $ 400 400/700 $ 20 $ 380
Land 220 220/700 11 209
Headquarters building 80 80/700 4 76
$ 35
The second step is to deal with the research centre. This requires the determination of any impairment
loss for the smallest cash-generating unit that includes the research centre. In this case, the smallest cash-
generating unit is the entity as a whole. The impairment loss is calculated as follows:
Unit A
Plant $ 500
Land 300
Headquarters building [$80 + $76] 156
Unit B
Plant 380
Land 209
Research Centre
Furniture 40
Equipment 30
1 615
Recoverable amount [$900 + $665] 1 565
Impairment loss $ 50

This impairment loss is then allocated across these assets on a pro rata basis:
Adjusted
Carrying Proportion carrying
amount of loss Loss amount
Unit A
Plant $ 500 500/1 615 $ 15 $ 485
Land 300 300/1 615 9 291
Headquarters building [$80 + $76] 156 156/1 615 5 151
Unit B
Plant 380 380/1 615 12 368
Land 209 209/1 615 7 202
Research Centre
Furniture 40 40/1 615 1 39
Equipment 30 30/1 615 1 29
$1 615 $ 50
LO5 15.5 CASH-GENERATING UNITS AND GOODWILL

In accounting for impairment losses for cash-generating units, one of the assets that may be recorded by
an entity is goodwill. IAS 36 contains specific requirements for accounting for goodwill and how its exist-
ence affects the allocation of impairment losses across the assets of a cash-generating unit.
Goodwill is recognised only when it is acquired in a business combination. It is not possible to determine a
fair value less costs of disposal for goodwill, or to identify a set of cash flows that relates specifically to goodwill.
Accounting for goodwill acquired in a business combination is specified in paragraph 32 of IFRS 3
Business Combinations. The acquirer measures goodwill acquired in a business combination at cost less any
accumulated impairment losses. Goodwill is not subject to amortisation. Instead, the acquirer tests the
carrying amount of goodwill annually in accordance with IAS 36.
When a business combination occurs, and goodwill is calculated as part of accounting for that combina-
tion, the goodwill acquired is allocated to one or more cash-generating units (IAS 36 paragraph 80). Even
though goodwill was acquired in relation to the entity as a whole, the cash flow earning capacity of goodwill
must be allocated across the cash-generating units. The aim is to allocate all assets, whether corporate assets
or goodwill, to the cash-generating units so they can be associated with the cash flows received by those units.
When deciding which units should have goodwill allocated to them, consideration should be given to
how internal management monitors the goodwill. According to paragraph 80, the goodwill should be
allocated to the lowest level at which management monitors the goodwill. When the business combination
occurred, the acquirer would have analysed the earning capacity of the entity it proposed to acquire, and
would have equated aspects of goodwill to various cash-generating units. It is possible that the allocation
of goodwill would be made to each of the segments identified by management under the application of
IFRS 8 Operating Segments. Paragraph 80 of IAS 36 states that the units to which goodwill is allocated
should not be larger than a segment based on either the entity’s primary or secondary reporting format.
This is due to the fact that IFRS 8 requires the determination of business and geographical segments based
on areas that are subject to different risks and return, and the internal financial reporting system within the
entity is used as a basis for identifying these segments.
Under IFRS 3, there is an allowance for a provisional initial accounting for the business combination. Par-
agraph 84 of IAS 36 therefore provides, consistent with IFRS 3, that where the allocation of goodwill cannot
be completed before the end of the annual period in which the business combination occurred, the initial
allocation is to be completed before the end of the first annual period beginning after the acquisition date.
15.5.1 Impairment testing of goodwill

A cash-generating unit that has goodwill allocated to it must be tested for impairment annually or more
frequently if there is an indication the unit may be impaired (IAS 36 paragraph 90). As with other impair-
ment tests, this involves comparing the carrying amount of the unit’s assets, including goodwill, with the
recoverable amount of the unit’s assets.
Recoverable amount exceeds carrying amount

If the recoverable amount exceeds the carrying amount, there is no impairment loss. In particular, there
is no impairment of goodwill. The goodwill balance remains unadjusted; that is, it is not reduced due to
impairment loss.
430 PART 2 Elements

In practice, it is impossible to distinguish purchased goodwill from other assets that might increase the
recoverable amount:
• internally generated goodwill — possibly created since the business combination.
• unrecognised identifiable net assets — intangibles may exist which do not meet the recognition criteria
under IAS 38 Intangible Assets.
• excess value over carrying amount of recognised assets — the impairment test uses the carrying amount of
the unit’s recognised assets. If the fair values of these assets are greater than their carrying amounts, the
extra benefits relating to these assets increase the recoverable amount of the unit.
The IASB acknowledges that these factors could reduce the likelihood of recognising impairment losses
for goodwill. The impairment test for goodwill is, at best, ensuring that the carrying amount of goodwill is
recoverable from cash flows generated by both acquired and internally generated goodwill. While this may
be inconsistent with the requirement that purchased goodwill should be reviewed annually for impair-
ment, it simplifies that annual review.
Users of the financial statements can take appropriate care when interpreting financial statements that
show a significant goodwill balance.
Carrying amount exceeds recoverable amount

If the carrying amount exceeds the recoverable amount, there is an impairment loss, and this loss is recog-
nised in accordance with paragraph 104 of IAS 36. This paragraph states that the impairment loss must be
allocated to reduce the carrying amount of the assets of the unit, or group of units, in the following order:
• firstly, to reduce the carrying amount of any goodwill allocated to the cash-generating unit
• then, to the other assets of the unit pro rata on the basis of the carrying amount of each asset in the unit.
These reductions in carrying amounts are treated as impairment losses on the individual assets of the
unit and recognised as any other impairment losses on assets.
However, paragraph 105 of IAS 36 provides some restrictions on the write-downs to individual assets:
In allocating an impairment loss in accordance with paragraph 104, an entity shall not reduce the carrying
amount of an asset below the highest of:
(a) its fair value less costs of disposal (if measurable);
(b) its value in use (if determinable); and
(c) zero.
The amount of the impairment loss that would otherwise have been allocated to the asset shall be allocated pro
rata to the other assets of the unit (group of units).
Timing of impairment tests

As noted earlier, goodwill has to be tested for impairment annually. However, the test does not have to
occur at the end of the reporting period. As paragraph 96 of IAS 36 notes, the test may be performed at
any time during the year, provided it is performed at the same time every year. According to paragraph
BC171 of the Basis for Conclusions on IAS 36, this measure was allowed as a means of reducing the costs
of applying the test. However, if a business combination has occurred in the current period, and an alloca-
tion has been made to one or more cash-generating units, all units to which goodwill has been allocated
must be tested for impairment before the end of that year — see paragraph 96 of IAS 36.
It is not necessary for all cash-generating units to be tested for impairment at the same time. If there are
two units being tested for impairment, one being a smaller cash-generating unit within a larger unit and
the larger unit contains an allocation of goodwill, it is necessary to test the smaller unit for impairment
first. This ensures that, if necessary, the assets of the smaller unit are adjusted before the testing of the
larger unit. Similarly, if the assets of a cash-generating unit containing goodwill are being tested at the
same time as the unit, then the assets must be tested first.
Other impairment issues relating to goodwill

IAS 36 raises a number of other issues that need to be considered in accounting for the impairment of
goodwill within a cash-generating unit:
• Disposal of an operation within a cash-generating unit. Where the cash-generating unit has a number of
distinct operations and goodwill has been allocated to the unit, if one of the operations is disposed of,
it is necessary to consider whether any of the goodwill relates to the operation disposed of. If it does,
the amount of goodwill is measured on the basis of the relative values of the operation disposed of
and the portion of the cash-generating unit retained, unless the entity can demonstrate that some other
method better reflects the goodwill associated with the operation disposed of. In calculating the gain
or loss on disposal of the operation, the allocated portion of the goodwill is included in the carrying
amount of the assets sold (paragraph 86).
For example, if part of a cash-generating unit was sold for $200 and the recoverable amount of the
remaining part of the unit is $600, then it is assumed that 25% (200/[200 + 600]) of the goodwill has
been sold and is included in the carrying amount of the operation disposed of.
• Reorganisation of the entity. Where an entity containing a number of cash-generating units restructures,
changing the composition of the cash-generating units, and where goodwill has been allocated to the

original units, paragraph 87 requires the reallocation of the goodwill to the new units. The allocation
is done on a relative value basis similar to that used where a cash-generating unit is disposed of, again
unless the entity can demonstrate that some other method better reflects the goodwill associated with
the operation disposed of.
LO6 15.6 REVERSAL OF AN IMPAIRMENT LOSS

An impairment loss is recognised after an entity analyses the future prospects of an individual asset or a
cash-generating unit. Subsequent to an impairment loss occurring because of doubts about the perfor-
mance of assets, it is possible for circumstances to change such that, when the recoverable amount of the
assets increases, consideration can be given to a reversal of a past impairment loss. Paragraph 110 of IAS 36
requires an entity to assess at the end of each reporting period whether there are indications that an impair-
ment loss recognised in previous periods may not exist or may have decreased. If such indications exist,
the entity should estimate the recoverable amount of the asset or unit.
If there is evidence of a favourable change in the estimates in relation to an asset (and only if there
has been a change in the estimates), a reversal of impairment loss can be recognised. The reversal process
requires the recognition of an increase in the carrying amount of the asset to its recoverable amount.
The ability to recognise a reversal of an impairment loss and the accounting for that reversal depend on
whether the reversal relates to an individual asset, a cash-generating unit or goodwill.
15.6.1 Reversal of an impairment loss — individual asset

Where the recoverable amount is greater than the carrying amount of an individual asset (other than
goodwill), the reversal of a previous impairment loss requires adjusting the carrying amount of the asset
to recoverable amount. In determining the amount by which the carrying amount is to be adjusted, one
limitation, as outlined in paragraph 117 of IAS 36, is that the carrying amount cannot be increased to an
amount in excess of the carrying amount that would have been determined had no impairment loss been
recognised.
15.6.2 Reversal of an impairment loss — cash-generating unit

If the reversal of the impairment loss relates to a cash-generating unit, in accordance with paragraph 122
of IAS 36 the reversal of the impairment loss is allocated pro rata to the assets of the unit, except for good-
will, with the carrying amounts of those assets. These reversals will then relate to the specific assets of the
cash-generating unit and will be accounted for as detailed above for individual assets. In relation to those
individual assets, the carrying amount of an asset cannot, as per paragraph 123 of IAS 36, be increased
above the lower of its recoverable amount (if determinable) and the carrying amount that would have
been determined had no impairment loss been recognised for the asset in previous periods.
If the situation envisaged in paragraph 123 occurs, then the amount of impairment loss reversal that
cannot be allocated to an individual asset is then allocated on a pro rata basis to the other assets of the
cash-generating unit, except for goodwill.
15.6.3 Reversal of an impairment loss — goodwill

Paragraph 124 of IAS 36 states that an impairment loss recognised for goodwill shall not be reversed in a
later period.
ILLUSTRATIVE EXAMPLE 15.3 Reversal of impairment loss
At 30 June 2015, Jimena SL incurred an impairment loss of $5000, of which $3000 was used to write
off the goodwill and $2000 to write down the assets. The allocation of the impairment loss to the assets
was as follows:
Carrying Proportion Adjusted carrying

amount of loss Loss amount
Land $10 000 1/5 $ 400 $ 9 600
Plant 40 000 4/5 1 600 38 400
$50 000 $2 000
The plant had previously cost $100 000 and was being depreciated at 10% per annum, requiring a
depreciation charge of $10 000 per annum. Subsequent to the impairment, the asset was depreciated on
a straight-line basis over 3 years, at $12 800 per annum.
432 PART 2 Elements

At 30 June 2016, the business situation had improved and Jimena SL believed that it should reverse
past impairment losses. A comparison of the carrying amounts of the assets at 30 June 2016 and their
recoverable amounts revealed:
Land $ 9 600
Plant [$38 400 − $12 800] 25 600
Furniture 800
36 000
Recoverable amount 38 800
Excess of recoverable amount over carrying amount $ 2 800
The excess cannot be allocated to the goodwill as impairment losses on goodwill can never be
reversed. If the excess were allocated to the assets it can only be allocated to the assets existing at the
previous impairment write-down as assets cannot be written up above their original cost. The excess of
recoverable amount is then allocated to the relevant assets on a pro rata basis:
Carrying Adjusted carrying

amount Share of loss amount
Land $ 9 600 $ 764 $10 364
Plant 25 600 2 036 27 636
$35 200 $ 2800
These assets cannot be written up above the amounts that they would have been recorded at if there
had been no previous impairment. These amounts would be:
Land $10 000

Plant $30 000 [$40 000 less $10 000 depreciation for the 2015–16 financial year]
As the land cannot be written up above $10 000, $364 of the $764 that was allocated to it must
be reallocated to the plant. This would increase the carrying amount of the plant to $28 000 (being
$27 636 + $364). This is still less than the maximum of $30 000. The journal entry to record the reversal
of the impairment loss is:
Land Dr 400
Accumulated Depreciation and Impairment Loss – Plant Dr 2 400
Income – Reversal of Impairment Loss Cr 2 800
(Reversal of impairment loss)
LO7 15.7 DISCLOSURE

Paragraph 126 of IAS 36 requires the following disclosures for each class of assets:
(a) the amount of impairment losses recognised in profit or loss during the period and the line item(s) of the
statement of comprehensive income in which those impairment losses are included;
(b) the amount of reversals of impairment losses recognised in profit or loss during the period and the line
item(s) of the statement of comprehensive income in which those impairment losses are reversed;
(c) the amount of impairment losses on revalued assets recognised in other comprehensive income during the
period; and
(d) the amount of reversals of impairment losses on revalued assets recognised in other comprehensive income
during the period.
As noted in chapter 11, paragraph 73(e) of IAS 16 Property, Plant and Equipment requires, in relation to the
reconciliation of the carrying amount at the beginning and end of the period for each class of property,
plant and equipment, disclosure of:
• increases or decreases during the period resulting from impairment losses recognised or reversed in
other comprehensive income
• impairment losses recognised in profit or loss during the period
• impairment losses reversed in profit or loss during the period.

Similar disclosures are required for intangibles under paragraph 118 of IAS 38 Intangible Assets for each
class of intangible asset.
As paragraph 128 of IAS 36 states, the disclosures required by paragraph 126 may be presented or
included in a reconciliation of the carrying amount of assets at the beginning and end of the period. (Such
disclosures were illustrated in chapter 11.) For parts (a) and (b) of paragraph 126, disclosure is required of
the relevant line item(s) used. If these were included in other expenses or other income then information
relating to impairment losses or reversals would be required in the note to the statement of profit or loss
and other comprehensive income relating to these line items in the statement of profit or loss and other
Paragraph 129 of IAS 36 details information to be disclosed for each reportable segment where an entity
applies IFRS 8 Operating Segments.
Paragraph 133 of IAS 36 requires disclosures in relation to any goodwill that has not been allocated to
a cash-generating unit at the end of the reporting period. In particular, an entity must disclose the amount
of the unallocated goodwill and the reasons that amount has not been allocated to the cash-generating
units in the entity.
Because the calculation of recoverable amount requires assumptions and estimates relating to future
cash flows, IAS 36 requires disclosures relating to the calculation of recoverable amount. Paragraph 132
encourages, but does not require, disclosure of key assumptions used to determine the recoverable amounts
of assets or cash-generating units.
Paragraph 134 of IAS 36 requires disclosures about the estimates used to measure the recoverable amount
of a cash-generating unit when goodwill or an intangible asset with an indefinite life is included in the car-
rying amount of the unit, and the carrying amount of goodwill or intangible assets with indefinite useful
lives allocated to that unit is significant in comparison with the entity’s total carrying amount of goodwill
or intangible assets with indefinite useful lives. Where the carrying amount of goodwill or intangible assets
is not significant for a unit, paragraph 135 requires that fact to be disclosed. If, for a number of such units,
the recoverable amounts are based on the same key assumptions and the aggregate carrying amount of
goodwill or intangible assets with indefinite lives is significant in comparison to the total for the entity,
paragraph 135 requires similar, but not as extensive, disclosures to those in paragraph 134.
SUMMARY
It is important that users of financial statements can rely on the information provided. In particular they
need to be assured that the assets in the statement of financial position are not stated at amounts greater
than an entity could expect to recover from those assets. It needs to be recognised that an entity can obtain
cash flows from two sources in relation to any asset: (1) by using the asset or (2) by selling the asset. One
of these involves an ongoing use of the asset whereas the other relates to an immediate sale of the asset.
Any test of the carrying amounts of assets against their recoverable amounts must take both sources of
cash flows into account.
For an entity to conduct an impairment test, there must be indications of impairment. Entities then
need to continuously obtain information about factors that may indicate that assets are impaired. These
sources of information may consist of an analysis of economic factors external to the organisation, such as
actions of competitors, or economic factors within the entity itself, such as the performance of the entity’s
property, plant and equipment over time. When there are indications of impairment, an entity conducts
an impairment test, comparing the carrying amounts of relevant assets and their recoverable amounts. The
latter involves measurement of value in use and fair value less costs of disposal.
In many cases, single assets do not produce cash flows for the entity. Instead, the assets of the entity are
allocated to units, called cash-generating units, as each unit produces independent cash flows for an entity.
In such cases, impairment tests are conducted on the cash-generating units, rather than on individual assets.
Where an impairment loss occurs, the loss must be allocated across the assets of the unit, with goodwill
being the first asset affected. Where corporate assets such as research facilities exist, it may be necessary to
combine a number of cash-generating units together in order to test for impairment of the corporate asset.
Having written down assets as a result of impairment tests, entities may see potential improvement in
the recoverable amounts of assets by observing the same indicators used for detecting impairment losses.
In such cases, where the recoverable amounts of assets have increased, impairment losses may be reversed,
subject to constraints. Impairment losses relating to goodwill, however, can never be reversed.
DEMONSTRATION PROBLEM 15.1 Impairment losses, no corporate assets
Eastern Ltd has two divisions, Kamal and Katherine, each of which is a separate cash-generating unit
(CGU). Eastern Ltd adopts a decentralised management approach whereby unit managers are expected
to operate their units. However, there is one corporate asset, the information technology network, which
is centrally controlled and provides a computer network to the company as a whole. The information
technology network is not a depreciable asset.
434 PART 2 Elements

At 31 December 2016 the net assets of each division, including its allocated share of the information
technology network, were as follows:
Kamal Katherine
Information technology (IT) network $ 284 000 $ 116 000
Land 450 000 290 000
Plant (20% p.a. straight-line depreciation) 1 310 000 960 000
Accumulated depreciation (plant) (917 000 ) (384 000 )
Goodwill 46 000 32 000
Patent (10% straight-line amortisation) 210 000 255 000
Accumulated amortisation (patent) (21 000 ) (102 000 )
Cash 20 000 12 000
Inventory 120 000 80 000
1 536 000 1 299 000
Liabilities (276 000) (189 000)
Net assets $ 1 260 000 $ 1 110 000
Additional information as at 31 December 2016:

• Kamal’s land had a fair value less costs of disposal of $437 000.
• Katherine’s patent had a carrying amount below fair value less costs of disposal.
• Katherine’s plant had a fair value less costs of disposal of $540 000.
• Receivables were considered to be collectable.
• The IT network is not depreciated, as it is assumed to have an indefinite life.
Eastern Ltd’s management undertook impairment testing at 31 December 2016 and determined the
recoverable amount of each cash-generating unit to be: $1 430 000 for Kamal and $1 215 000 for Katherine.
Required
Prepare any journal entries necessary to record the results of the impairment testing for each of the CGUs.
Solution
The first step is to determine whether either CGU has an impairment loss. This is done by comparing
the carrying amount of the assets of each CGU with the recoverable amount of these assets. Note that
it is the carrying amount of the assets not the net assets that is used — the test is for the impairment of
assets, not net assets.
Kamal Katherine
Carrying amount of assets $ 1 536 000 $ 1 299 000
Recoverable amount 1 430 000 1 215 000
Impairment loss $ (106 000) $ (84 000)
As a result of the comparison, both CGUs have suffered impairment losses.

For each CGU, the impairment loss is used to write off any goodwill and then to allocate any balance
across the other assets in proportion to their carrying amounts.
Kamal CGU
Kamal has goodwill of $46 000. Therefore, the first step is to write off goodwill of $46 000.
The second step is to allocate the remaining impairment loss of $60 000 (i.e. $106 000 − $46 000).
Note that although all the assets are included in the calculation to determine whether the CGU has
incurred an impairment loss, the allocation of that loss is only to those assets that will be written down
as a result of the allocation process. Cash and receivables are not written down as they are recorded at
amounts equal to fair value. The inventory is recorded under IAS 2 at the lower of cost and net realisable
value, and as such is excluded from the impairment test write-down under IAS 36. The allocation of the
balance of the impairment loss is done on a pro rata basis, in proportion to the assets’ carrying amounts.
Carrying Allocation Adjusted carrying

amount Proportion of loss amount
IT network $ 284 000 284/1 316 $12 948 $271 052
Land 450 000 450/1 316 20 517 429 483
Plant 393 000 393/1 316 17 918 375 082
Patent 189 000 189/1 316 8 617 180 383
$ 1 316 000 $60 000

After the initial allocation across the assets, a check has to be made on the amount of each write-
down as IAS 36 places limitations on the amount to which assets can be written down. Paragraph 105
of IAS 36 states that for each asset the carrying amount should not be reduced below the highest of the
following:
• its fair value less costs of disposal
• its value in use
• zero.
In this example, the land has a fair value less costs of disposal of $437 000. Hence it cannot be
written down to $429 483 as per the above allocation table. Only $13 000 (to write the asset down from
$450 000 to $437 000) of the impairment loss can be allocated to it. Therefore, the remaining $7517
allocated loss (i.e. $20 517 − $13 000) must be allocated to the other assets. This allocation is based on
the adjusted carrying amounts, the right-hand column of the table above.

IT Network $271 052 271 052/826 517 $2 465 $268 587
Plant 375 082 375 082/826 517 3 411 371 671
Patent 180 383 180 383/826 517 1 641 178 742
$826 517 $7 517
The impairment loss for each asset is then based, where relevant, on the accumulation of both alloca-
tions. With non-depreciable assets such as land, the asset is simply written down, whereas with depreciable
assets such as plant, the account increased is the Accumulated Depreciation and Impairment losses account.
The journal entry for Kamal is:

Goodwill Cr 46 000
Land Cr 13 000
IT Network [$12 948 + $2 465] Cr 15 413
Losses – Plant [$17 918 + $3 411] Cr 21 329
Losses – Patent [$8 617 + $1 641] Cr 10 258
Katherine CGU
As with the Kamal CGU, the impairment loss is used to write off the goodwill balance, $32 000, and
then the balance of the impairment loss, $52 000 (i.e. $84 000 − $32 000), is allocated across the
remaining assets, except for cash, receivables and inventory. Further, as the patent’s carrying amount is
below fair value less costs of disposal, no impairment loss can be allocated to it.

IT network $116 000 116/982 $ 6 143 $109 857
Land 290 000 290/982 15 356 274 644
Plant 576 000 576/982 30 501 545 499
$982 000 $52 000
Because the plant has a fair value less costs of disposal of $540 000 and this is below the adjusted
carrying amount of $545 499, the full impairment loss of $30 501 can be allocated to it.
The journal entry for Katherine is:

Goodwill Cr 32 000
IT Network Cr 6 143
Land Cr 15 356
Losses – Plant Cr 30 501
436 PART 2 Elements

DEMONSTRATION PROBLEM 15.2 Impairment losses, corporate asset
Parkes Ltd has three CGUs, a head office and a research facility. The carrying amounts of the assets and
their recoverable amounts are as follows:
Head Research Parkes

Unit A Unit B Unit C office facility Ltd
Carrying amount $ 100 $ 150 $200 $ 150 $ 50 $ 650
Recoverable amount 129 164 271 584
The assets of the head office are allocable to the three units as follows:
• Unit A: $19
• Unit B: $56
• Unit C: $75
The assets of the research facility cannot be reasonably allocated to the CGUs.
Required
Assuming all assets can be adjusted for impairment, prepare the journal entry relating to any impair-
ment of the assets of Parkes Ltd.
Solution
For each unit there needs to be a comparison between the carrying amounts of the assets of the units
and their recoverable amounts to determine which, if any, of the CGUs is impaired. As the asset of the
head office can be allocated to each of the units, the carrying amounts of each of the units must then
include the allocated part of the head office.
Calculation of impairment losses for units
Unit A Unit B Unit C

Carrying amount $ 119 $ 206 $ 275
Recoverable amount 129 164 271
Impairment loss $ — $ 42 $ 4
Because the assets of Unit A are not impaired, no write-down is necessary. For Units B and C, the
impairment losses must be allocated to the assets of the units. The allocation is in proportion to the
carrying amounts of the assets.
Allocation of impairment loss
Unit B Unit C
To head office $ 11 [42 × 56/206] $ 1 [4 × 75/275]
To other assets 31 [42 × 150/206] 3 [4 × 200/275]
$ 42 $4
In relation to the research centre, the assets of the centre cannot be allocated to the units, so the
impairment test is based on the smallest CGU that contains the research centre, which in this case is the
entity as a whole, Parkes Ltd. For this calculation, the carrying amounts of the assets of the units as well
as the head office are reduced by the impairment losses already allocated. The total assets of Parkes Ltd
consist of all the assets of the entity.
Impairment testing for CGU as a whole
Head Research Parkes

Unit A Unit B Unit C office centre Ltd
Carrying amount 100 150 200 150 50 650
Impairment loss – 31 3 12 — 46
Net 100 119 197 138 50 604
Recoverable amount 584
Impairment loss 20

Because the carrying amount of the assets of Parkes Ltd is greater than the recoverable amount of the
entity, the entity has incurred an impairment loss. This loss is allocated across all the assets of the entity
in proportion to their carrying amounts.
Allocation of impairment loss
Adjusted
Carrying Allocation carrying
Unit A $ 100 100/604 × 20 $ 3 $ 97
Unit B 119 119/604 × 20 4 116
Unit C 197 197/604 × 20 6 191
Head office 138 138/604 × 20 5 132
Research centre 50 50/604 × 20 2 48
$ 604 $20
Journal entry for impairment loss

The journal entry for the impairment loss recognises the reduction in each of the assets. As the com-
position of the assets is not detailed in this question, the credit adjustments are made against the
asset accounts. They could also have been made against an Accumulated Depreciation and Impairment
losses account. Obviously if the composition of each of the assets of each unit had been given, the
impairment loss would have been allocated to specific assets rather than assets as a total category as
in the solution here.
Impairment Loss Dr 66
Assets – Unit A Cr 3
Assets – Unit B Cr 34
Assets – Unit C Cr 9
Assets – Head Office Cr 18
Assets – Research Facility Cr 2
1. What is an impairment test?
2. Why is an impairment test considered necessary?
3. When should an entity conduct an impairment test?
4. What are some external indicators of impairment?
5. What are some internal indicators of impairment?
6. What is meant by recoverable amount?
7. How is an impairment loss calculated in relation to a single asset accounted for?
8. What are the limits to which an asset can be written down in relation to impairment losses?
9. What is a cash-generating unit?
10. How are impairment losses accounted for in relation to cash-generating units?
11. Are there limits in adjusting assets within a cash-generating unit when impairment losses occur?
12. How is goodwill tested for impairment?
13. What is a corporate asset?
14. How are corporate assets tested for impairment?
15. When can an entity reverse past impairment losses?
16. What are the steps involved in reversing an impairment loss?
References
Amcor Ltd 2014, Annual Report 2014, Amcor Limited, Australia, www.amcor.com.au.
European Financial Reporting Advisory Group 2003, Comments of EFRAG on Exposure Draft 3 Business
Combinations, 4 April, p. 10, www.iasplus.com.
Lafarge Malaysia Berhad 2014, Annual Report 2014, www.lafarge.com.my.
Nokia Corporation 2014, Nokia in 2014, Nokia Corporation, Finland, www.nokia.com.
438 PART 2 Elements

Exercise 15.1 CASH-GENERATING UNITS

★ Fresh Milk Ltd owns a large number of dairy farms. It has a number of factories that are used to pro-
duce milk products that are then sent to other factories to be converted into milk-based products such
as yoghurt and custard. In applying IAS 36 Impairment of Assets, the accountant for Fresh Milk Ltd is con-
cerned about correctly identifying the cash-generating units (CGUs) for the company, and has sought your
advice on such questions as to whether the milk production section is a separate CGU even though the
company does not sell milk directly to other parties, or whether it should be included in the milk-based
products CGU.
Required
Write a report to the accountant of Fresh Milk Ltd, including the following:
1. Define a CGU.
2. Explain why impairment testing requires the use of CGUs, rather than being based on single assets.
3. Explain the factors that the accountant should consider in determining the CGUs for Fresh Milk Ltd.
Exercise 15.2 IMPAIRMENT TESTING AND GOODWILL

★ At 30 June 2016, Longreach Ltd is considering undertaking an impairment test. Having only recently
adopted the international accounting standards, the management of Longreach Ltd seeks your advice in
relation to this test under IAS 36 Impairment of Assets.
Required
Write a report to management, specifically explaining:
1. the purpose of the impairment test
2. how the existence of goodwill will affect the impairment test
3. the basic steps to be followed in applying the impairment test.
Exercise 15.3 FREQUENCY OF IMPAIRMENT TEST

★ In setting up its systems to apply IAS 36 Impairment of Assets, management of Durban Ltd wants to know
how often the company needs to apply an impairment test on its assets, and what information it needs to
generate to determine whether a test is needed.
Required
Prepare a response to management.
Exercise 15.4 IMPAIRMENT LOSS

★ Tambo Ltd has determined that its fine china division is a cash-generating unit. The carrying amounts of
the assets at 30 June 2016 are as follows:
Factory $ 210 000

Land 150 000
Equipment 120 000
Inventory 60 000
Tambo Ltd calculated the recoverable amount of the division to be $510 000.
Required
Provide the journal entry(ies) for the impairment loss, assuming that the fair value less costs of disposal of
the land are (a) $140 000 and (b) $145 000.
Exercise 15.5 IDENTIFICATION OF CGUS

★★ Burger Queen is a chain of fast-food restaurants — most reasonably sized towns in the country have a
Burger Queen outlet. The key claim to fame of the Burger Queen restaurants is that their fried chips are
extra crunchy. Also, to ensure that there is a consistent standard of food and service across the country, the
management of the chain of restaurants conducts spot checks on restaurants. Failure to provide the high
standard expected by Burger Queen management can mean that the franchise to a particular location can
be taken away from the franchisee. Burger Queen management is responsible for the television advertising
across the country as well as the marketing program, including the special deals that may be available at
any particular time.

Each restaurant is responsible for its own sales, cooking of food, training of staff, and general matters such
as cleanliness of the store. However, all material used in the making of the burgers and other items sold are
provided at a given cost from the central management, which can thereby control the quality and the price.
Required
Identify the cash-generating unit(s) in this scenario. Give reasons for your conclusions.
Exercise 15.6 IDENTIFICATION OF CGUS

★★ Marla Macalister is in the business of making rubber tubing that comes in all sorts of sizes and shapes.
Marla has established three factories in the north, south and east parts of the city. Each factory has a
large machine that can be adjusted to produce all the varieties of tubing that Marla sells. Each machine is
capable of producing around 100 000 metres of tubing a week, depending on diameter and shape. Marla’s
current sales amount to about 250 000 metres a week. Each factory is never worked to full capacity. How-
ever, sales are sufficiently high that Marla cannot afford to shut one of the factories.
In order to satisfy customer demand as quickly as possible, all orders are directed to Marla, who allo-
cates the jobs to the various factories depending on the current workload of each factory. This also ensures
that efficient runs of particular types of tubing can be done at the same time. Each factory is managed
individually in terms of maintenance of the machines, the hiring of labour and the packaging and delivery
of the finished product.
Required
Identify the cash-generating unit(s) in this scenario. Give reasons for your conclusions.
Exercise 15.7 VALUE IN USE

★★ Management is assessing the future cash flows in relation to an entity’s assets, and considers that there are
two possible scenarios for future cash flows. The first, for which there is a 70% probability of occurrence,
would provide future cash flows of $5 million. The second, which has a probability of occurrence of 30%,
would provide future cash flows of $8 million. Management has decided that the calculation of value in use
should be based on the most likely scenario, namely the one that will produce cash flows of $5 million.
Required
Evaluate management’s decision.
Exercise 15.8 15.8 WRITE-DOWN

★★ Joburg Enterprises Ltd acquired a building in which to conduct its operations at a cost of $10 million. The
building generates no cash flows on its own and is considered a part of the cash-generating unit, which is
the firm as a whole. Since the building was acquired, the value of inner-city properties has declined owing
to an overabundance of office space and the downturn in the economy. The company would receive only
$8 million dollars if it decided to sell the building now. However, the company believes the building is
serving its purpose and the profits are high, so there is no current intention of selling the building.
Required
Discuss whether the building should be written down to $8 million. Provide any journal entries necessary.
Exercise 15.9 ASSET IMPAIRMENT

★★ Parkes Ltd acquired a network facility for its administration section on 1 July 2014. The network facility
cost $550 000 and was depreciated using a straight-line method over a 5-year period, with a residual value
of $50 000. On 30 June 2016, the company assessed the current market value of the facility given that
there was an active market for such facilities as many companies used a similar network. The value was
determined to be $300 000.
Required
Discuss whether the network facility asset is impaired and whether it should be written down to $300 000.
Provide any journal entries necessary.
Exercise 15.10 ALLOCATION OF CORPORATE ASSETS AND GOODWILL

★★ Cheng Ltd acquired all the assets and liabilities of Roma Ltd on 1 January 2017. Roma Ltd’s activities were
run through three separate businesses, namely the Sandstone Unit, the Sapphire Unit and the Silverton
Unit. These units are separate cash-generating units. Cheng Ltd allowed unit managers to effectively
operate each of the units, but certain central activities were run through the corporate office. Each unit was
allocated a share of the goodwill acquired, as well as a share of the corporate office.
440 PART 2 Elements

At 31 December 2017, the assets allocated to each unit were as follows:
Sandstone Sapphire Silverton

Factory $ 820 $ 750 $ 460
Accumulated depreciation (420) (380) (340)
Land 200* 300** 150*
Equipment 300 410 560
Accumulated depreciation (60) (320) (310)
Inventory 120 80 100*
Goodwill 40 50 30
Corporate property 200 150 120
* These assets have carrying amounts less than fair value less costs of disposal.
** This asset has a fair value less costs of disposal of $293.
Cheng Ltd determined the recoverable amount of each of the business units at 31 December 2017:
Sandstone $ 1 170
Sapphire 900
Silverton 800
Required
Determine how Cheng Ltd should allocate any impairment loss at 31 December 2017.
Exercise 15.11 ALLOCATION OF CORPORATE ASSETS AND GOODWILL

★★★ Liao Ltd has two cash-generating units, Division One and Division Two. At 30 June 2017, the net assets of
the two divisions were as follows:
Division One Division Two

Cash $ 12 000 $ 8 000
Inventory 30 000 40 000
Plant 320 000 0
Accumulated depreciation (Plant) (120 000) 0
Land 90 000 150 000
Buildings 110 000 140 000
Accumulated depreciation (Buildings) (40 000) (60 000)
Furniture & fittings 0 30 000
Accumulated depreciation (Furniture & fittings) 0 (10 000)
Total assets 422 000 306 000
Provisions 20 000 40 000
Borrowings 30 000 66 000
Net assets $ 372 000 $ 200 000
Additional information regarding the divisions’ assets is as follows:

• the receivables of both divisions were considered to be collectable
• Division Two’s land had a fair value less costs of disposal of $135 000 at 30 June 2017.
At 30 June 2017 Liao Ltd also had the following corporate assets, which Liao’s management decided to
allocate equally to the two divisions:
• goodwill of $14 000
• a head office building with a carrying amount of $160 000 (net of $50 000 accumulated depreciation).
Liao Ltd’s management conducted impairment testing on the company’s assets at 30 June 2017 and
determined that Division One’s recoverable amount was $415 000 and Division Two’s recoverable amount
was $310 000.
Required
Prepare the journal entries required at 30 June 2017 to account for any impairment losses.

Exercise 15.12 CORPORATE ASSETS, ALLOCATED AND UNALLOCATED
★★★ Ararat Ltd has three divisions, Aramac, Alpha and Amby, which operate independently of each other to
produce milk products. The company has a headquarters and a research centre located in Albury, with the
divisions located throughout South Africa. The research centre interacts with all the divisions to assist in
the improvement of the manufacturing process and the quality of the products manufactured by the entity.
There is not as yet any basis on which to determine how the work of the research centre will be allocated
to each of the three divisions, as this will depend on priorities of the company overall and issues that arise
in each division. The company headquarters provides approximately equal services to each of the divi-
sions, but an immaterial amount to the research centre.
Neither the headquarters nor the research centre generates cash inflows.
On 30 June 2017, the net assets of Ararat Ltd were as follows:
Head Research
Aramac Alpha Amby office centre
Land $ 440 000 $ 280 000 $ 160 000 $110 000 $ 67 000
Plant & equipment 840 000 620 000 540 000 80 000 45 000
Accumulated depreciation (240 000 ) (200 000 ) (160 000 ) (10 000 ) (12 000)
Inventories 240 000 180 000 140 000 0 0
Accounts receivable 120 000 100 000 60 000 0 0
$ 1 400 000 $ 980 000 $ 740 000 $180 000 $100 000
Liabilities 120 000 100 000 100 000 0 0
Net assets $ 1 280 000 $ 880 000 $ 640 000 $180 000 $100 000
Management of Ararat Ltd believes there are economic indicators to suggest that the company’s assets
may have been impaired. Accordingly, they have had recoverable amount assessed for each of the divisions:
Aramac $ 1 550 000

Alpha 1 000 000
Amby 750 000
The land held by Aramac Ltd was measured at fair value using the revaluation model because of the spe-
cialised nature of the land. At 30 June 2017, the fair value was $440 000. The land held by Alpha Ltd was
measured at cost, and had a fair value less costs of disposal of $270 264 at 30 June 2017.
Required
Determine how Ararat Ltd should account for any impairment of the entity. Justify your decisions and
complete any required journal entries.
Exercise 15.13 IMPAIRMENT LOSS

★★★ Casey Ltd prepared the following draft statement of financial position at 30 June 2017:
Cash $ 5 000 Share capital $ 1 000 000

Receivables 15 000 Retained earnings 280 000
Land (at fair value 1/7/16) 160 000 General reserve 120 000
Company headquarters 1 000 000 1 400 000
Accumulated depreciation (180 000) Long-term loans 400 000
Factories 1 790 000 Provisions 40 000
Accumulated depreciation (910 000) Other liabilities 160 000
Goodwill 60 000 600 000
Accumulated impairment losses (40 000)
Intangibles 150 000
Accumulated amortisation (50 000)
Total assets 2 000 000 Equity and liabilities 2 000 000
At the end of the reporting period, after undertaking an analysis, management determined that it was
probable that the assets of the entity were impaired. Management conducted an impairment test, deter-
mining that the recoverable amount for the entity’s assets was $1 820 000. The whole entity was regarded
as a cash-generating unit.
442 PART 2 Elements

Land is measured by Casey Ltd at fair value, while all other assets are accounted for by the cost model.
At 30 June 2017, the fair value of the land was determined to be $150 000. The land had previously been
revalued upwards by $20 000. The tax rate is 30%.
Required
(Show all workings.)
1. Prepare the journal entries required on 30 June 2017 in relation to the measurement of the assets of
Casey Ltd.
2. Assume that, as the result of the allocation of the impairment loss, the factories were to be written
down to $800 000. If the fair value less costs of disposal of the factories was determined to be $750 000,
outline the adjustments, if any, that would need to be made to the journal entries you prepared in
requirement 1, and explain why adjustments are or are not required.

The two main types of impairment examined in accounting of discretion that was available to managers before SFAS 121.
research are of long-term tangible assets and goodwill. We His evidence therefore suggests that the standard did not
start with long-term tangible assets. Bartov et al. (1998) succeed in curtailing managerial discretion.
examine the market reaction to announcements of these Turning to studies of goodwill, Henning et al. (2000) pro-
impairments. Like research findings before them they vide evidence consistent with the view that goodwill is an
observe that the stock market reaction seems to be small asset (see also the Academic Perspective to chapter 14). Spe-
relative to the magnitude of recorded impairments. One cifically, they regress market value of equity on goodwill and
possible explanation for this is that the recording of the other assets and liabilities and find that goodwill is positively
impairment is delayed relative to the underlying economic related to the firm’s market value. This positive association
loss event. If this is the case, then the market might have indicates that capital markets perceive goodwill as an asset.
reacted beforehand and so the accounting impairment con- Hayn and Hughes (2006) turn attention to impairments by
veys no new information. Another explanation may be that attempting to quantify the delay in such impairments. They
markets do not initially fully comprehend the significance of identify 58 companies who had impaired goodwill 6 or
the impairment. To explore these explanations Bartov et al. more years after the acquisition. Hayn and Hughes (2006)
(1998) examine 373 impairments during the 1981–1985 then provide evidence of unusual poor performance by the
period. For impairments recorded in the context of busi- acquirers of up to 5 years before the impairment is recog-
ness changes (e.g., restructuring) they do not find significant nised. This evidence therefore suggests that impairments of
market reactions, but for other impairments they document goodwill are recorded with considerable delay.
negative stock return during a 4-day window around the One possible underlying reason for goodwill impairments
impairment announcement. Nevertheless, all impairment- is that the acquiring firms overpay for target firms in the first
announcing firms experience a decline in stock prices in the place. This is more likely in cases where the acquisition is
2 years leading up to the announcement. This evidence financed by the acquirer’s own shares. Gu and Lev (2011)
therefore suggests that markets reacted to the underlying argue that the overpayment problem is more pronounced
economic events before the recording of the loss in the when the acquirer’s stock is overpriced itself. They develop
books. Interestingly, the trend in falling prices continues for an index that captures the overpricing of the acquirer’s
an additional year following the impairment announcement. stock. The index is based on three underlying measures,
Hence the evidence suggests both that the loss recognition is including industry-adjusted price-to-earnings ratio, discre-
delayed relative to the underlying economic event and that it tionary accruals, and net equity issues. They then employ
is not fully assessed by market participants. a large sample for 1990–2006 including 7055 acquisitions
Alciatore et al. (2000) examine write-downs in a specific and show that stock-funded acquisitions are associated
industry — the oil and gas industry — and provide interesting with larger increases in recorded goodwill than cash-funded
evidence that pertains to the delay in loss recognition. Com- acquisitions. The difference in recorded goodwill between
panies in this industry who trade on a US exchange are stock- and cash-bidders becomes larger with the measure of
required to compare the cost of wells recorded on the bal- overpricing of the acquirers’ own stock. Gu and Lev (2011)
ance sheet to the present value of future cash flows, which in then examine goodwill impairments recorded in 2001–2006
this industry are closely tied to oil prices. Thus the economic for firms that were involved in acquisition activity in 1990–
loss event is clearly identifiable. Focusing on the period of 2000. They find that the magnitude of the impairment is
1984 to mid-1988 when oil and gas prices declined, the positively related to the overpricing of the acquirers’ own
authors provide evidence that the recording of the write- stock.
downs takes place after the decline in oil and gas prices. This Impairment of goodwill is based on managers’ estimates
is broadly consistent with managerial incentive to delay rec- of the underlying cash flows that the cash-generating unit
ognition of bad news (Kothari et al., 2009). is expected to produce in the future. This estimate is largely
Riedl (2004) further explores the link between impair- subject to managerial discretion. Ramanna and Watts (2012)
ments and underlying economic factors. He postulates that examine a sample of firms for which the book-to-market
the quality of recorded impairments should be judged with (BM) ratio is greater than 1 for 2 consecutive years. The
respect to whether they capture the effect of underlying eco- authors argue that goodwill impairment is more likely in
nomic factors. He employs several proxies for economic such firms as the market-based value of goodwill is nega-
factors, including changes in GDP, change in industry ROA, tive. Hence, firms that exhibit BM > 1 for 2 consecutive
and change in sales. His sample is based on over 2750 firm- years may be avoiding recognising impairments. One reason
year observations including 455 firm-year observations with for this could be because managers of these firms expect
impairment charges (including impairments of goodwill). improvement in future performance that would negate the
Some of these impairments were recorded following the need to impair goodwill. That is, these managers possess
implementation of SFAS 121 (FASB, 1995) in the US, which good news not known to investors. Ramanna and Watts
is similar to IAS 36 in many respects. In his sample, impair- (2012) proxy for insider good news is insider purchase of
ment firms generally perform worse than non-impairment own stock. However, they do not find that insider purchase
firms. His most intriguing result, however, is that whereas of own stock is at a different level than of insiders of firms
impairments are related to economic factors pre-SFAS 121, that do recognise goodwill impairments. The authors there-
they are not in the post-standard period. As Riedl (2004) fore conclude that delayed impairments of goodwill are not
points out, the aim of the standard was to reduce the level owed to impending good news.
444 PART 2 Elements

Taken together, the literature reviewed here suggests that for long-lived assets to be disposed of. SFAS No. 121.
impairments are prone to significant managerial discretion. Norwalk, CT: FASB.
This is manifested in delayed recording of impairments, impair- Gu, F., and Lev, B. 2011. Overpriced shares, ill-advised
ments that are divorced from underlying economic events, and acquisitions, and goodwill impairment. The Accounting
in the case of goodwill, these impairments are predictable Review, 86(6), 1995–2022.
insofar as they are more likely to take place in stock-for-stock Hayn, C., and Hughes, P. J. 2006. Leading indicators of
acquisitions where the acquirer’s stock is overpriced. goodwill impairment. Journal of Accounting, Auditing &
Finance, 21(3), 223–265.
References Henning, S. L., Lewis, B. L., and Shaw, W. H. 2000. Valuation
of the components of purchased goodwill. Journal of
Alciatore, M., Easton, P., and Spear, N. 2000. Accounting for Accounting Research, 38(2), 375–386.
the impairment of long-lived assets: Evidence from the Kothari, S., Shu, S., and Wysocki, P. 2009. Do managers
petroleum industry. Journal of Accounting and Economics, withhold bad news? Journal of Accounting Research 47(1),
29(2), 151–172. 241–276.
Bartov, E., Lindahl, F. W., and Ricks, W. E. 1998. Stock price Ramanna, K., and Watts, R. L. 2012. Evidence on the use of
behavior around announcements of write-offs. Review of unverifiable estimates in required goodwill impairment.
Accounting Studies, 3(4), 327–346. Review of Accounting Studies, 17(4), 749–780.
Financial Accounting Standards Board (FASB). 1995. Riedl, E. J. 2004. An examination of long-lived asset
Accounting for the impairment of long-lived assets and impairments. The Accounting Review, 79(3), 823–852.

Part 3
disclosures
Presentation and
16 Financial statement presentation 449
17 Statement of cash flows 485
18 Operating segments 517
19 Other key notes disclosures 537
16 Financial statement
presentation
ACCOUNTING IAS 1 Presentation of Financial Statements

STANDARDS IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
IN FOCUS
IAS 10 Events after the Reporting Period

OBJECTIVES
1 describe the main components of financial statements
2 explain the general principles underlying the preparation and presentation of financial
statements
3 apply the requirements for the classification of items reported in the statement of financial
position, and apply the requirements for the presentation of information in the statement of
financial position and/or in the notes
4 apply the requirements for the presentation of information in the statement of profit or loss and
other comprehensive income and/or in the notes
5 apply the requirements for the presentation of information in the statement of changes in equity
and/or in the notes
6 discuss other disclosures required by IAS 1 in the notes to the financial statements
7 apply the requirements of IAS 8 regarding the selection and application of accounting policies,
and in respect of accounting for changes in accounting policies, changes in accounting estimates
and errors
8 distinguish between adjusting and non-adjusting events after the reporting period in accordance
with IAS 10.
CHAPTER 16 Financial statement presentation 449

INTRODUCTION
You are probably already familiar with financial statements. In this chapter we will build on your existing
knowledge as we take a closer look at the requirements of IFRS® Standards for dealing with some complex
and technical issues in the presentation of financial statements. You have probably noticed that current and
non-current assets and liabilities are usually separately identified in the statement of financial position.
Do they have to be classified this way? How do preparers decide whether an asset should be classified as
current or non-current? Why is there so much variation in the way that companies report on profit and
comprehensive income? What should preparers do if they realise there has been an error in the finan-
cial statements of previous periods? How should entities account for changes of accounting policies and
accounting estimates? If events occur after the end of the reporting period, can they be reflected in the
financial statements? IFRS Standards are principles-based accounting standards. In this chapter we will
consider the principles that underlie the preparation of general purpose financial statements in order to
provide information that is useful for creditors and investors and other users in making decisions about
providing resources to the entity.
LO1 16.1 COMPONENTS OF FINANCIAL STATEMENTS

The principles and other considerations relating to the presentation of financial statements are contained
in IAS 1 Presentation of Financial Statements. A complete set of financial statements is defined in paragraph
10 and comprises:
• a statement of financial position
• a statement of profit or loss and other comprehensive income
• a statement of changes in equity
• a statement of cash flows
• notes, comprising significant accounting policies and other explanatory information
• comparative information, such as financial statements and notes for the preceding period, are also
a component of a complete set of financial statements: when an entity retrospectively applies an
accounting policy or makes retrospective adjustments to the amount or classification of items in
financial statements, the complete set of financial statements includes a statement of financial position
as at the beginning of the preceding period (we will return to this requirement in section 16.7).
Each component of the financial statements must be clearly identified in the financial statements and
distinguished from other information reported in the same document (IAS 1 paragraphs 49–51). While
IAS 1 refers to the statements as a ‘statement of financial position’, a ‘statement of profit or loss and
other comprehensive income’, a ‘statement of changes in equity’ and a ‘statement of cash flows’, reporting
entities may use other labels when presenting these financial statements in accordance with IAS 1. For
example, BHP Billiton labels its statement of financial position a ‘balance sheet’.
Paragraph 51 requires identification of the following:
• name of the reporting entity and any change in that name since the preceding reporting period
• whether the financial statement covers an individual entity or a group of entities
• the date of the end of the reporting period (e.g. for a statement of financial position) or the reporting
period covered by the financial statement (for reports on flows, such as the statement of profit or loss
and other comprehensive income)
• the presentation currency, as defined in IAS 21 The Effects of Changes in Foreign Exchange Rates
• the level of rounding used in presenting amounts in the financial statements, usually thousands or
millions.
Entities often present other information, such as certain financial ratios or a narrative review of oper-
ations by management or the directors. These reports are sometimes referred to as ‘management discus-
sion and analysis’. In addition, some entities voluntarily prepare sustainability reports or corporate social
responsibility reports. This other information is reported outside the financial statements and is not within
the scope of pronouncements issued by the International Accounting Standards Board (IASB®).
IAS 1 applies to all general purpose financial statements, except that its requirements relating to the
structure and content of financial statements do not apply to condensed interim financial statements
prepared in accordance with IAS 34 Interim Financial Reporting. This chapter deals with the require-
ments of IAS 1 for the presentation of the statement of financial position, the statement of profit or
loss and other comprehensive income, the statement of changes in equity and notes. (The statement of
cash flows is considered in chapter 17.) The requirements of IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors and IAS 10 Events after the Reporting Period are also considered (see sections 16.7 and
16.8, respectively).
In addition to the disclosure requirements covered in this chapter, IFRS Standards prescribe disclosures
relating to specific financial statement elements and transactions and events. Specific disclosures relevant
to the topics of the various chapters of this book are outlined in those chapters.
450 PART 3 Presentation and disclosures

LO2 16.2 GENERAL PRINCIPLES OF FINANCIAL STATEMENTS
IAS 1 describes eight general principles that need to be applied in the presentation of financial statements.
These requirements are intended to ensure that the financial statements of an entity are a faithful pres-
entation of its financial position, financial performance and cash flows in accordance with the Conceptual
Framework (see chapter 1).
16.2.1 Fair presentation and compliance with IFRS Standards

Paragraph 15 of IAS 1 states that ‘financial statements shall present fairly the financial position, financial
performance and cash flows of an entity’. This means that the Conceptual Framework’s definitions and recog-
nition criteria for assets, liabilities, equity, income and expenses should be applied in faithfully representing
the effects of transactions, other events and conditions.
Does compliance with IFRS Standards result in financial statements that ‘present fairly’? Paragraph 10
makes the explicit assumption that it does, subject to additional disclosures, when necessary. This is
reiterated in paragraph 17, which states that compliance with IFRS Standards achieves fair presentation
in virtually all circumstances. Fair presentation requires (paragraph 17):
• selecting and applying accounting policies in accordance with IAS 8 (see section 16.7.1);
• presenting information in a way that provides relevant, reliable, comparable and understandable
information; and
• providing additional disclosures, where necessary.
However, paragraph 19 of IAS 1 notes that, in extremely rare circumstances, management may conclude
that compliance with the requirements of an IFRS Standard would be so misleading that it would conflict
with the objective of financial statements specified in the Conceptual Framework. The reporting require-
ments that arise in this situation are considered later (see section 16.6.1).
16.2.2 Going concern

Paragraph 25 of IAS 1 states that financial statements shall be prepared on a going concern basis unless
management intends to either liquidate the entity or cease trading, or has no realistic alternative but to
do so. The Conceptual Framework makes a similar underlying assumption. When management is aware of
any material uncertainties that cast doubt upon the entity’s ability to continue as a going concern, those
uncertainties must be disclosed (IAS 1 paragraph 25). When financial statements are not prepared on a
going concern basis, that fact must be disclosed, together with the basis on which the financial statements
are prepared and the reason why the entity is not regarded as a going concern.
If, for example, an entity has been placed in receivership and it is anticipated that liquidation will
follow, the going concern assumption would be inappropriate. In such circumstances, the financial state-
ments would typically be prepared on a ‘liquidation’ basis, which means that assets and liabilities are
measured at the amounts expected to be received or settled on liquidation. In the case of assets, this will
often be a ‘fire-sale’ value rather than a fair value (for discussion of fair value measurement, see chapter 3).
16.2.3 Accrual basis of accounting

Financial statements, except for the statement of cash flows, must be prepared using the accrual basis of
accounting. This is discussed further in the Conceptual Framework (see chapter 1).
16.2.4 Materiality and aggregation

Omissions or misstatements of items are material if they could, individually or collectively, influence the eco-
nomic decisions that users make on the basis of the financial statements.
Paragraph 7 goes on to explain that judgements about materiality should be made in the context of
surrounding circumstances, taking into consideration the size and nature of the item.
Financial statements result from processing large volumes of transactions that are then aggregated into
classes according to their nature or function. These classes form the line items on the statement of finan-
cial position, statement of profit or loss and other comprehensive income, statement of changes in equity,
and statement of cash flows. Paragraph 29 requires separate presentation of each material class of similar
items in the financial statements. As explained in paragraph 30A, an entity should not obscure material
information by aggregating it with immaterial items because this practice would reduce the understanda-
bility of financial statements. Items of a dissimilar nature or function must be presented separately unless
they are immaterial.
The minimum line items specified by IAS 1 are discussed later in the chapter (see sections 16.3, 16.4 and
16.5). Paragraph 31 confirms that these minimum requirements and requirements for disclosures in the
notes prescribed by IAS 1 and other IFRS Standards are subject to materiality.

16.2.5 Offsetting
• If certain assets and liabilities are offset in the statement of financial position, it means they are
represented on a net basis. For example, if a receivable of $10 000 were offset against a payable of
$25 000, a net liability of $15 000 would be reported. Paragraph 32 of IAS 1 states that an entity
shall not offset assets and liabilities, or income and expenses, unless required or permitted by an IFRS
Standard. For example, IAS 32 Financial Instruments: Presentation permits financial assets and liabilities
to be offset if there is a legal right of set-off and the entities intend to settle amounts owed to/by
each other on a net basis.
• Offsetting detracts from the understandability of financial statements unless it reflects the substance of
transactions or events (paragraph 33). For example, in reporting on the disposal of a non-current asset,
it is usually appropriate to offset the carrying amount of the asset against the proceeds to report a net
gain or loss. The application of offsetting is an area of considerable judgement and subjectivity.
16.2.6 Frequency of reporting

Financial statements must be prepared at least annually. If an entity’s reporting period changes, the length
of the reporting period will be greater or less than a year in the period of the change. For example, if an
entity with a reporting period ending on 31 March changed its reporting period to end on 31 December,
the first financial statements it prepares for the period ending 31 December would only cover a 9-month
period. When this occurs, paragraph 36 of IAS 1 requires the entity to disclose why the reporting period
is longer or shorter and the fact that the amounts presented in the financial statements are not entirely
comparable.
16.2.7 Comparative information

IAS 1 paragraph 38 requires the disclosure of comparative information for the preceding period for all amounts
reported in the financial statements, unless otherwise permitted by an IFRS Standard. This includes narra-
tive information where it is relevant to understanding the current period financial statements. For example,
comparative narrative details of a contingent liability that has developed over time may be relevant to users.
Presentation of additional comparative information beyond the minimum required is permitted pro-
vided that the additional information complies with IFRS Standards. For example, an entity may choose to
provide a third statement of cash flows as an additional comparative statement.
Due to changed circumstances, or in order to provide a fair representation, an entity may change the
classification of items reported in financial statements. For example, an entity may change the classifica-
tion of a real estate asset from investment property to property, plant and equipment. If the presentation
or classification of an item in the financial statements is changed, the entity must reclassify comparative
amounts, to the extent practicable (IAS 1 paragraph 41). Further, the entity must present a statement of
financial position for the end of the current period, the end of the preceding period, and the beginning of
the previous period (IAS 1 paragraphs 40A and 40B). Thus in the event of a change in the presentation or
classification of items presented in financial statements, at least three statements of financial position must
be presented.
Additional comparative information must also be disclosed in the event of changes in accounting poli-
cies or corrections of errors. The accounting treatment of changes in accounting policies and correction of
errors, including additional disclosure requirements for retrospective adjustments, are dealt with in IAS 8
(and addressed later in this chapter).
16.2.8 Consistency of presentation

Paragraph 45 of IAS 1 requires the presentation and classification of items in the financial statements to be
consistent from one period to the next. However, this requirement does not apply where an IFRS Standard
requires a change in presentation. A change in presentation is also permitted if there has been a significant
change in the nature of the entity’s operations and a change in presentation is considered appropriate
using the criteria specified in IAS 8 for the selection of accounting policies.
When such a change is made, the comparative information must also be reclassified. For example, if,
after a major change in operations, an entity elects to change the way it classifies expenses, the comparative
financial information must also be reclassified.
LO3 16.3 STATEMENT OF FINANCIAL POSITION

As discussed in chapter 1, a major purpose of financial statements is to provide information about an entity’s
financial position. Accordingly, the statement of financial position summarises the elements directly
related to the measurement of financial position: an entity’s assets, liabilities and equity. It thus provides

the basic information for evaluating an entity’s capital structure and analysing its liquidity, solvency and
financial flexibility. It also provides a basis for computing summary indicators, such as return on total
assets and the ratio of liabilities to equity.
However, the view of an entity’s financial position presented by the statement of financial position has
some limitations arising from:
• the requirement or flexibility to measure certain assets at historical cost or depreciated historical cost
instead of a current value, such as fair value (see chapter 3 for further details)
• the mandatory omission of certain internally generated intangible assets, such as internally generated
brand names, from the statement of financial position in accordance with IAS 38 Intangible Assets (see
chapter 13 for further details)
• off-balance-sheet rights and obligations — for example, the rights and obligations pertaining to non-
cancellable operating leases are not recognised on the statement of financial position (see chapter 12 for
further details).
The notes to the financial statements are an important source of information that can mitigate the
effects of these limitations.
16.3.1 Statement of financial position classifications

The statement of financial position presents a structured summary of the assets, liabilities and equity of
an entity. To help users of financial statements to evaluate an entity’s financial structure and its liquidity,
solvency and financial flexibility, assets and liabilities are classified according to their function in the oper-
ations of the entity, and their liquidity and financial flexibility characteristics.
Paragraph 60 of IAS 1 requires an entity to classify assets and liabilities as current or non-current in its
statement of financial position, unless a presentation based on liquidity is considered to provide more
relevant and reliable information. When that exception arises, all assets and liabilities are required to be
presented broadly in order of liquidity.
IAS 1 specifies criteria for classification of assets and liabilities as current. When an entity applies the
current/non-current classification, assets and liabilities that do not meet the criteria for classification as
current are classified as non-current.
Current assets are described in paragraph 66 of IAS 1 as those that:
(a) are expected to be realised, sold or consumed within the entity’s normal operating cycle;
(b) are held for trading;
(c) are expected to be realised within 12 months after the reporting period; or
(d) are cash or cash equivalents.
For example, inventory is classified as current because it is expected to be sold within the entity’s normal
operating cycle.
Current liabilities are described in paragraph 69 of IAS 1 as those that:
(a) are expected to be settled within the entity’s normal operating cycle;
(b) are held for trading;
(c) are due to be settled within 12 months after the reporting period; or
(d) the entity does not have an unconditional right to defer for at least 12 months after the reporting
period.
Paragraph 73 of IAS 1 explains that if an entity has the discretion to refinance or roll over an obligation
for at least 12 months after the reporting period under the terms of an existing loan facility, and expects to
do so, the obligation is classified as non-current, even if it would otherwise be due within 12 months of
the end of the reporting period. This would be an unconditional right referred to in paragraph 69(d). The
criterion of an unconditional right to defer settlement has been a source of ambiguity in paragraph 69(d)
resulting in uncertainty in the classification of liabilities that are subject to an annual review. At the time
of writing the IASB has issued an exposure draft with proposed changes to the wording of this paragraph
to reduce ambiguity.
The criteria for classifying liabilities as current or non-current are based solely on the conditions existing
at the end of the reporting period. For example, if an entity had a long-term loan that fell due in August
2016 and entered into an agreement after 30 June 2016 to refinance or to reschedule payments on the loan,
the liability would be classified as current in the statement of financial position at 30 June 2016. Similarly,
paragraph 74 explains that if an entity breaches an undertaking under a long-term loan agreement during
the reporting period with the effect that the loan is repayable on demand, the loan is classified as current.
However, the loan should be classified as non-current if the lender agrees by the end of the reporting period
to waive the right to demand immediate repayment for at least 12 months after the reporting period.
Figure 16.1 shows the classification of assets in the consolidated statement of financial position of
BHP Billiton at 30 June 2015, while figure 16.2 shows the classification of liabilities. Note that some
of BHP Billiton’s interest bearing liabilities and other financial liabilities are classified as current liabilities
and some as non-current liabilities.

2015 2014
Notes US$M US$M
ASSETS
Current assets
Cash and cash equivalents 7 6 753 8 803
Trade and other receivables 8 4 321 6 741
Other financial assets 21 83 87
Inventories 10 4 292 6 013
Current tax assets 658 318
Other 262 334
Total current assets 16 369 22 296
Non-current assets
Trade and other receivables 8 1 499 1 867
Other financial assets 21 1 159 2 349
Inventories 10 466 463
Property, plant and equipment 11 94 072 108 787
Intangible assets 12 4 292 5 439
Investments accounted for using the equity method 31 3 712 3 664
Deferred tax assets 13 2 861 6 396
Other 150 152
Total non-current assets 108 211 129 117
Total assets 124 580 151 413
FIGURE 16.1 Consolidated current and non-current assets of BHP Billiton at 30 June 2015
2015 2014
Notes US$M US$M
LIABILITIES
Current liabilities
Trade and other payables 9 7 389 10 145
Interest bearing liabilities 15 3 201 4 262
Other financial liabilities 22 251 16
Current tax payable 207 919
Provisions 14, 20, 26 1 676 2 504
Deferred income 129 218
Total current liabilities 12 853 18 064
Trade and other payables 9 29 113
Interest bearing liabilities 15 27 969 30 327
Other financial liabilities 22 1 031 303
Deferred tax liabilities 13 4 542 7 066
Provisions 14, 20, 26 7 306 9 891
Deferred income 305 267
Total non-current liabilities 41 182 47 967
FIGURE 16.2 Consolidated current and non-current liabilities of BHP Billiton at 30 June 2015
The current/non-current classification is ordinarily considered to be more relevant when an entity has a
clearly identifiable operating cycle. This is because it distinguishes between those assets and liabilities that
are expected to circulate within the entity’s operating cycle and those used in the entity’s operations over
the long term. The typical cycle operates from cash, purchase of inventory (in the case of a manufacturer,
production) and then receivables through sales of inventory and finally back to cash through collection of
the receivables. The average time of the operating cycle varies with the nature of the operations and may
extend beyond 12 months. Long operating cycles are common in real estate development, construction
and forestry.

Current assets may include inventories and receivables that are expected to be sold, consumed or real-
ised as part of the normal operating cycle beyond 12 months after the reporting period. Similarly, current
liabilities may include payables that are expected to be settled more than 12 months after the reporting
period if the operating cycle exceeds 12 months. Because of these possibilities paragraph 61 of IAS 1
requires disclosure that distinguishes between the amount that is expected to be recovered or settled within
12 months after the reporting period and more than 12 months after the reporting period for each line
item of assets and liabilities. This requirement is irrespective of whether assets and liabilities are classified
on the current/non-current basis or in order of liquidity.
A presentation based broadly on order of liquidity is usually considered to be more relevant than a
current/non-current presentation for the assets and liabilities of financial institutions. This is because
financial institutions do not supply goods or services within a clearly identifiable operating cycle. For
example, HSBC Holdings plc presents the assets and liabilities of the group in order of liquidity. Figure 16.3
shows an extract from HSBC Holdings plc’s statement of financial position.
2014 2013
Notes US$M US$M
Assests
Cash and balances at central banks 129 957 166 599
Items in the course of collection from other banks 4 927 6 021
Hong Kong Government certificates of indebtedness 27 674 25 220
Trading assets 12 304 193 303 192
Financial assets designated at fair value 15 29 037 38 430
Derivatives 16 345 008 282 265
Loans and advances to banks 112 149 120 046
Loans and advances to customers 974 660 992 089
Reverse repurchase agreements – non-trading 17 161 713 179 690
Financial investments 18 415 467 425 925
Prepayments, accrued income and other assets 23 75 176 76 842
Current tax assets 1 309 985
Interests in associates and joint ventures 20 18 181 16 640
Goodwill and intangible assets 21 27 577 29 918
Deferred tax assets 8 7 111 7 456
Total assets at 31 December 2 634 139 2 671 318
FIGURE 16.3 Consolidated assets of HSBC Holdings plc as at 31 December 2014

Source: Reproduced with permission from HSBC Holdings plc Annual Report and Accounts 2014 (p. 337).
The classification of assets and liabilities as current or non-current is a particularly important issue for cal-
culating summary indicators for assessing an entity’s liquidity and solvency. For example, an entity’s current
ratio (current assets to current liabilities) is often used as an indicator of liquidity and solvency. Lenders may
also include terms in debt contracts requiring the borrower to maintain a minimum ratio of current assets to
current liabilities. If the entity falls below that ratio then the financier has the right to demand repayment of
the borrowing, which may, in turn, affect the assessment of whether the entity is a going concern.
16.3.2 Information required to be presented in the statement

of financial position
IAS 1 does not prescribe a standard format that must be adopted for the statement of financial position.
Rather, it prescribes a list of items that are considered to be sufficiently different in nature or function to
warrant presentation in the statement of financial position as separate line items. These items are listed in
paragraph 54:
(a) property, plant and equipment;
(b) investment property;
(c) intangible assets;
(d) financial assets (excluding amounts under (e), (h) and (i));
(e) investments accounted for using the equity method;
(f) biological assets;
(g) inventories;
(h) trade and other receivables;
(i) cash and cash equivalents;

(j) the total of assets classified as held for sale and assets included in disposal groups classified as held for
sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations;
(k) trade and other payables;
(l) provisions;
(m) financial liabilities (excluding amounts shown under (k) and (l));
(n) liabilities and assets for current tax, as defined in IAS 12 Income Taxes;
(o) deferred tax liabilities and deferred tax assets, as defined in IAS 12;
(p) liabilities included in disposal groups classified as held for sale in accordance with IFRS 5;
(q) non-controlling interests, presented within equity; and
(r) issued capital and reserves attributable to owners of the parent.
Most entities would not present all of the items shown above because they may not have any amounts
to report for particular items, or the item may be considered to be immaterial. As an example, compare the
list from paragraph 54 with the line items reported by BHP Billiton in its statement of financial position,
as shown in figures 16.1 and 16.2.
Paragraph 55 of IAS 1 requires additional line items, headings and subtotals to be included in the state-
ment of financial position when they are relevant to an understanding of the entity’s financial position.
In accordance with paragraph 58 of IAS 1, judgement about the presentation of additional items should
be based on an assessment of the nature and liquidity of assets, the function of assets, and the amounts,
nature and timing of liabilities.
For example, HSBC Holdings plc presents ‘Prepayments, accrued income and other assets’ as a separate
line item, in addition to several separate line items for different types of financial assets in its consolidated
balance sheet (statement of financial position) as shown in figure 16.3.
Figure 16.4 presents the equity section of BHP Billiton’s consolidated balance sheet (statement of finan-
cial position) at 30 June 2015. Does BHP Billiton present any additional line items of equity beyond the
minimum listed in paragraph 54 of IAS 1?
2015 2014
Notes US$M US$M
EQUITY
Share capital – BHP Billiton Limited 17 1 186 1 186
Share capital – BHP Billiton plc 17 1 057 1 069
Treasury shares 17 (76) (587)
Reserves 18 2 557 2 927
Retained earnings 18 60 044 74 548
Total equity attributable to members of BHP Billiton Group 64 768 79 143
Non-controlling interests 18 5 777 6 239
FIGURE 16.4 Consolidated equity of BHP Billiton at 30 June 2015


of financial position or in the notes
To provide greater transparency and enhance the understandability of the statement of financial position,
paragraph 77 of IAS 1 requires the subclassification of line items to be reported either in the statement or
in the notes. For example, an entity might provide subclassification of intangible assets as brand names,
licences and patents. Paragraph 78 of IAS 1 explains that subclassifications of line items in the statement
of financial position are also dependent on the size, nature and function of the amounts involved. Judge-
ment about the need for subclassifications should be made with regard to the same factors previously
outlined when judging whether additional line items should be presented in the statement of financial
position (see section 16.2.4). Some subclassifications are governed by specific IFRS Standards. For example,
IAS 16 requires items of property, plant and equipment to be disaggregated into classes (see chapter 11).
Entities typically report land and buildings as a separate class from machinery and equipment.
Figure 16.5 shows the subclassifications of inventories reported in note 12 to the 2015 consolidated
financial statements of BHP Billiton. The Group subclassifies its inventory as raw materials, work in pro-
gress and finished goods. Amounts measured at cost and net realisable value are separately identified. Note
10 also provides information about inventory write-downs recognised during the period with comparative
information.

2015 2014
US$M US$M
Current
Raw materials and consumables – at net realisable value(a) – 39
– at cost 1 453 2 161
1 453 2 200
Work in progress – at net realisable value(a) 260 185
– at cost 1 913 2 269
2 173 2 454
Finished goods – at net realisable value(a) 29 239
– at cost 637 1 120
666 1 359
Total current inventories 4 292 6 013
Non-current
Raw materials and consumables – at net realisable value(a) – –
– at cost 230 225
230 225
Work in progress – at net realisable value(a) 6 4
– at cost 118 130
124 134
Finished goods – at net realisable value(a) 33 –
– at cost 79 104
112 104
Total non-current inventories 466 463
(a) US$182 million of inventory write-downs were recognised during the year (2014: US$95 million; 2013: US$62
million). Inventory write-downs of US$42 million made in previous periods were reversed during the year (2014:
US$69 million; 2013: US$18 million).
FIGURE 16.5 Consolidated inventories of BHP Billiton at 30 June 2015

Paragraph 79(a) of IAS 1 requires additional disclosures about the entity’s shares such as units in a trust,
in the statement of financial position, the statement of changes in equity, or in the notes. The most com-
monly applicable of these disclosures include, for each class of capital:
• the number of authorised shares, issued and fully paid shares, and issued but not fully paid shares
• par value, or that there is no par value
• a reconciliation of the number of outstanding (issued) shares at the beginning and end of the period.
Other required disclosures about equity pertain to: rights, preferences and restrictions on dividends and
repayment of capital; shares held by the entity, its subsidiaries or its associates; and shares subject to options
and contracts. Paragraph 79(b) requires disclosure of the nature and purpose of each reserve within equity.
Entities that have no share capital must disclose equivalent information to that required by paragraph
79(a) for each category of equity interests. For example, a unit trust would report on the number of units
authorised by the trust deed, details about units issued, par value, a reconciliation of the number of units
at the beginning and end of the period, rights to and restrictions on distributions, equity held in subsidi-
aries and units reserved under options and contracts.
LO4 16.4 STATEMENT OF PROFIT OR LOSS AND OTHER

COMPREHENSIVE INCOME
The statement of profit or loss and other comprehensive income is the prime source of information about
an entity’s financial performance. It can also be used to assist users to predict an entity’s future perfor-
mance and future cash flows.
However, limitations of the statement of profit or loss and other comprehensive income can arise from:
• the mandatory expensing of expenditure relating to certain self-generated intangible assets as required
by IAS 38 (see chapter 13); and
• earnings management through selective judgements relating to the recognition and measurement of
items of income or expense, such as an impairment loss, with the objective of achieving a reported profit
outcome, such as smoothing earnings, meeting earnings targets or projecting an image of earnings growth.

16.4.1 Items of comprehensive income
The statement of profit or loss and other comprehensive income reports on all non-owner transactions and
valuation adjustments affecting net assets during the period. Profit or loss is the most common measure
of an entity’s performance. It is used in the determination of other summary indicators, such as earnings
per share and the return on equity. Profitability ratios may be used in contracts, such as executive remu-
neration plans.
While the statement of profit or loss and other comprehensive income incorporates all income and
expenses, a distinction is made between profit or loss for the period and other comprehensive income.
However, the distinction between items recognised in profit or loss and those recognised in other com-
prehensive income is dependent upon prescriptions of accounting standards and accounting policy
choices, rather than being driven by conceptual differences. For example, IAS 16 requires asset reval-
uation losses to be recognised in profit or loss, unless reversing a previous revaluation gain. However,
IAS 16 also requires asset revaluation gains to be recognised in other comprehensive income, unless
reversing a previous revaluation loss (see chapter 11). Accordingly, a revaluation loss would be reported
in profit or loss while a revaluation gain would be reported below the profit line in other comprehensive
income.

of profit or loss and other comprehensive income
IAS 1 does not prescribe a standard format for the statement of profit or loss and other comprehensive
income. It does, however, require that the statement of profit or loss and other comprehensive income be
presented either as:
• a single statement with a profit or loss section and another section for comprehensive income or a
statement of profit or loss and a separate statement presenting comprehensive income.
The single statement format is illustrated in figure 16.6.
Paragraph 81A requires disclosure of:
• profit or loss
• total other comprehensive income
• total comprehensive income.
Can you can find each of these items in figure 16.6?
(Check: profit for 2016 = $121 250 000; other comprehensive income for 2016 = a loss of $14 000 000;
and total comprehensive income for 2016 = $107 250 000.)
Paragraph 81B of IAS 1 requires the following items to be presented in the statement of profit or loss
and other comprehensive income:
(a) profit or loss for the period attributable to:
(i) non-controlling interests; and
(ii) owners of the parent; and
(b) comprehensive income for the period attributable to:
(i) non-controlling interests; and
(ii) owners of the parent.
These items may arise when preparing consolidated financial statements for groups (see chapter 23).
Can you can find each of these items in figure 16.6?
(Check: profit attributable to non-controlling interests for 2016 = $24 250 000; and total comprehensive
income attributable to non-controlling interests for 2016 = $21 450 000.)
The following sections will consider the items that are considered to be of sufficient importance to the
reporting of the performance of an entity to warrant their presentation in the statement of profit or loss
and other comprehensive income. The profit or loss section and the other comprehensive income section
are considered separately.
Profit or loss section
Profit or loss is the total of income less expenses, excluding the items of other comprehensive income
(IAS 1 paragraph 7). Paragraph 82 of IAS 1 identifies the items that must be presented in the profit or
loss section:
(a) revenue;
(b) finance costs;
(c) share of profit or loss of associates and joint ventures accounted for using the equity method (see online
chapter C);
(d) tax expense;
(e) [deleted]
(ea) a single amount for the total of discontinued operations (see IFRS 5).

Other comprehensive income section
Income and expenses are recognised in other comprehensive income if that treatment is required or permitted
by another IFRS Standard. Paragraph 82A of IAS 1 requires the presentation of items of other comprehensive
income classified by nature and grouped on the basis of whether, in accordance with another IFRS Standard:
(a) they will not be reclassified subsequently to profit or loss; and
(b) they will be reclassified subsequently to profit or loss when specific conditions are met.
Reclassification of items to profit or loss is discussed further in section 16.4.3. If an entity recognises the share
of other comprehensive income of associates and joint ventures accounted for using the equity method,
these amounts must be presented as separate items. (See online chapter C.) Similar to other items presented
in this section, items that may be reclassified subsequent to profit or loss are distinguished from those that
will not be reclassified to profit or loss.
Examples of the items of other comprehensive income include:
• asset revaluation gains (see chapter 11)
• foreign currency gains and losses on translation of the financial statements of net investments in
foreign operations (see chapter 24)
• remeasurement of the net defined benefit liability (asset) (see chapter 10).
Items classified as other comprehensive income may be reported net of tax in the statement of profit
or loss and other comprehensive income. Alternatively, each item of other comprehensive income may be
shown on a before-tax basis, along with aggregate amounts of income tax relating to other comprehensive
income, distinguishing between income tax applicable to the group of items that might be subsequently
reclassified to profit or loss, and the group of items that will not be subsequently reclassified to profit or
loss. Further, an entity must disclose the amount of income tax relating to each item of other comprehen-
sive income, in accordance with paragraph 90 of IAS 1. This may be presented either in the statement of
profit or loss and other comprehensive income or in the notes.
Additional line items and labelling
Paragraph 85 of IAS 1 requires additional line items, headings and subtotals to be presented in the state-
ment of profit or loss and other comprehensive income when they are relevant to understanding the enti-
ty’s financial performance. Disclosure of additional line items may help users to understand the entity’s
performance and to make predictions about future earnings and cash flow because items may vary in
frequency and the extent to which they recur. Paragraph 86 further explains that the nature, function and
materiality of the items of income and expense should be considered in making judgements concerning
the inclusion of additional line items.
An entity may also amend the descriptions used and the ordering of items when this is necessary to
explain the elements of financial performance. However, paragraph 87 of IAS 1 specifically prohibits the
presentation of any items of income and expense as ‘extraordinary items’ either in the statement of profit
or loss and other comprehensive income or in the notes. This prohibition was introduced in an earlier
accounting standard. ‘Extraordinary items’ had previously been defined as income or expenses that were
non-recurring and did not arise from the ordinary activities of the entity. The IASB concluded at the time
that items previously reported as extraordinary items, such as a loss on the disposal of part of the business,
resulted from the normal business activities. However, entities may indicate that some items are unusual
and less likely to recur through their description or the use of other labels. For example, the BHP Billiton
financial statements report on ‘exceptional items’, including the gain on sale of the Pinto Valley mining
operations, in the notes.
Figure 16.6 illustrates a statement of profit or loss and other comprehensive income as a single state-
ment, with expenses classified according to function. The classification of expenses is discussed in section 16.4.3.
Figure 16.6 is based on an illustrative example in the IASB Implementation Guidance that accompanies, but
is not part of, IAS 1.
FIGURE 16.6 Statement of profit or loss and other comprehensive income in one statement with
expenses classified according to function
XYZ GROUP
for the year ended
2016 2015
$’000 $’000
Revenue 390 000 355 000

Cost of sales (245 000) (230 000)
Gross profit 145 000 125 000
(continued)

2016 2015
$’000 $’000

Distribution costs (9 000) (8 700)
Administrative expenses (20 000) (21 000)
Share of profit of associates 35 100 30 100
Loss for the year from discontinued operations — (30 500)
PROFIT FOR THE YEAR 121 250 65 500
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gains on property revaluations 933 3 367
Remeasurements of defined benefit pension plans (667) 1 333
Share of gain (loss) on property revaluation of associates 400 (700)
Income tax relating to items that will not be reclassified (166) (1 000)
500 3 000
Items that may be reclassified subsequently to profit or loss:
Exchange differences on translating foreign operations 5 334 10 667
Available-for-sale financial assets (24 000) 26 667
Cash flow hedges (667) (4 000)
Income tax relating to items that may be reclassified 4 833 (8 334)
(14 500) 25 000
Other comprehensive income for the year, net of tax (14 000) 28 000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 107 250 93 500
Profit attributable to:
Owners of the parent 97 000 52 400
Non-controlling interests 24 250 13 100
121 250 65 500
Total comprehensive income attributable to:
107 250 93 500
Earnings per share: $ $
Basic and diluted 0.46 0.30
Source: Adapted from IASB 2012, pp. B1030–31.

of profit or loss and other comprehensive income or
in the notes
To enhance the understandability of the statement of profit or loss and other comprehensive income, par-
agraph 97 of IAS 1 requires the separate disclosure of the nature and amount of material items of income
and expense. Paragraph 98 identifies circumstances that would give rise to the separate disclosure of items
of income and expense as including:
(a) write-downs of inventories to net realisable value or of property, plant and equipment to recoverable amount,
as well as reversals of such write-downs;
(b) restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring;
(c) disposals of items of property, plant and equipment;
(d) disposals of investments;
(e) discontinued operations;

(f) litigation settlements; and
(g) other reversals of provisions.
Disclosure of material items is important to users of financial statements wishing to predict the likely
future profit and cash flows. For example, a gain or loss on disposal of operations is typically non-recurring
and the disposal may have implications for the generation of future cash flows.
Paragraph 99 of IAS 1 requires an entity to present an analysis of expenses classified either by their
function or nature. Classification by function (e.g. cost of sales, distribution expenses) is illustrated in
figure 16.6. Classification by nature (e.g. raw materials and consumables used, employee benefits expense,
depreciation expense) is illustrated in figure 16.7. An entity should adopt the presentation that provides
more relevant and reliable information. Disclosure of the subclassification of expenses helps users of
financial statements to identify relationships between expenses and various measures of the volume of
activity, such as the ratio of cost of sales to sales revenue. If the classification of expenses is by function,
the entity must disclose additional information about the nature of expenses, including depreciation and
amortisation expense and employee benefits expense, because it is useful for predicting future cash flows
(IAS 1 paragraph 105).
ALPHA LTD
Statement of Profit or Loss and Other Comprehensive Income (EXTRACT)
for the year ended
2016 2015
$’000 $’000
Revenue 330 000 300 000

Changes in inventories of finished goods and work in progress (85 000) (78 000)
Raw materials and consumables used (80 500) (73 000)
Employee benefits expense (92 000) (90 000)
Depreciation and amortisation expense (18 000) (18 000)
Impairment of property, plant and equipment (2 200) —
Loss for the year from discontinued operations (3 500) —
PROFIT FOR THE YEAR 35 000 28 000
35 000 28 000
Earnings per share: $ $
Basic and diluted 0.60 0.50
FIGURE 16.7 Profit or loss section with expenses classified according to nature
Some income and expense items are required to be initially recognised in other comprehensive income
and subsequently reclassified to profit or loss. For example, as discussed in chapter 7, gains and losses on a
financial asset measured at fair value through other comprehensive income are recognised in other com-
prehensive income and accumulated in equity, and when the financial asset is derecognised, the accumu-
lated gain or loss is reclassified from equity to profit or loss. The subsequent recognition in profit or loss
of an item previously recognised in other comprehensive income is referred to as a reclassification adjust-
ment in IAS 1. While the standard uses the term ‘reclassification’, in practice, it is also commonly referred
to as recycling of gains and losses through profit or loss.
Not all items recognised in other comprehensive income are subject to potential reclassification. For
example, revaluation gains recognised in accordance with IAS 16 Property, Plant and Equipment are not
reclassified to profit or loss.
Paragraph 92 of IAS 1 requires the disclosure of reclassification adjustments relating to items of
other comprehensive income. A reclassification adjustment is included with the related item of other

comprehensive income in the period that the adjustment is reclassified to profit or loss. These amounts
may have been recognised in other comprehensive income in a previous period. They could also have
been recognised in other comprehensive income in the same period. For example, some of the gains and
losses accumulated in equity pertaining to a financial instrument may have been recognised in other com-
prehensive income in both the current reporting period and previous periods.
In accounting for a reclassification adjustment, gains previously recognised in other comprehensive
income are deducted from other comprehensive income in the period in which they are recognised in
profit or loss. This is to avoid double counting of the gain. Conversely, losses previously recognised in
other comprehensive income are added back to other comprehensive income in the period in which they
are recognised in profit or loss. Illustrative example 16.1 demonstrates how to present a reclassification
adjustment in the statement of profit or loss and other comprehensive income.
ILLUSTRATIVE EXAMPLE 16.1 Reclassification adjustment
During March 2016 Investor Ltd purchased a small parcel of shares in other companies for $120 000,
which was their fair value at that time. The shares were measured at fair value and Investor Ltd elected
to present in other comprehensive income any gains and losses arising from changes in fair value of the
shares, as permitted by IFRS 9 Financial Instruments, taking into consideration the business model under
which the shares are held (see chapter 7).
On 31 December 2016 Investor Ltd revalued the shares to their fair value of $146 000. The gain was
$20 000, net of income tax of $6000.
On 31 December 2017 Investor Ltd revalued the shares to their fair value of $170 000. The gain was
$18 000, net of income tax of $6000.
The gains and losses on revaluation of the shares are recognised in other comprehensive income and
accumulated in the ‘Investment in equity instruments reserve’ in equity.
On 31 December 2017, Investor Ltd sold the shares for $170 000. At that time the accumulated credit
in the ‘Investment in equity instruments’ in relation to the shares was $38 000 (net of tax of $12 000).
There were no other items of other comprehensive income for the year ended 31 December 2016 or 31
December 2017.
INVESTOR LTD
Statements of Profit or Loss and Other Comprehensive Income
for the year ended 31 December
2017 2016
Notes $’000 $’000
Revenue 2 980 740

Cost of sales 3 (400) (300)
Selling and administrative expenses 4 (240) (200)
Finance costs 4 (100) (100)
Reclassification of gain on financial instruments 5 50 —
Profit before taxation 290 140
Income tax expense 6 (100) (40)
PROFIT FOR THE YEAR 190 100
Other comprehensive income:
Items that may be reclassified subsequently to profit or loss:
Gain on revaluation of financial instruments 7 18 20
Reclassification adjustment for gains on revaluation of financial instruments 7 (38) —
Other comprehensive income for the year, net of tax (20) 20
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 170 120
Owners of Investor Ltd 180 95
190 100
Owners of Investor Ltd (20) 20
(20) 120

Prior to the disposal of the shares, Investor Ltd had recognised gains in other comprehensive income
over two periods, comprising $20 000 in 2016 and $18 000 in 2017. On the disposal and derecognition
of the shares the accumulated gain of $38 000 must be reclassified to profit. The gain is presented as
$50 000, being the amount before tax. The related tax effect of $12 000 is included in the income tax
expense line item. To avoid double counting, the gain is deducted from other comprehensive income
and added to profit. Thus, the reclassification adjustment of $38 000 has no net effect on total com-
prehensive income in 2017 because it increases profit by $38 000 and decreases other comprehensive
income by the same amount.
LO5 16.5 STATEMENT OF CHANGES IN EQUITY

The statement of changes in equity provides a reconciliation of the opening and closing amounts of each
component of equity for the period. The purpose of the statement of changes in equity is to report trans-
actions with owners, such as the issue of new shares and the payment of dividends, and the effects of any
retrospective adjustments to beginning-of-period components of equity (see section 16.7).
16.5.1 Presentation of the statement of changes in equity

The statement of changes in equity presents information about movements in the components of equity,
which include share capital, retained earnings and amounts accumulated in equity for each class of items
recognised in other comprehensive income, such as the asset revaluation surplus and the foreign currency
translation reserve. The statement is often presented as a table with the components of equity listed in
separate columns. The opening balance, current period movements and closing balance are shown in dif-
ferent rows. As for the other financial statements, comparative amounts are required to be reported in the
statement of changes in equity. The comparative figures are often presented in a separate table from the
current period figures.
16.5.2 Information required to be reported in the statement

of changes in equity
Paragraph 106 of IAS 1 requires the following information to be presented in the statement of changes in
equity:
• total comprehensive income for the period, distinguishing between amounts attributable to owners
of the parent entity and to non-controlling interests;
• the effects of retrospective application or retrospective restatement recognised in accordance with IAS 8
for each component of equity; and
• a reconciliation between the carrying amount at the beginning and the end of the period for each
item of equity.
The reconciliation of the carrying amount must include, as a minimum, the changes resulting from
profit or loss, other comprehensive income; and transactions with owners in their capacity as owners,
showing separately contributions by and distributions to owners and changes in ownership interests in
subsidiaries.
Profit (loss) for the period increases (decreases) retained earnings. Other items of comprehensive
income affect other components of equity. For example, a gain on revaluing assets, net of its tax effect,
increases the asset revaluation surplus.
Figure 16.8 shows the consolidated statement of changes in equity of the BHP Billiton for the year
ended 30 June 2015. The complete statement also presents comparative information, following the same
tabular format.
16.5.3 Information to be presented in the statement of changes

in equity or in the notes
An analysis of other comprehensive income by item must be included in the statement of changes in
equity or in the notes. Similarly, the amount of dividends recognised as distributions to owners during the
period and the amount of dividends per share for the period must be disclosed either in the statement of
changes in equity or in the notes.

464
PART 3 Presentation and disclosures
FIGURE 16.8 Consolidated statement of changes in equity of BHP Billiton for the year ended 30 June 2015
Attributable to members of BHP Billiton Group
Share capital Total equity

attributable to
BHP BHP members of Non-
Billiton Billiton Treasury Retained BHP Billiton controlling Total
US$M Limited plc shares Reserves earnings Group interests equity
Balance as at 1 July 2014 1 186 1 069 (587) 2 927 74 548 79 143 6 239 85 382
Total comprehensive income — — — (96) 1 865 1 769 973 2 742
Transactions with owners:
Shares cancelled — (12) 501 12 (501) — — —
Purchase of shares by ESOP Trusts — — (355) — — (355) — (355)
Employee share awards exercised
net of employee contributions
and other adjustments — — 363 (461) 101 3 — 3
Employee share awards forfeited — — — (13) 13 — — —
Accrued employee entitlement for
unexercised awards — — — 247 — 247 — 247
Distribution to option holders — — — (1) — (1) (1) (2)
Dividends — — — — (6 596) (6 596) (639) (7 235)
In-specie dividend on demerger –
refer to note 29 ‘Discontinued operations’ — — — — (9 445) (9 445) — (9 445)
Equity contributed — — — 1 — 1 52 53
Transfers within equity on demerger — — — (59) 59 — — —
Conversion of controlled entities
to equity accounted investments — — 2 — — 2 (847) (845)
Balance as at 30 June 2015 1 186 1 057 (76) 2 557 60 044 64 768 5 777 70 545
Total comprehensive income — — — (24) 13 901 13 877 1 392 15 269
Employee share awards exercised net
of employee contributions — — 321 (221) (91) 9 — 9
Distribution to option holders — — — (2) — (2) (2) (4)
Dividends — — — — (6 276) (6 276) (252) (6 528)
Equity contributed — — — 989 — 989 477 1 466
Total comprehensive income — — — 77 11 309 11 386 1 599 12 985
Employee share awards exercised net
of employee contributions — — 438 (243) (178) 17 — 17
Issue of share options to non-controlling interests — — — 49 — 49 — 49
Dividends — — — — (6 076) (6 076) (837) (6 913)
Equity contributed — — — — — — 73 73
Divestment of equity accounted investment — — — (18) 18 — — —
CHAPTER 16 Financial statement presentation

465
LO6 16.6 NOTES
Notes are an integral part of the financial statements. Their purpose is to enhance the understandability of
the statement of financial position, statement of profit or loss and other comprehensive income, statement of
cash flows and statement of changes in equity. An entity should present the notes in a systematic order and
cross-reference each item in the financial statement, such as the statement of financial position, in accord-
ance with paragraph 113 of IAS 1. An earlier version of IAS 1 suggested a particular order for notes but the
standard was amended, effective from 1 January 2016, to emphasise the need to consider understandability
and comparability in determining an appropriate systematic order for the presentation of notes.
The following information must be disclosed in the notes in accordance with paragraph 112 of IAS 1:
• information about the basis of preparation of the financial statements and the specific accounting
policies used, in accordance with paragraphs 117–24
• information required by other IFRS Standards unless presented in the financial statements
• other information that is relevant to understanding the financial statements, unless presented elsewhere.
We will first consider the statements about compliance with IFRS Standards followed by the summary of
significant accounting policies used and sources of estimation uncertainty, information about capital, and
other disclosures.
16.6.1 Compliance with IFRS Standards

An explicit and unreserved statement of compliance with IFRS Standards should be made if, and only if, the
financial statements comply with the requirements of IFRS Standards (IAS 1 paragraph 16). If applicable,
the statement is often included in the note about the basis of preparation of the financial statements.
In extremely rare circumstances, management may conclude that compliance with a requirement in an
IFRS Standard would be so misleading that it would conflict with the objective of financial statements. Does
this mean that management should depart from compliance with IFRS Standards in order to present finan-
cial statements that serve the decision-making needs of present and potential investors, lenders and other
creditors? The answer to this question depends on domestic reporting requirements. In some countries the
law may require compliance with IFRS Standards. In some jurisdictions departure from the requirements of
an IFRS Standard may be permitted in the extremely rare circumstances referred to in IAS 1, where manage-
ment believe it would be misleading.
When assessing whether compliance would be misleading, management must consider why the objec-
tives of financial statements would not be achieved in the current circumstances and how the entity’s cir-
cumstances differ from other entities that do comply with the requirement.
What should managers do if they conclude that compliance with IFRS Standards would be so misleading
as to defeat the objectives of financial reporting? The answer to this depends on whether departure from IFRS
Standards is permitted in the domestic reporting regime, as shown in figure 16.9.
Disclosures required by IAS 1 when management concludes compliance with an IFRS Standard would be misleading
Domestic reporting Domestic reporting regime permits Domestic reporting regime prohibits
regime departure from an IFRS Standard departure from an IFRS Standards
Action Depart from the IFRS Standard Do not depart from the IFRS Standards
Disclosure • that management has concluded that the financial • the title of the relevant IFRS Standard
statements present fairly the entity’s financial position, • the nature of the requirement
financial performance and cash flows • the reason for management’s
• that the financial statements are in compliance with conclusion that compliance is
IFRS Standards except for the specific departure to misleading and
achieve a fair presentation • the adjustments necessary to each
• the title of the IFRS Standard from which the entity item for each period presented
has departed that are required to achieve a fair
– the treatment required by the IFRS Standard presentation.
– the nature of the departure
– why the treatment would be so misleading in the
circumstances that it would be in conflict with the
objectives of financial statements specified in the
Conceptual Framework
– the financial effect of the departure on each item in
the financial statements for each period presented.
Relevant paragraphs IAS 1, paragraphs 19–22 IAS 1, paragraphs 23–24
FIGURE 16.9 Reporting requirements when management concludes compliance with an IFRS Standard would be misleading

16.6.2 Statement of significant accounting policies
and sources of estimation uncertainty
In deciding whether to disclose particulars of an accounting policy, managers must consider its relevance
in assisting users to understand how transactions and events have been reported in the financial state-
ments. In some cases, disclosure is prescribed by other IFRS Standards. For example, IAS 16 requires disclo-
sure of the depreciation methods used for each class of property, plant and equipment (paragraph 73(b))
(see chapter 11).
Paragraph 117 of IAS 1 explains that the summary of significant accounting policies should include the
measurement bases used. For example, an entity should disclose whether cost or fair value has been used
in measuring property, plant and equipment subsequent to initial recognition. Paragraph 73(a) of IAS 16
also requires disclosure of this information.
The measurement of some assets and liabilities can involve assumptions, such as the rate of growth
used in the measurement of the recoverable amount. An entity must disclose information about the
assumptions concerning the future, and other major sources of estimation uncertainty at the end of
the reporting period, where there is a significant risk that they may result in material adjustments to
the carrying amounts of assets and liabilities within the next financial year (IAS 1 paragraph 125). It is
not uncommon for entities to include the disclosures about measurement uncertainty in that section
of the notes.
The application of IFRS Standards often requires the exercise of judgement. For example, the application
of IAS 17 Leases often involves judgement about whether substantially all the risks and rewards of
ownership have been transferred by a lease (see chapter 12). Paragraph 122 of IAS 1 requires disclosure of
the judgements that have the most significant effect on the amounts recognised in financial statements in
the summary of accounting policies.
16.6.3 Information about capital

Paragraph 134 of IAS 1 requires disclosure of information that enables users of financial statements
to evaluate the entity’s management of capital. This requirement encompasses qualitative information
about objectives, policies and processes, including a description of what is managed as capital, the
nature of any externally imposed capital requirements, whether the entity has complied with externally
imposed requirements, and, if the entity has not complied with external requirements, the implications
of non-compliance.
Quantitative disclosures are also required, including summary data of what is managed as capital. This
may differ from reported equity because an entity may exclude some components of equity, such as for-
eign currency translation reserves, from what is managed as capital, while including some items that are
classified as liabilities, such as subordinated debt.
The standard adopts a management perspective by focusing on how capital is viewed by management,
rather than prescribing specific definitions of capital for the purposes of the disclosures. The entity is
required to base its capital disclosures on the information provided internally to key management per-
sonnel (paragraph 135).
16.6.4 Other disclosures

It is not uncommon for dividends to be proposed or declared (i.e. approved by the appropriate authorising
body, such as the board of directors) after the reporting date but before the financial statements are
issued. Unless the dividends are declared before the end of the reporting period they cannot be recog-
nised in the financial statements. IAS 10 Events after the Reporting Period requires disclosure in the notes
of any dividends that have been proposed or declared before the release of the financial statements but
not recognised in the financial statements. Paragraph 137(a) of IAS 1 requires the disclosure to include
the amount of the dividends that have been proposed or declared but not recognised, and the related
amount per share. The amount of any cumulative preference dividends that have not been recognised as
liabilities must also be disclosed (paragraph 137(b)).
Paragraph 138 of IAS 1 requires disclosure of certain non-financial information including:
• the legal form of the entity, such as whether it is a company or a trust
• the country of incorporation
• the address of the registered office or the principal place of business (if different from the registered
office)
• a description of the nature of the entity’s operations and its principal activities
• the name of the parent and the ultimate parent of the group
• if a limited-life company, the length of its life.

LO7 16.7 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING
ESTIMATES AND ERRORS
We will now consider how to:
• select and account for changes in accounting policies
• account for changes in accounting estimates
• correct prior period errors.
The requirements are specified in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
The term accounting policy refers to principles or conventions applied in preparing the financial state-
ments, such as using the straight-line method of depreciation for property, plant and equipment. An
accounting estimate is a judgement applied in determining the carrying amount of an item in the financial
statements such as an estimate of the useful life of a depreciable asset. The use of reasonable estimates is
an essential part of the process of preparing financial statements because many items reported in the finan-
cial statements — such as provisions for warranties — cannot be calculated with precision. For example,
an entity’s accounting policy may be to measure its provision for warranty claims based on history, the
volume of sales and the length of outstanding warranty periods. The calculation of the amount of the war-
ranty provision is an accounting estimate that applies this accounting policy.
A prior period error is an omission or misstatement in the financial statements of a prior period resulting
from the misuse or failure to use reliable information. Errors may arise from mathematical miscalcula-
tions, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud (IAS
8 paragraph 5). For example, assume Company C owns a building from which it derives rental income. In
testing for impairment, Company C measures the value in use of the building by discounting future rental
income. The amount of rental income should be reduced by any waivers of rent allowed to tenants, such as
rent-free periods offered to new tenants. Assume that in measuring the value in use in a prior period, the cash
inflows forgone from rent-free periods were added to annual rentals, instead of being deducted, and that this
resulted in an overstated carrying amount of the building. The misstatement would be classified as an error
in the prior-period financial statements because it results from a mistake in the application of information
that was available at the time. In contrast, if, in hindsight, the building was found to have been overstated
because the estimated rental growth rates used in a prior period were too high, the subsequent restatement of
the carrying amount of the building would be treated as a change of accounting estimate.
16.7.1 Selecting and changing accounting policies

Accounting standards prescribe accounting policies for certain topics, transactions or events. IAS 8
deals with situations where there are no applicable accounting standards, and sets out the principles
that entities must apply in selecting appropriate accounting policies. Paragraph 10 of IAS 8 specifies
that where there is no IFRS Standard dealing with a particular transaction, preparers should use judge-
ment in developing and applying accounting policies so that the resulting information is relevant and
reliable. The concept of reliability encompasses:
• faithful representation
• reflecting economic substance over legal form
• neutrality, freedom from bias
• prudence and
• completeness in all material respects.
The concept of substance over form is particularly important. This is an area revealed as a weakness in
the rules-based approach to standard setting used by the US and implicated in some of the corporate col-
lapses in that country in 2001 and 2002. Transactions that were, in substance, financing transactions were
accounted for as sales, applying very literal interpretations of the US rules. Applying the principle of sub-
stance over form should result in transactions being accounted for in accordance with their underlying eco-
nomic implications. The accounting treatment of certain preference shares provides an example of applying
the principle of substance over form. While the form of the preference shares is equity, their economic sub-
stance is a liability if the terms allow for redemption at the option of the holder. Accordingly, in applying
the principle of substance over form, IAS 32 requires such preference shares to be classified as liabilities.
IAS 8 provides what is commonly termed the ‘hierarchy’ of relevant sources of information to be used
by management in selecting and applying accounting policies. Paragraph 11 states that management must
firstly consider the requirements and guidance of any IFRS Standard dealing with similar or related issues.
Secondly, management must consider the Framework’s definitions, recognition criteria and measurement
concepts of assets, liabilities, income and expenses. Provided they do not conflict with the sources in
paragraph 11, management may also consider the most recent pronouncements of other standard setters
that use a similar conceptual framework, other accounting literature and accepted industry practices.
Paragraph 13 of IAS 8 requires an entity to apply accounting policies consistently for similar transactions,
events or conditions unless otherwise required by an accounting standard. Accordingly, IAS 8 paragraph 14
specifies only two circumstances in which an entity is permitted to change an accounting policy. These are:

• if the change is required by an IFRS Standard; or
• if the change, made voluntarily, results in the financial statements providing reliable and more relevant
information about the effects of transactions, other events or conditions on the entity’s financial
position, financial performance or cash flows.
However, the initial application of a policy to revalue assets in accordance with IAS 16 Property, Plant
and Equipment or IAS 38 Intangible Assets must be accounted for as a revaluation in accordance with those
standards and not as a change in accounting policy under IAS 8. Note that this applies to the initial appli-
cation of a revaluation policy only. IAS 8 would apply if an entity initially chooses the revaluation method
under IAS 16 or IAS 38, and then changes to the cost method at a later date.
Where an entity changes an accounting policy because it is required to do so, it must account for that
change in accordance with the transitional provisions of the accounting standard requiring the change. If
the accounting standard does not specify how to account for the change, then the change must be applied
retrospectively. Retrospective application is also required for all voluntary changes in accounting policy (IAS 8
paragraph 19). Retrospective application means applying a new accounting policy to transactions, other
events and conditions as if that policy had always been applied (paragraph 5). When an entity retrospec-
tively applies a change of accounting policy, the opening balance of each affected component of equity for
the earliest prior period presented must be adjusted, and the other comparative amounts must be disclosed
for each prior period presented as if the new accounting policy had always been applied (IAS 8 paragraph
22). Further, when an entity applies an accounting policy retrospectively (or other retrospective restatement
or reclassification), paragraph 40A of IAS 1 requires presentation of a statement of financial position as at
the beginning of the preceding period if it has a material effect on the information presented. As clarified in
paragraph 40B, the entity would be required to present three statements of financial position as at:
• the end of the current period;
• the end of the preceding period; and
• the beginning of the preceding period.
IAS 8 requires extensive disclosures when an entity changes its accounting policy. These include:
• the nature of the change in accounting policy
• for the current period and each prior period presented, to the extent practicable, the amount of the
adjustment for:
– each financial statement line item affected and
– basic and diluted earnings per share, if IAS 33 Earnings per Share applies to the entity
• the amount of the adjustment relating to periods before those presented, to the extent practicable
• if retrospective application is impracticable, the reason for that condition and a description of how and
from when the change in accounting policy has been applied.
Additional disclosures are required for changes required by an IFRS Standard and for voluntary changes,
as follows:
• Change of accounting policy required by an IFRS Standard
– the title of the IFRS Standard
– that the change in accounting policy is made in accordance with its transitional provisions, if applicable
– a description of the transitional provisions, if applicable
– the transitional provisions that might have an effect on future periods, if applicable.
• Voluntary change of accounting policy
– the reasons why the new accounting policy provides reliable and more relevant information.
As noted in section 16.5.2, paragraph 106(b) of IAS 1 requires disclosure of the effects of retrospective
adjustments for each component of equity in the statement of changes in equity.
Illustrative example 16.2 shows how to apply retrospectively a change in accounting policy.
ILLUSTRATIVE EXAMPLE 16.2 Applying a change in accounting policy retrospectively
Ace Ltd operates in the agricultural industry and has many large orchards of fruit trees. Effective from 1
January 2016, Ace Ltd changed its accounting policy for fruit trees as a result of changes to IAS 41 Agri-
culture and IAS 16 Property, Plant and Equipment. Until the end of 2015 Ace Ltd had measured its fruit
trees at fair value with changes in fair value recognised in profit or loss.
The changes in accounting standards resulted in fruit trees being classified as property, plant and
equipment and accounted for in accordance with IAS 16. Thus the fruit trees are accounted for at cost
until they reach maturity. Then, the entity has a choice of retaining the cost model or choosing the reval-
uation model, with revaluation gains recognised in other comprehensive income and accumulated in
equity, unless reversing a previous downward revaluation.
The orchards had been acquired at the beginning of 2013 at a cost of $2 400 000. By the end of 2014
(and therefore at the beginning of 2015) the fair value of the fruit trees was $3 000 000. The gains
on revaluation of the fruit trees recognised through profit or loss by 31 December 2014 had increased
retained earnings by $420 000. The deferred tax liability arising from the temporary difference between
the carrying amount and the tax base of the fruit trees was $180 000.

On 31 December 2015 Ace Ltd revalued the fruit trees by $400 000 to their fair value of $3 400 000
in accordance with IAS 41. The gain on revaluation was recognised in profit. The following information
was obtained from Ace Ltd’s 2015 financial statements:
2015 2014
$’000 $’000
Revenue 5 200
Gain on revaluation of fruit trees 400
Depreciation expense (200)
Profit before tax 1 050
Income tax expense (315)
Profit for the period 735
Agricultural assets – fruit trees 3 400 3 000
Deferred tax liability 365 245
Retained earnings at the end of the year 1 385 650
Ace Ltd chose the cost model to account for the fruit trees in accordance with IAS 16. The useful life
of the fruit trees was estimated as 16 years with no residual value. The annual depreciation expense for
the fruit trees is $150 000, being $2 400 000/16 years.
Retrospective application of the changes to IAS 16 means that Ace Ltd’s financial statements should be
presented as if the cost model under IAS 16 had always been applied.
In applying IAS 16, Ace Ltd would make the following adjustments to the comparative financial state-
ments for the year ended 31 December 2015:
(a) Profit before tax is decreased by $550 000 comprising:
i. the gain on revaluation, $400 000, which would not have been recognised under the cost model; and
ii. the depreciation of the fruit trees, $150 000.
(b) Income tax expense is decreased by $165 000, comprising:
i. decrease of $120 000 pertaining to the reversal of the temporary difference arising from the
decrease in the carrying amount of the fruit trees [($3 400 000 − $3 000 000) × 30%]; and
ii. decrease of $45 000 pertaining to the temporary difference arising from the depreciation of the
fruit trees [($2 400 000 − $2 250 000) × 30%].
(c) The fruit trees are measured at cost of $2 400 000 less accumulated depreciation.
(d) Accumulated depreciation of the fruit trees is recognised and measured as $450 000 at 31 December
2015 ($150 000 × 3).
(e) Retained earnings at the beginning of 2015 is reduced by $630 000, comprising:
i. $420 000, being the accumulated revaluation gains, net of tax, that would not have been recog-
nised under the cost model.
ii. $210 000, being the depreciation expense, net of tax, for the 2 years ended 31 December 2014
[$150 000 × (1 − 30%) × 2 years].
(f) Deferred tax liability is decreased by $435 000 comprising:
i. $180 000, reversal of the temporary difference at the end beginning of 2015;
ii. $120 000, reversal of temporary difference (refer item (b)(i) above);
iii. $135 000, temporary difference arising from retrospective depreciation of fruit trees which does
not affect the tax base (refer item (d) above).
The following extracts from the financial statements of Ace Ltd for the year ended 31 December 2016
illustrate the retrospective application of the change in accounting policy.
ACE LTD
Statements of Profit or Loss and Other Comprehensive Income
for the year ended 31 December
Restated
2016 2015
$’000 $’000
Revenue 5 850 5 200

Cost of goods sold (2 900) (2 500)
Wages and salaries expenses (1 200) (1 100)
Depreciation expense (350) (350)
Other expenses (850) (750)

Income tax expense (165) (150)
Profit for the period 385 350
Other comprehensive income for the year — —
ACE LTD
Statements of Changes in Equity
Share capital Retained earnings Total

$’000 $’000 $’000
Balance at 31 December 2015 as restated 1 200 370 1 570

Comprehensive income for the year ended
31 December 2016 — 385 385
Balance at 31 December 2016 1 200 755 1 955
ACE LTD
Statements of Changes in Equity
Share capital Retained earnings Total

$’000 $’000 $’000
Balance at 31 December 2014 as previously reported 1 200 650 1 850

Change in accounting policy for fruit trees — (630) (630)
Balance at 31 December 2014 as restated 1 200 20 1 220
Comprehensive income for the year ended
31 December 2015 — 350 350
Balance at 31 December 2015 1 200 370 1 570
ACE LTD
Statements of Financial Position
at 31 December
Restated Restated
2016 2015 2014
$’000 $’000 $’000
Assets
Current assets
Cash and cash equivalents 50 50 50
Accounts receivable 850 800 650
Total current assets 900 850 700
Non-current assets
Fruit trees 1 800 1 950 2 100
Other property, plant and equipment 1 200 1 400 1 600
Total non-current assets 3 000 3 350 3 700
Total assets 3 900 4 200 4 400

Liabilities and equity
Current liabilities
Accounts payable 440 400 550
Current tax payable 210 190 200
Provisions 150 250 290
Provisions 50 150 195
Deferred tax liability 15 60 105
Financial liabilities 1 080 1 580 1 840
Total non-current liabilities 1 145 1 790 2 140
Total liabilities 1 945 2 630 3 180
Equity
Share capital 1 200 1 200 1 200
Total equity 1 955 1 570 1 220
Total liabilities and equity 3 900 4 200 4 400
Additional disclosures in the notes for the change in accounting policy

The company has adopted IAS 16 Property, Plant and Equipment, as amended in 2014. As a result, fruit
trees are accounted for under the cost model. In accordance with the transitional provisions of IAS 16,
the change in accounting policy was applied retrospectively. The comparative financial statements for
2015 have been restated. The effect of the change for each line item affected is tabulated below:
Effect on 2015
$’000
Decrease in gain on revaluation of fruit trees (400)

Increase in depreciation expense (150)
Decrease in profit before tax (550)
Decrease in income tax expense (165)
Decrease in profit for the period (385)
Decrease in fruit trees (1 450)
Decrease in deferred tax liability (435)
Decrease in retained earnings (1 015)
Effect on 2014
$’000
Decrease in fruit trees (900)

Decrease in deferred tax liability (270)
Decrease in retained earnings (630)
Paragraphs 23–25 of IAS 8 deal with circumstances where retrospective application of a change in
accounting policy is impracticable and thus cannot be applied. In the context of IAS 8 ‘impracticable’
means ‘the entity cannot apply it after making every reasonable effort to do so’ (paragraph 5). For example,
the retrospective application of an accounting policy would be impracticable if it required assumptions
about what management’s intent might have been at a prior point in time. Hindsight is not used when
applying a new accounting policy retrospectively. For example, an asset measured on the fair value basis
retrospectively should be measured at the fair value as at the date of the retrospective adjustment and
should not take into account subsequent events. When it is impracticable for an entity to apply a new
accounting policy retrospectively because it cannot determine the cumulative effect of applying the policy

to all prior periods, the entity should apply the new policy prospectively from the start of the earliest
period practicable. This may be the current period.
16.7.2 Changes in accounting estimates

Recall that an accounting estimate is a judgement applied in determining the carrying amount of an item in
the financial statements. An estimate may need to be revised if changes occur in the circumstances on which
it was based, or as a result of new information or more experience. Paragraph 36 of IAS 8 requires changes
in accounting estimates to be accounted for prospectively. Prospective application is defined in paragraph
5. When a new accounting estimate is applied prospectively the effect of the change is recognised in the
current period and any future periods affected by the change but no adjustment is made to prior periods.
Paragraph 37 of IAS 8 states that if the change in estimate affects assets, liabilities or equity, then the
carrying amounts of those items shall be adjusted in the period of the change. Paragraphs 39 and 40 pre-
scribe disclosures for changes in accounting estimates that have an effect in the current or future periods.
The entity must disclose the nature and amount of the change. However, if it is impracticable to estimate
the effect on future periods the entity must disclose that fact.
Illustrative example 16.3 demonstrates accounting for a change in an accounting estimate, including the
required disclosures.
ILLUSTRATIVE EXAMPLE 16.3 Accounting for a change in an accounting estimate
Company Z installed factory plant in January 2012. The company had been depreciating its factory plant
on a straight-line basis, with an estimated useful life of 15 years and nil residual value. Four years later, in
January 2016, the directors of Company Z determined that, due to technological developments, the factory
plant’s useful life was 10 years in total — that is, it had a remaining useful life of 6 years. Company Z’s
reporting period ends on 31 December. As at 1 January 2016, the balance of factory plant was as follows:
Cost $ 150 000

Accumulated depreciation (40 000)
Carrying amount 110 000
For the year ended 31 December 2016, Company Z’s depreciation expense will be $18 333. This is
calculated as $110 000/6 (being the carrying amount of the asset at 1 July 2016 divided by the remaining
useful life).
Extract from Company Z’s financial statements for the year ended 31 December 2016:
Company Z has historically depreciated its factory plant over 15 years. The company’s directors deter-
mined that, effective from 1 January 2016, the factory plant should be depreciated over 10 years. The
effect of the change in the estimated useful life of the factory plant in the current period is to increase
the depreciation expense from $10 000 to $18 333 and to increase accumulated depreciation by $8333.
In future periods, annual depreciation expense for the factory plant will be $18 333 over the remaining
useful life of the plant.
16.7.3 Correction of errors

An ‘error’ is an omission or misstatement in the financial statements. If a material error is discovered
in a subsequent period, paragraph 42 of IAS 8 requires retrospective correction by restating comparative
amounts for each prior period presented in which the error occurred. Where the error occurred before
the first prior period presented, the entity must restate opening balances of assets, liabilities and equity
of the earliest period presented.
Retrospective restatement is required unless it is impracticable to do so (IAS 8 paragraphs 43–45). Sim-
ilar disclosures are required for correction of errors as for changes in accounting policy (paragraph 49).
However, as the correction of errors requires the retrospective restatement of items in the financial state-
ments, a statement of financial position as at the beginning of the earliest comparative period must also
be presented (IAS 1 paragraph 40A).
LO8 16.8 EVENTS AFTER THE REPORTING PERIOD

The objective of IAS 10 is to prescribe when an entity should adjust its financial statements for events after
the reporting period, and what disclosures the entity should make about events after the reporting period.
IAS 10 paragraph 3 defines an event after the reporting period as occurring after the end of the reporting

period but before the financial statements are authorised for issue. Events after the reporting period are
classified as being:
• adjusting events, which provide further evidence of conditions that existed at the end of the
reporting period, and can include an event that indicates that the going concern assumption may be
inappropriate; and
• non-adjusting events, which indicate conditions that arose after the end of the reporting period, such
as the unintended destruction of property that existed at the end of the reporting period.
Usually the date at which financial statements are authorised for issue is when the directors or other
governing body formally approve the financial statements for issue to shareholders and/or other users.
Although subsequent ratification by the shareholders at an annual meeting may be required, that is not
usually the date of authorisation for issue.
16.8.1 Adjusting events after the reporting period

Paragraph 8 of IAS 10 requires an entity to adjust the amounts recognised in its financial statements to
reflect adjusting events after the reporting period. Examples of adjusting events after the reporting period
include the following:
• the receipt of information after the reporting period that indicates an asset was impaired as at the end
of the reporting period — this may occur, for example, if a trade receivable recorded at the end of the
reporting period is shown to be irrecoverable because of the insolvency of the customer that occurs
after the reporting period
• the sale of inventories after the reporting period that provides evidence of their net realisable value at
the end of the reporting period
• the judge’s decision on a court case, after the reporting period, confirming that the entity had a present
obligation at the end of the reporting period.
Illustrative example 16.4 demonstrates accounting for an adjusting event after the reporting period.
ILLUSTRATIVE EXAMPLE 16.4 Accounting for an adjusting event after the reporting period
Blue Ltd’s financial statements for the year ended 31 December 2016 included a receivable of $35 000
in respect of a major customer, Red Ltd. On 31 January 2017 the liquidator of Red Ltd advised that the
company was insolvent and would be unable to repay the full amount owed. The liquidator advised
Blue Ltd in writing that Red Ltd’s creditors would receive 10 cents in the dollar (i.e. 10 cents for every
dollar owed). The liquidator estimated that the amount would be paid in November 2017. Blue Ltd’s
financial statements were authorised for issue by the directors on 25 February 2017.
In accordance with IAS 10, the insolvency of Red Ltd is an adjusting event after the reporting period
because it provides further evidence of the collectability of the receivable at 31 December 2016. Blue Ltd
will adjust the receivable from $35 000 to $3500 as follows:

Receivables Cr 31 500
(Impairment of receivable)
16.8.2 Non-adjusting events after the reporting period

Paragraph 10 of IAS 10 states that an entity shall not adjust the amounts recognised in its financial state-
ments to reflect non-adjusting events after the reporting period. Examples of non-adjusting events include:
• a major business combination after the reporting period
• the destruction of property by fire after the reporting period
• the issuance of new share capital after the reporting period
• commencing major litigation arising solely out of events that occurred after the reporting period.
Although these events are not adjusted for, paragraph 21 of IAS 10 requires the following disclosure for
each material category of non-adjusting event after the reporting period:
• the nature of the event; and
• an estimate of its financial effect, or a statement that such an estimate cannot be made.
Paragraph 11 of IAS 10 refers to a controversial area of accounting for events after the reporting period.
It states that a decline in the market value of investments between the end of the reporting period and the
date when the financial statements are authorised for issue is a non-adjusting event, because the decline

in market value does not normally relate to the condition of the investments at the end of the reporting
period but instead reflects circumstances that have arisen subsequently. This appears to be inconsistent
with the treatment of the receivables referred to in paragraph 9(b)(i) of IAS 10, regarding the insolvency of
a debtor after the reporting period. IAS 10 paragraph 9(b)(i) states that this would constitute an adjusting
event because the insolvency confirms that a loss existed at the end of the reporting period. The critical
issue here is the amount and uncertainty of the future cash flows arising from the receivable, not whether
the debtor was insolvent at the end of the reporting period. There may have been some concerns about
collectability at the end of the reporting period.
A view that reconciles the differing treatment is that the additional information about the debtor’s insol-
vency provides further evidence that the receivable was impaired and enables a better assessment of the
extent of impairment. However, for assets, such as investments in securities that are traded in an active
market, the market value at the reporting date would have been observable. Thus, the position taken in
paragraph 11 is that the change in market value of the securities observed after the reporting period is
indicative of conditions that arose after the reporting period, and, as such, is a non-adjusting event after
the reporting period.
SUMMARY
IAS 1 Presentation of Financial Statements, IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
and IAS 10 Events after the Reporting Period deal with fundamental disclosures and considerations that
underpin financial statement presentation.
IAS 1 prescribes overall considerations to be applied in the preparation of financial statements, and
the structure and content of financial statements, which comprise a statement of financial position,
statement of profit or loss and other comprehensive income, statement of cash flows, statement of
changes in equity and notes. The prescribed disclosures are designed to enhance the understandability
of the financial statements for the users of general purpose financial statements in their economic deci-
sion making.
IAS 8 prescribes the accounting treatment for changes in accounting policies, changes in accounting esti-
mates and correction of prior period errors. Changes in accounting policies and corrections of errors are
applied retrospectively, while changes in accounting estimates are recognised prospectively.
IAS 10 distinguishes between two types of events after the reporting period — adjusting and non-adjusting.
Adjusting events must be recognised in the financial statements, whereas non-adjusting events must be
disclosed only.
1. Describe the eight general principles to be applied in the presentation of financial statements. Which
principles are more subjective? Explain your answer.
2. Why is it important for entities to disclose the measurement bases used in preparing the financial
statements?
3. How do the presentation and disclosure requirements of IFRS Standards reflect the objectives of finan-
cial statements? Illustrate your argument with examples from IAS 1, IAS 8 and IAS 10.
4. What is the purpose of a statement of financial position? What comprises a complete set of financial
statements in accordance with IAS 1?
5. What are the major limitations of a statement of financial position as a source of information for users
of general purpose financial statements?
6. Under what circumstances are assets and liabilities ordinarily classified broadly in order of liquidity
rather than on a current/non-current classification?
7. Can an asset that is not realisable within 12 months be classified as a current asset? If so, under what
circumstances?
8. Explain the difference between classification of expenses by nature and by function.
9. Does the separate identification of profit and items of other comprehensive income provide a mean-
ingful distinction between the effects of different types of non-owner transactions and events?
10. What is the objective of a statement of changes in equity?
11. Why is a summary of accounting policies important to ensuring the understandability of financial
statements to users of general purpose financial statements?
12. Provide an example of a judgement made in preparing the financial statements that can lead to estima-
tion uncertainty at the end of the reporting period. Describe the disclosures that would be required in
the notes.
13. What disclosures are required in the notes in regard to accounting policy judgements?
14. What is the difference between an accounting policy and an accounting estimate? Provide an example
of each.

15. Explain the difference between retrospective application of a change in accounting policy and pro-
spective application of a change in accounting estimate. Why do you think the standard setters require
prospective application of a change in accounting estimate?
16. Explain the difference between adjusting and non-adjusting events after the reporting period. Provide
examples to illustrate your answer.
References
BHP Billiton 2015, Annual Report 2015, BHP Billiton, www.bhpbilliton.com.
HSBC Holdings plc 2014, Annual Report 2014, HSBC Holdings plc, London, www.hsbc.com.
International Accounting Standards Board (IASB) 2012, IASB documents published to accompany International
Accounting Standard 1 Presentation of Financial Statements, IASB, London, www.ifrs.org.
Exercise 16.1 CURRENT ASSET AND LIABILITY CLASSIFICATIONS

★ The general ledger trial balance of Joshua Limited at 31 December 2016 includes the following asset and
liability accounts:
(a) Interest payable £ 2 000
(b) Trade receivables 100 000
(c) Accounts payable 85 000
(d) Prepayments 12 000
(e) Inventory of finished goods 120 000
(f) Allowance for doubtful debts 8 000
(g) Cash 10 000
(h) Accrued wages and salaries 20 000
(i) Inventory of raw materials 60 000
(j) Loan (due 31 October 2017) 100 000
(k) Lease liability 75 000
(l) Current tax payable 30 000
• The lease liability includes an amount of £13 000 for lease payments due before 31 December 2017.
• The company classifies assets and liabilities using a current/non-current basis.
Required
Prepare the current assets and current liabilities sections of the statement of financial position of Joshua
Limited as at 31 December 2016, using the minimum line items permitted under IAS 1.
Exercise 16.2 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

★ The general ledger trial balance of Lachlan Ltd includes the following accounts at 31 December 2016:
(a) Sales revenue $1 200 000
(b) Interest income 24 000
(c) Gain on sale of plant 5 000
(d) Valuation gain on trading securities 20 000
(e) Dividend revenue 5 000
(f) Cost of sales 840 000
(g) Finance expenses 18 000
(h) Selling and distribution expenses 76 000
(i) Administrative expenses 35 000
(j) Income tax expense 85 000
• Lachlan Ltd also recognised a loss of $1000 net of tax on valuation of investment securities. Valuation
gains and losses on the investment securities are recognised in other comprehensive income.
• A gain of $4000 net of tax was recognised on the revaluation of land.
• Lachlan Ltd uses the single statement format for the statement of profit or loss and other
• Lachlan Ltd classifies expenses by function.
Required
Prepare the statement of profit or loss and other comprehensive income of Lachlan Ltd for the year ended
31 December 2016, showing the analysis of expenses in the statement.

Exercise 16.3 STATEMENT OF CHANGES IN EQUITY
★ The shareholders’ equity section of the statement of financial position of Riley Ltd at 31 December 2016
is shown below.
2016 2015
Share capital £200 000 £160 000
General reserve 50 000 40 000
Foreign currency translation reserve 74 000 60 000
£494 000 £420 000
• Riley Ltd issued 16 000 shares at £2.50 each on 31 May 2016 for cash.
• A transfer of £10 000 was made from retained earnings to the general reserve.
• Comprehensive income for the year was £144 000, including a foreign currency translation gain of
£14 000 recognised in other comprehensive income.
• Dividends paid during 2016 comprised: final dividend for 2015, £50 000; interim dividend, £60 000.
Required
Prepare the statement of changes in equity of Riley Ltd for the year ended 31 December 2016 in accordance
with IAS 1.
Exercise 16.4 MATERIALITY, OFFSETTING

★ Company A is a retailer that imports about 30% of its goods. The following foreign exchange gains and
losses were recognised in profit during the year:
Loss Gain
€m €m
Foreign currency borrowings with Bank L 50

Forward exchange contracts used as hedging instruments 1
Forward exchange contracts not used as hedges 3
Foreign currency borrowings with Bank S 10
Materiality has been determined as €5 million for items recognised in profit or loss.
Required
Identify which of the above gains and losses are permitted to be offset in Company A’s financial statements.
Exercise 16.5 ACCOUNTING POLICIES, ACCOUNTING ESTIMATES

★ State whether each of the following is an accounting policy or an accounting estimate for Company A:
(a) The useful life of depreciable plant is determined as being 6 years.
(b) Company A recognises income arising from service contracts on the basis of the stage of completion.
(c) Company A determines that it will calculate its warranty provision using past experience of defective
products.
(d) The current year’s warranty provision is calculated by providing for 1% of current year sales, based
on last year’s warranty claims amounting to 1% of sales.
Exercise 16.6 PREPARATION OF A STATEMENT OF FINANCIAL POSITION

★ The summarised general ledger trial balance of Noah Ltd includes the following accounts at 31 December
2016:
Dr Cr
Cash deposits $ 117 000
Trade debtors 1 163 000
Allowance for doubtful debts $ 50 000

Dr Cr
Sundry receivables 270 000
Prepayments 94 000
Sundry loans (current) 20 000
Raw materials on hand 493 000
Finished goods 695 000
Investments in corporate bonds 30 000
Land (at cost) 234 000
Buildings (at cost) 687 000
Accumulated depreciation – buildings 80 000
Plant and equipment (at cost) 6 329 000
Accumulated depreciation – plant and equipment 3 036 000
Goodwill 2 425 000
Brand names 40 000
Patents 25 000
Deferred tax asset 189 000
Trade payables 1 078 000
Sundry payables 568 000
Bank overdraft 115 000
Bank loans 1 848 000
Other loans 646 000
Current tax payable 74 000
Provision for employee benefits 222 000
Dividends payable 100 000
Provision for warranty 20 000
Share capital 3 459 000
$ 12 811 000 $ 12 811 000
• The bank overdraft is payable within 12 months. It does not form part of cash equivalents.
• Bank loans include $620 000 repayable within 1 year.
• Other loans outstanding are repayable within 1 year.
• Provision for employee benefits includes $143 000 payable within 1 year.
• Provision for warranty is in respect of a 6-month warranty given over certain goods sold.
• The investments in corporate bonds are long-term investments.
Required
Prepare the statement of financial position of Noah Ltd at 31 December 2016 in accordance with IAS 1,
using the captions that a listed company is likely to use.
Exercise 16.7 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

★★ The general ledger trial balance of James Ltd includes the following accounts at 31 December 2016:
(a) Sales revenue $975 000
(b) Interest income 20 000
(c) Share of profit of associates accounted for using the equity method 15 000
(d) Gain on sale of securities investments 10 000
(e) Decrease in inventories of finished goods 25 000
(f) Raw materials and consumables used 350 000
(g) Employee benefit expenses 150 000
(h) Loss on translation of foreign operations (nil tax effect) 25 000
(i) Depreciation of property, plant and equipment 45 000
(j) Impairment loss on property 80 000
(k) Finance costs 35 000
(l) Other expenses 45 000
(m) Income tax expense (current) 75 000
• Securities investments are revalued regularly, with changes in fair value recognised in other
comprehensive income and accumulated in equity in the investments revaluation reserve. When
securities are sold, the accumulated amount recognised in equity for the asset is reclassified to profit

or loss. Movements in the investments revaluation reserve during the year ended 31 December 2016
comprised:
– gross revaluation increases recognised $44 000 (related deferred income tax $14 000)
– gross reclassifications on sale of securities investments $10 000 gain (related income tax $3000).
• James Ltd uses the single statement format for the statement of profit or loss and other comprehensive
income.
• James Ltd presents an analysis of expenses by nature in the statement of profit or loss and other
Required
Prepare the statement of profit or loss and other comprehensive income of James Ltd for the year ended
31 December 2016.
Exercise 16.8 PRESENTATION OF ITEMS IN THE FINANCIAL STATEMENTS

★★ Consider the following items for Cooper Ltd at 31 December 2016:
(a) contingent liabilities
(b) the effect on retained earnings of the correction of a prior period error
(c) cash and cash equivalents
(d) capital contributed during the year
(e) revaluation gain on land (not reversing any previous revaluation)
(f) judgements that management has made in classifying financial assets
(g) income tax expense
(h) provisions.
Required
State whether each item is reported:
1. in the statement of financial position
2. in profit or loss in the statement of profit or loss and other comprehensive income
3. in other comprehensive income in the statement of profit or loss and other comprehensive income
4. in the statement of changes in equity
5. in the notes to the financial statements.
Exercise 16.9 ACCOUNTING POLICIES, ACCOUNTING ESTIMATES, ERRORS

★★ State whether the following changes should be accounted for and, if so, whether retrospectively or pro-
spectively, in accordance with IAS 8:
(a) A change in accounting policy made voluntarily.
(b) A change in accounting policy required by an accounting standard.
(c) A change in an accounting estimate.
(d) An immaterial error discovered in the current year, relating to a transaction recorded 2 years ago.
(e) A material error discovered in the current year, relating to a transaction recorded 2 years ago. Manage-
ment determines that retrospective application would cause undue cost and effort.
(f) A change in accounting policy required by an accounting standard. Retrospective application of that
standard would require assumptions about what management’s intent would have been in the relevant
period(s).
Exercise 16.10 CHANGE IN ACCOUNTING ESTIMATE

★★ On 1 January 2011 Company H acquired a building. The company depreciated the building on a
straight-line basis, with an estimated useful life of 15 years and nil residual value. In 2016, Company
H’s directors reviewed the depreciation rates for similar buildings used in its industry and decided that
the buildings should be depreciated over a total period of 20 years. Company H’s reporting period ends
on 31 December.
As at 1 January 2016, the balance of administration buildings was as follows:
Cost $ 5 000 000

Accumulated depreciation (1 666 667)
Carrying amount 3 333 333
Required
Prepare the note describing Company H’s change in accounting estimate for the year ended 31 December
2016, including comparative figures, in accordance with IAS 8. Show all workings.

Exercise 16.11 ADJUSTING/NON-ADJUSTING EVENTS AFTER THE REPORTING PERIOD
★★★ The financial statements of Company N are authorised for issue on 12 February 2017 and the end of the
reporting period is 31 December 2016. State whether each of the following material items would be an
adjusting or non-adjusting event after the reporting period in the financial statements of Company N. Give
reasons for your answer.
(a) At 31 December Company N had recorded an overdue receivable from Company P at $25 000 because
collection of the full amount of $40 000 was in doubt. On 16 January, a receiver was appointed to
Company P. The receiver informed Company N that the $40 000 would be paid in full by 30 April
2017.
(b) On 24 January Company N issued corporate bonds for $1 000 000, with interest of 5% payable semi-
annually in arrears.
(c) Company N’s investments in listed shares are held-for-trading and measured at fair value, with gains
and losses recognised in profit or loss. As at 31 December, these investments were recorded at the market
value at that date, which was $500 000. During January and February 2017, there was a steady decline in
the market values of all the shares in the portfolio. By 12 February 2017 the market value of the invest-
ments had fallen to $400 000.
(d) Company N had reported a contingent liability at 31 December in respect of a lawsuit against the
company by an employee who was injured during 2016. The case was not heard until the first week of
February 2017. On 11 February, the judge handed down her decision, against Company N. The judge
determined that Company N was liable to pay damages and costs totalling $3 000 000.
(e) As in part (d), except that the damages and costs awarded against Company N were $50 million,
leading Company N to place itself into voluntary liquidation.
PREPARATION OF A STATEMENT OF FINANCIAL POSITION, STATEMENT OF PROFIT OR LOSS AND

Exercise 16.12
★★★ OTHER COMPREHENSIVE INCOME AND STATEMENT OF CHANGES IN EQUITY
The summarised general ledger trial balance of Matthew Ltd, a manufacturing company, for the year ended
31 December 2016 is detailed below:
Dr Cr
Sales revenue $ 5 000 000
Interest income 22 000
Sundry income 25 000
Change in inventory of work in progress $ 125 000
Change in inventory of finished goods 60 000
Raw materials used 2 200 000
Employee benefit expense 950 000
Amortisation – patent 25 000
Rental expense 70 000
Advertising expense 142 000
Freight out expense 133 000
Interest expense 30 000
Other expenses 8 000
Income tax expense 320 000
Cash 4 000
Cash on deposit, at call 80 000
Trade receivables 495 000
Allowance for doubtful debts 18 000
Other receivables 27 000
Raw materials inventory, 31 December 2016 320 000
Finished goods inventory, 31 December 2016 385 000
Land 94 000
Buildings 220 000
Accumulated depreciation – land and buildings 52 000
Plant and equipment 1 380 000
Accumulated depreciation – plant and equipment 320 000
Patents 140 000

Dr Cr
Accumulated amortisation – patent 50 000
Goodwill 620 000
Bank loans 92 000
Other loans 450 000
Trade payables 452 000
Provision for employee benefits 120 000
Income tax payable 35 000
Retained earnings, 31 December 2015 310 000
Dividends paid 210 000
Share capital 1 137 000
Dividends reinvested 41 000
Deferred cash flow hedge (equity) 65 000
$ 8 324 000 $ 8 324 000
• All of the deferred cash flow hedge arose in the current period. This item was recognised in other
comprehensive income. The related tax was nil.
• $20 000 of bank loans is repayable within 1 year.
• $90 000 of other loans is repayable within 1 year.
• Matthew Ltd uses the single statement format for the statement of profit or loss and other
comprehensive income and presents an analysis of expenses by nature in the statement.
Required
Prepare the statement of financial position, statement of profit or loss and other comprehensive income
and statement of changes in equity of Matthew Ltd for the year ended 31 December 2016 in accordance
with the requirements of IAS 1, using statement captions that a listed company is likely to use.

Under IAS 1 certain changes in net assets are reported as volatility of OCI if it is reported in the statement of changes
other comprehensive income (OCI) rather than in the in equity. Hirst and Hopkins (1998) run an experiment based
income statement (IS). One concern that academics have on professional subjects who examine a case where a ficti-
raised is whether items reported in OCI are interpreted tious firm sells available-for-sale (AFS) instruments to realise a
differently than items reported in the IS. Dhaliwal et al. holding gain. The sale of the AFS instruments is not expected
(1999) examine a sample of over 11 000 firm-year observa- to affect the firms’ value because they were already carried at
tions between 1994 and 1995 and find that most compa- fair value. However, Hirst and Hopkins (1998) find that the
nies report non-zero OCI. They then examine the association location of information about this gain matters for valuation.
between stock returns and the sum of net income and OCI — Specifically, reporting the resulting changes in comprehensive
or, adjusted income — and establish that it is positive. The income attracts lower valuations than reporting in the state-
explanatory power of adjusted income for stock return is ment of changes in equity. The implication is that professional
larger than that of net income alone. This is consistent with investors focus on performance measures such as comprehen-
decision usefulness of OCI. However, further investigation sive income and analyse related disclosures more diligently.
reveals that the additional usefulness primarily stems from Bamber et al. (2010) build on the above-mentioned
fair-value adjustments of available-for-sale securities that are research to argue that managers believe that reporting OCI in
reported in OCI and not from other sources of OCI. The a performance statement will increase investors’ perception
authors also explore the association between net income and of performance volatility. This acts as an incentive to report
adjusted income with stock prices. They find that the asso- OCI in the statement of changes in equity. Bamber et al.
ciation is stronger for net income. Moreover, net income (2010) further hypothesise that this incentive is stronger
is more closely related to future cash flows and future net for managers whose compensation is more equity-based
income than adjusted income. The conclusion the authors (because higher volatility reduces stock prices) and who
draw from this evidence is that OCI is a noisy measure of face the threat of dismissal. To test their hypotheses Bamber
performance and hence is not as useful as net income. How- et al. (2010) assemble a sample of 440 S&P 500 firms between
ever, this finding may be due to the fact that Dhaliwal et al. 1998 and 2001. They find that 81% of sample firms report OCI
(1999) do not separate between net income and OCI to see in the statement of changes in equity. They also find evidence
how each component individually and incrementally is used that the likelihood of reporting OCI in the statement of changes
by investors. This task is performed by Barton et al. (2010) in equity is greater for managers that receive more equity com-
employing a very large international sample (46 countries) pensation but decreases with measures of CEO power (which is
between 1996 and 2005. They examine an alternative spec- inversely related to dismissal risk).
ification whereby net income and total comprehensive Older versions of IAS 1 required that financial statements
income are tested separately and incrementally to each other. give a ‘true and fair view’ (TFV) of the financial affairs of the
This alternative specification, however, does not change the reporting entity. Older versions of IAS 1 further required that
insight that OCI is measured with considerable noise and is a reporting entity departs from promulgated standards if by
not value relevant. However, conflicting evidence is provided following them the reporting will be misleading, and hence
by Chambers et al. (2007). Specifically, they find from a US inconsistent with TFV. Such a departure is called TFV over-
sample of 2705 firm-year observations in the 1998–2003 ride. In preparation for the 2005 adoption of IFRS Standards
period that OCI is positively related to stock returns. The con- in Europe IAS 1 was revised to require fair presentation, and,
trast with Dhaliwal et al. (1999) is explained by the fact that furthermore, to discourage TFV overrides (the language of the
Dhaliwal et al. (1999) do not actually use OCI numbers as standard now speaks about rare circumstances in which an
prescribed by SFAS 130 (now ASC 220) (FASB, 1997), but override can be invoked). An important question in this con-
proxy for these numbers. Similarly, Barton et al. (2010) largely text is whether companies use TFV overrides to improve the
employ reports prepared under older versions of IAS 1. quality of financial reports, or do so only when it is conven-
While IFRS Standards now require the reporting of OCI ient for them. There is unfortunately scarce empirical research
either immediately following the income statement or in the on this topic, in part because following the adoption of IFRS
statement of comprehensive income, this has not always been Standards most firms have been discouraged from overrides.
the case. In the US, for example, certain items of OCI could An exception is the study by Livne and McNichols (2009)
be reported in the statement of changes in equity. Adopting who examine TFV overrides in the UK prior to the 2005 adop-
this approach therefore shifts the location of OCI from a tion of IFRS Standards. The authors first develop a classifica-
performance-focused statement — the statement of compre- tion system to assess the severity of an override. A more costly
hensive income — to the balance sheet. But, does the loca- override is expected to be invoked to the extent that it delivers
tion of OCI reporting matter? One may argue that the most better outcomes to managers. Livne and McNichols (2009)
important issue is that the relevant figures are clearly reported, find that more costly overrides (overrides of UK GAAP) are
regardless of their location. However, if investors have limited associated with poor performance. This evidence therefore
attention, as is argued by Hirshleifer and Teoh (2003), they suggests that overrides were invoked opportunistically in an
may focus on performance measures at the expense of informa- effort to improve reported performance and financial posi-
tion disclosed elsewhere in the financials (e.g., the statement tion. Further, firms that invoked TFV overrides are associated
of changes in equity). Experimental evidence indeed sug- with poorer quality of financial statements. This evidence sug-
gests that location may matter. Maines and McDaniel (2000) gests that allowing more flexibility to invoke an override may
provide evidence that non-professional investors ignore the lead to unintended consequences.

References Financial Accounting Standards Board (FASB). 1997.
Reporting comprehensive income. SFAS No. 130. Stamford,
Bamber, L.S., Jiang, J., Petroni, K.R., and Wang, I.Y., 2010. CT: FASB
Comprehensive income: Who’s afraid of performance Hirshleifer, D., and Teoh, S.H., 2003. Limited attention,
reporting? The Accounting Review, 85(1), 97–126. information disclosure, and financial reporting. Journal of
Barton, J., Hansen, T.B., and Pownall, G., 2010. Which Accounting and Economics, 36(1), 337–386.
performance measures do investors around the world Hirst, D.E., and Hopkins, P.E., 1998. Comprehensive income
value the most—and why? The Accounting Review, 85(3), reporting and analysts’ valuation judgments. Journal of
753–789. Accounting Research, 36, 47–75.
Chambers, D., Linsmeier, T.J., Shakespeare, C., and Livne, G., and McNichols, M., 2009. An empirical investigation
Sougiannis, T., 2007. An evaluation of SFAS No. 130 of the true and fair override in the United Kingdom. Journal
comprehensive income disclosures. Review of Accounting of Business Finance & Accounting, 36(1–2), 1–30.
Studies, 12(4), 557–593. Maines, L.A., and McDaniel, L.S., 2000. Effects of
Dhaliwal, D., Subramanyam, K.R., and Trezevant, R., 1999. comprehensive-income characteristics on nonprofessional
Is comprehensive income superior to net income as a investors’ judgments: The role of financial-statement
measure of firm performance? Journal of Accounting and presentation format. The Accounting Review, 75(2),
Economics, 26(1), 43–67. 179–207.

17 Statement of cash flows
ACCOUNTING IAS 7 Statement of Cash Flows
STANDARDS
IN FOCUS
LEARNING
OBJECTIVES After studying this chapter, you should be able to:
1 explain the purpose of a statement of cash flows and its usefulness
2 explain the definition of cash and cash equivalents
3 explain the classification of cash flow activities and classify cash inflows and outflows into
operating, investing and financing activities
4 contrast the direct and indirect methods of presenting net cash flows from operating activities
5 prepare a statement of cash flows and use a worksheet to prepare a statement of cash flows
with more complex transactions
6 prepare other disclosures required or encouraged by IAS 7.
CHAPTER 17 Statement of cash flows 485

INTRODUCTION AND SCOPE
Ultimately, all existing and potential investors, lenders and other creditors would like to receive cash from
their investment. Consequently, information about an entity’s receipts and payments is important to such
users of financial statements. The statement of cash flows provides this information by reporting cash
inflows and outflows classified into operating, investing and financing activities, and the net movement in
cash and cash equivalents during the period.
This chapter explains how to present a statement of cash flows in accordance with IAS 7 Statement of
Cash Flows.
LO1 17.1 PURPOSE OF A STATEMENT OF CASH FLOWS

The overall purpose of a statement of cash flows is to present information about the historical changes in
cash and cash equivalents of an entity during the period classified by operating, investing and financing
activities. The statement of cash flows can help users of financial statements to:
• evaluate the entity’s ability to generate cash and cash equivalents
• predict future cash flows
• evaluate the accuracy of past cash flow predictions and forecasts.
When used in combination with other financial statements, the statement of cash flows can help
users to:
• evaluate an entity’s financial structure (including liquidity and solvency) and its ability to meet its
obligations and to pay dividends
• evaluate the entity’s ability to affect the amount and timing of future cash flows, to enable it to adapt
to changing business opportunities and circumstances
• understand the reasons for the difference between profit or loss for a period and the net cash flow
from operating activities (the reasons for the differences are often helpful in evaluating the quality of
earnings of an entity)
• compare the operating performance of different entities because cash flows are not directly affected by
different accounting choices and judgements under accrual accounting.
LO2 17.2 DEFINING CASH AND CASH EQUIVALENTS

Paragraph 6 of IAS 7 defines cash and cash equivalents as follows:
Cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash
and which are subject to an insignificant risk of changes in value.
Paragraph 7 of IAS 7 explains that cash equivalents are held for the purpose of meeting short-term cash
commitments, and not for investment or other purposes. Cash equivalents must be able to be converted
into a known amount of cash. This means that the amount of cash that will be received must be known at
the time of the initial investment in the cash equivalent. It must also have no more than an insignificant
risk of changing in value. Therefore, an investment will qualify as a cash equivalent only if it has a short
maturity (usually 3 months or less). Examples of cash and cash equivalents include cash on hand, cash
at bank, short-term money market securities and 90-day term deposits. Equity investments typically do
not qualify as cash equivalents, but it is necessary to consider their substance; equity instruments such as
preferred shares acquired shortly before their specified maturity date may fall within the definition of cash
equivalents.
Bank borrowings are ordinarily classified as a financing activity. A bank overdraft is a special case.
It can arise where a customer has a facility with the bank that allows the customer’s account to be
overdrawn (i.e. to go below nil). The amount of the bank overdraft can vary on a daily basis up to an
agreed limit. This would not usually be considered as part of cash and cash equivalents. However, if the
bank overdraft is repayable on demand and forms an integral part of an entity’s cash management, it
is included in cash and cash equivalents. Such overdrafts may fluctuate from being overdrawn to being
positive (i.e. cash at bank).
The statement of cash flows reports on changes in aggregate cash and cash equivalents. Therefore, move-
ments between items classified as cash and cash equivalents, such as a transfer from cash at bank to a
90-day term deposit, are not reported in the statement of cash flows. The concept of cash and cash equiv-
alents used in IAS 7 is summarised and illustrated in figure 17.1.

Form Conditions Examples
Cash Cash on hand Notes and coins

Demand deposits Call deposits held at
financial institutions
Cash equivalents Short-term, highly liquid Readily convertible Bank bills

investments into known amounts of Non-bank bills
cash and subject to an
Deposits on short-term
insignificant risk of change
money market, such as
in value
7-day deposits
Bank overdraft Repayable on demand and Cheque account that is
form an integral part of an in overdraft and which is
entity’s cash management repayable on demand
FIGURE 17.1 Concept of cash and cash equivalents used in IAS 7

Source: Loftus et al. 2015.
LO3 17.3 CLASSIFYING CASH FLOW ACTIVITIES

As stated earlier, cash flow activities reported in the statement of cash flows are classified into operating,
investing and financing activities. Paragraph 6 of IAS 7 defines these activities as follows:
Operating activities are the principal revenue-producing activities of the entity and other activities that are not
investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash
equivalents.
Financing activities are activities that result in changes in the size and composition of the contributed equity and
borrowings of the entity.
Only expenditures that result in a recognised asset in the statement of financial position are eligible for
classification as investing activities. For example, Green GmbH incurs expenditure of €50 000 on research
for a carbon-neutral air conditioner. Expenditure incurred in the research phase must be recognised as an
expense in accordance with IAS 38 Intangible Assets. Accordingly, the cash paid in relation to the research
project is not classified as an investing cash flow because it has not resulted in the recognition of an asset
in the statement of financial position of Green GmbH.
Note that the operating activities category is a default category; it includes all activities that are not clas-
sified as either investing activities or financing activities. Figure 17.2 summarises typical cash receipts and
payments of an entity, classified by activity.
Operating activities Investing activities

Cash inflows from: Cash inflows from:
Sale of goods Sale of property, plant and equipment
Rendering of services Sale of intangibles
Royalties, fees, commissions Sale of shares and debt instruments of
Interest received (or investing activity) other entities
Dividends received (or investing activity) Repayment of loans by other parties
Cash outflows for: Cash outflows for:
Payments to suppliers of goods and services Purchases of property, plant and equipment
Payments to employees for services Purchases of intangibles
Payments to the government for income Purchases of shares and debt instruments
tax and other taxes of other entities
Payments to lenders for interest or other Loans to other entities
borrowing cost (or finance activity)
Financing activities
Cash inflows from: Cash outflows for:
Issuing shares and other equity instruments Buying back own shares (reduction in capital)
Issuing debentures, unsecured notes Repayment of debentures, unsecured notes
Borrowings, such as loans Repayment of borrowings, such as loans
Payment of dividends to shareholders (or operating)
FIGURE 17.2 Typical cash receipts and payments classified by activity

17.3.1 Classifying interest and dividends received and paid
IAS 7 does not prescribe how interest and dividends received and paid should be classified. Rather, para-
graph 31 of IAS 7 requires cash flows from interest and dividends received and paid to be disclosed
separately and classified consistently from period to period as operating, investing or financing activities.
Although most financial institutions classify interest paid and interest and dividends received as oper-
ating cash flows there is no consensus on how to classify these cash flows for other entities. Some entities
classify interest paid and interest and dividends received as operating cash flows because they may relate
to items that determine profit or loss, while other entities classify interest paid as financing cash flows
and interest and dividends received as investing cash flows, viewing them as the costs of financing or the
returns on investments respectively. Paragraph 34 notes that dividends paid may be classified as financing
cash flows because they are a cost of obtaining equity finance or as cash from operating activities, to assist
users to determine the ability of the entity to pay dividends from operating cash flows.
BHP Billiton classifies interest received and interest paid as cash flows from operating activities as shown
in figure 17.3.
2014 2013
2015 US$M US$M
US$M Restated Restated
Operating activities
Profit before taxation from Continuing operations 8 056 21 735 20 828
Adjustments for:
Non-cash or non-operating exceptional items 3 196 (551) (331)
Depreciation and amortisation expense 9 158 7 716 6 067
Net gain on sale of non-current assets (9) (73) (17)
Impairments of property, plant and equipment, financial assets and intangibles 828 478 344
Employee share awards expense 247 247 210
Net finance costs 614 914 1 149
Share of operating profit of equity accounted investments (548) (1 185) (1 142)
Other 265 (79) 5
Changes in assets and liabilities:
Trade and other receivables 1 431 (349) 904
Inventories 151 (158) (276)
Trade and other payables (990) 238 (239)
Net other financial assets and liabilities (8) (90) 89
Provisions and other liabilities (771) 475 (565)
Cash generated from operations 21 620 29 318 27 026

Dividends received 17 14 6
Dividends received from equity accounted investments 723 1 250 710
Interest received 86 120 112
Interest paid (627) (915) (960)
Income tax refunded 348 848 —
Income tax paid (3 225) (6 123) (6 921)
Royalty-related taxation refunded — 216 —
Royalty-related taxation paid (1 148) (1 088) (956)
Net operating cash flows from Continuing operations 17 794 23 640 19 017
Net operating cash flows from Discontinued operations 1 502 1 724 1 137
Net operating cash flows 19 296 25 364 20 154
FIGURE 17.3 BHP Billiton cash flows from operating activities for the year ended 30 June 2015
17.3.2 Classifying taxes on income

Paragraph 35 of IAS 7 requires income tax paid to be separately disclosed in the statement of cash flows
and classified as cash flows from operating activities, unless it can be specifically identified with financing or
investing activities. As noted in paragraph 36 of IAS 7, while the tax expense may often be readily identifiable
with investing or financing activities, the associated cash flows may arise in different periods, making it very

difficult to classify tax payments as cash paid for investing or financing activities. Accordingly, taxes paid are
usually classified as cash flows from operating activities. Refer to figure 17.3 to identify the income tax paid
reported by BHP Billiton in the operating activities section of the statement of cash flows.
LO4 17.4 FORMAT OF THE STATEMENT OF CASH FLOWS

The general format of a statement of cash flows follows the three cash flow activities. Cash flows from
operating activities are presented first, followed by cash flows from investing activities and then those from
financing activities. The resultant net increase or decrease in cash and cash equivalents during the period is
then used to report the movement in cash and cash equivalents from the balance at the beginning of the
period to the balance at the end of the period.
17.4.1 Reporting cash flows from operating activities

Paragraph 18 of IAS 7 provides that cash flows from operating activities may be reported using one of two
methods:
• the direct method — which presents major classes of gross cash receipts and gross cash payments in the
statement of cash flows
• the indirect method — which adjusts profit or loss for the effects of transactions of a non-cash nature,
any deferrals or accruals of past or future operating cash receipts or payments, and items of income or
expense associated with investing or financing cash flows. Alternatively, the cash flows from operations
may be presented under the indirect method by adjusting revenues for changes in receivables and
adjusting expenses for changes in inventories, payables and other accruals (IAS 7 paragraph 20).
Although both methods are permitted, IAS 7 explicitly encourages the use of the direct method.
Figure 17.4 illustrates the typical format of a statement of cash flows that uses the direct method.
Statement of Cash Flows

for the year ended 31 December . . .
Cash flows from operating activities

Cash receipts from customers $ xxx
Cash paid to suppliers and employees ( xxx)
Cash generated from operations xxx
Interest received xxx
Interest paid ( xxx)
Income taxes paid ( xxx)
Net cash from operating activities xxx
Cash flows from investing activities
Acquisition of subsidiary, net of cash acquired ( xxx)
Purchase of property and plant ( xxx)
Proceeds from sale of plant xxx
Net cash used in investing activities (xxx)
Cash flows from financing activities
Proceeds from share issue xxx
Proceeds from borrowings xxx
Payment of borrowings ( xxx)
Dividends paid ( xxx)
Net cash from financing activities xxx
Net increase in cash and cash equivalents xxx
Cash and cash equivalents at beginning of year xxx
Cash and cash equivalents at end of year xxx
FIGURE 17.4 Typical format of a statement of cash flows using the direct method of reporting cash
flows from operating activities
Figure 17.5 illustrates the typical format of the indirect method of reporting cash flows from operating
activities.
As can be seen in figure 17.5, depreciation expense is added back to profit in calculating cash flows from
operating activities. This is because depreciation expense reduces profit but has no effect on cash flows.
The loss on the sale of investment is added back to profit because it reduces profit but does not affect cash
flows from operating activities. Conversely, a gain on the disposal of equipment would be deducted from

profit in calculating cash flows from operations. The related cash flow (i.e. the cash proceeds on the sale of
the equipment) is included in cash flows from investing activities.
Profit before tax is adjusted for the difference between an amount recognised in profit and the corre-
sponding operating cash flows, such as the change in receivables, which reflects the difference between sales
revenue and cash collected from customers. This process is explained in more detail later (see section 17.5). In
applying the indirect method, the total amount of interest income is deducted, rather than the difference
between interest income measured on an accrual basis and the amount of interest received. This is because
paragraph 31 of IAS 7 requires disclosure of interest received in the statement of cash flows, irrespective of
whether cash flows from operating activities are presented using the direct method or the indirect method.

for the year ended 31 December . . .
Profit before tax $ xxx

Adjustments for:
Depreciation xxx
Foreign exchange loss xxx
Loss on sale of equipment xxx
Interest income ( xxx)
Interest expense xxx
Increase in trade and other receivables ( xxx)
Decrease in inventories xxx
Increase in accounts payable xxx
Decrease in accrued liabilities ( xxx)
Cash generated from operations xxx
Interest received xxx
Interest paid ( xxx)
Income taxes paid ( xxx)
Net cash from operating activities xxx
FIGURE 17.5 Typical format for the indirect method of reporting cash flows from operating activities
Can you tell the difference between the two methods of presenting the operating activities section of the
statement of cash flows? Test yourself. Which method is used by BHP Billiton in figure 17.3?
17.4.2 Reporting cash flows from investing and financing activities

Paragraph 21 of IAS 7 requires separate reporting of the major classes of gross cash receipts and gross cash
payments arising from investing and financing activities, except for certain cash flows (outlined in the
following section) that may be reported on a net basis.
17.4.3 Reporting cash flows on a net basis

Paragraph 22 of IAS 7 allows the following cash flows to be reported on a net basis:
(a) cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer
rather than those of the entity, such as the acceptance and repayment of a bank’s demand deposits, and rents
collected from tenants by an agent and paid to the property owners; and
(b) cash receipts and payments for items in which the turnover is quick, the amounts are large, and the matur-
ities are short. For example, assume an entity finances some of its operations with a 90-day bill acceptance
facility with its bank. This means that the entity writes commercial bills, giving rise to a contractual obli-
gation to pay the face value of the bill. The bank accepts the bill and pays the entity a discounted amount,
with the difference being interest effectively paid by the entity. Thus, the entity is borrowing the discounted
amount of the bill and repaying the face value, which is the sum of the amount borrowed and interest. The
entity will have cash inflows from financing activities each time a commercial bill is accepted by the bank
and cash outflows from financing activities each time one of its commercial bills matures. The entity may
offset the cash received for the 90-day bills against the repayment on maturity, such that only the net move-
ment in the level of borrowing is reported.
Paragraph 24 of IAS 7 permits the following cash flows to be reported on a net basis by financial
institutions:
(a) cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date;
(b) the placement of deposits with and withdrawal of deposits from other financial institutions; and
(c) cash advances and loans made to customers and the repayment of those advances and loans.

LO5 17.5 PREPARING A STATEMENT OF CASH FLOWS
Unlike the statement of financial position and statement of profit or loss and other comprehensive
income, the statement of cash flows is not prepared from an entity’s general ledger trial balance.
Preparation requires information to be compiled about the cash inflows and cash outflows of the
entity for the reporting period. It is possible to compile the required information through a detailed
analysis and summary of the entity’s records of cash receipts and cash payments, such as cash receipts
and cash payments journals. However, a statement of cash flows is usually prepared from compara-
tive statements of financial position to determine the net amount of changes in assets, liabilities and
equities over the period. This method can also be used to prepare the consolidated statement of cash
flows for a group of entities. The comparative statements of financial position are supplemented by
various items of information from the statement of profit or loss and other comprehensive income
and additional information extracted from the accounting records of the entity to enable certain cash
receipts and payments to be fully identified. There are two main approaches to calculations and work-
ings for the statement of cash flows: one approach uses a formula based on the reconstruction of
ledger accounts; and the other approach uses a worksheet to analyse movements in items reported in
the comparative statements of financial position. We will commence with the first approach using the
information presented in figure 17.6.
FIGURE 17.6 Financial statements and additional accounting information of Violet Inc.
VIOLET INC.
Income
Sales revenue $800 000
Gain on sale of plant 4 000
809 000
Expenses
Cost of sales $480 000
Wages and salaries expense 120 000
Depreciation — plant and equipment 25 000
Other expenses 76 000 705 000
Profit for the year 74 000
Gain on revaluation of land 2 000
Income tax (600)
Other comprehensive income net of tax 1 400
Total comprehensive income for the year $ 75 400
VIOLET INC.
Comparative Statements of Financial Position as at:
31 December 31 December Increase

2016 2017 (decrease)
Cash at bank $ 60 000 $ 56 550 $ (3 450)
Inventory 65 000 70 000 5 000
Prepayments 8 000 9 500 1 500
Interest receivable 150 100 (50)
Plant and equipmenta 150 000 165 000 15 000
Land 12 000 14 000 2 000
Intangible assetsb — 15 000 15 000
$365 150 $409 150
(continued)

VIOLET INC.

Wages and salaries payable 4 000 5 000 1 000
Accrued interest — 200 200
Other expenses payable 3 000 1 800 (1 200)
Current tax payable 14 000 16 000 2 000
Deferred tax liability 5 000 8 600 3 600
Long-term borrowingsc 60 000 70 000 10 000
Share capital 200 000 200 000 —
Retained earningsd 37 150 61 150 24 000
Revaluation surplus — 1 400 1 400
$365 150 $409 150
Additional information extracted from the company’s records:
(a) Plant that had a carrying amount of $10 000 was sold for $14 000 cash. New equipment purchased for
cash amounted to $50 000.
(b) All intangibles were acquired for cash.
(c) An additional borrowing of $10 000 in cash was made during the year.
(d) Dividends paid in cash were $50 000.
17.5.1 Cash flows from operating activities

The first step in preparing a statement of cash flows is to determine the cash flows from operating activi-
ties. The process used varies according to whether the direct or the indirect method of presentation is used.
First we will work the approach for the direct method using a series of equations to calculate the gross cash
inflows and gross cash outflows that are presented in the operating activities section of the statement of
cash flows.
Determining cash receipts from customers
The starting point for determining how much cash was received from customers is the sales revenue
reported in the statement of profit or loss and other comprehensive income. This figure reflects sales made
by the entity during the period irrespective of whether the customers have paid for their purchases. Credit
sales are recorded by a debit to accounts receivable and a credit to sales revenue. However, cash received
from customers includes sales made in the previous period if cash is not collected until the current period,
and excludes sales made in the current period if customers have not paid by the end of the current period.
Hence, cash received from customers (assuming there have been no bad debts written off or settlement
discounts given) equals:
Sales revenue + Beginning accounts receivable − Ending accounts receivable
Using the Violet Inc. information from figure 17.6, receipts from customers is determined as follows:
Sales revenue $ 800 000

+ Beginning accounts receivable 70 000
Cash collectable from customers 870 000
− Ending accounts receivable (79 000)
Receipts from customers $ 791 000
The entity may offer settlement discounts to customers for prompt or early payment of their accounts.
For example, if a customer who owes $100 takes advantage of an offer of a 5% discount for prompt pay-
ment, the customer would pay only $95 to settle the receivable, and the entity would record an expense
of $5 for discount allowed for the non-cash reduction in receivables. Settlement discounts are accounted
for as a non-cash expense (discount allowed) in profit or loss and a reduction in accounts receivable.
Thus, settlement discounts allowed reduce the amount of cash that can be collected from customers.
Accordingly, discount allowed must be adjusted for in calculating cash receipts from customers. Similarly,

adjustment would be necessary for bad debts written off if the entity used the direct write-off method
of accounting for uncollectable debts. Calculation of cash receipts from customers under the allowance
method of accounting for uncollectable debts is considered later in this chapter.
The logic of this calculation is apparent from the following summarised Accounts Receivable account in
the general ledger for the year:
Accounts Receivable
Opening balance 70 000 Bad Debts Expense —

Sales Revenue 800 000 Discount Allowed —
Cash receipts 791 000
Closing balance 79 000
870 000 870 000
The above summarised general ledger account can be reconstructed from the statement of financial
position including comparative amounts (the opening and closing balances) and statement of profit
or loss and other comprehensive income (bad debts expense, discount allowed and sales revenue). The
cash receipts amount is then determined as the ‘plug’ figure (balancing item) in the Accounts Receivable
account.
The above approach may be simplified by working with the change in receivables over the period. Under
this approach, cash received from customers (assuming there are no bad debts written off or discounts
allowed) equals:
Sales revenue − Increase in accounts receivable

or
+ Decrease in accounts receivable
Thus, cash received from customers for Violet Inc. can alternatively be determined as:
$800 000 − $9000 = $791 000
Determining interest received

A similar approach is used to determine interest received, which equals:
Interest revenue − Increase in interest receivable

or
+ Decrease in interest receivable
Thus, Violet Inc.’s interest received is:
$5000 + $50 = $5050
Determining cash paid to suppliers and employees

Payments to suppliers may comprise purchases of inventory and payments for services. However, not all
inventory purchased during the year is reflected in profit or loss as cost of sales because cost of sales
includes beginning inventory and excludes ending inventory. The cost of purchases of inventory made
during the period equals:
Cost of sales − Beginning inventory + Ending inventory
Alternatively, this could be expressed as:
Cost of sales + Increase in inventory

or
− Decrease in inventory
Using a similar approach to that outlined for cash receipts from customers, it is then necessary to adjust
for accounts payable at the beginning and end of the period to calculate cash paid to suppliers for pur-
chases of inventory. Thus, cash paid to suppliers of inventories is calculated as:
Purchases of inventories + Beginning accounts payable − Ending accounts payable

Purchases of inventory + Decrease in accounts payable

or
− Increase in accounts payable
As shown in figure 17.6, Violet Inc.’s comparative statements of financial position report an increase in
inventory of $5000 and in accounts payable of $3000. Hence, cash paid to suppliers for purchases is cal-
culated as follows:
Cost of sales $480 000

+ Increase in inventory 5 000
Purchases for year 485 000
− Increase in accounts payable (3 000)
Payments to suppliers for purchases of inventory $482 000
If the entity receives a discount from its suppliers for prompt or early payment of accounts payable the
settlement discount received is accounted for as discount revenue and a reduction in accounts payable.
Thus, settlement discounts reduce the amount of cash paid to suppliers and must be deducted in calcu-
lating cash paid to suppliers.
The logic of the previous calculations incorporating the adjustment for discount received is apparent
from the following summarised inventory and accounts payable (for inventory) accounts in the general
ledger for the year:
Inventory Accounts Payable
Opening balance 65 000 Cost of Sales 480 000 Discount Received — Opening balance 42 000
Purchases 485 000 Closing balance 70 000 Cash payments 482 000 Purchases 485 000
Closing balance 45 000
550 000 550 000 527 000 527 000
The above summarised general ledger accounts can be reconstructed from the information contained
in the comparative statements of financial position (the opening and closing balances) and the state-
ment of profit or loss and other comprehensive income (cost of sales). The purchases amount is then
determined in the Inventory account and inserted on the credit side of the Accounts Payable account.
The amount of cash payments can then be determined as the ‘plug’ figure in reconciling the Accounts
Payable account.
A similar approach is taken to determine the amount of payments made to suppliers for services and to
employees. Adjustments must be made to the relevant expenses recognised in profit or loss for changes in
the beginning and ending amounts of prepayments and relevant accounts payable and accrued liabilities.
Thus, the amount of cash paid to suppliers for services is calculated as follows:
Expenses charged to profit or loss − Beginning prepayments

+ Ending prepayments
+ Beginning accounts payable/accruals
− Ending accounts payable/accruals
Expenses charged to profit or loss + Increase in prepayments

or
− Decrease in prepayments
+ Decrease in accounts payable/accruals
or
− Increase in accounts payable/accruals
Violet Inc.’s comparative statements of financial position show:
Increase in prepayments $ 1 500

Increase in wages and salaries payable 1 000
Decrease in other expenses payable (1 200)

Thus cash paid to suppliers of services is calculated as follows:
Other expenses $76 000

+ Increase in prepayments 1 500
+ Decrease in other expenses payable 1 200
Payments to suppliers of services $78 700
Similarly, cash paid to employees is calculated as follows:
Wages and salaries expense $120 000

− Increase in wages and salaries payable 1 000
Payments to employees $119 000
Using the previous calculations, total payments to suppliers and employees to be reported in the state-
ment of cash flows comprise:
Payments to suppliers for purchases $482 000

Payments to suppliers for services 78 700
Payments to employees 119 000
Total payments to suppliers and employees $679 700
Determining interest paid

Using the same approach as for other expenses, Violet Inc.’s interest paid is determined as follows:
Interest expense $4 000

− Increase in accrued interest 200
Interest paid $3 800
Determining income tax paid

The determination of income tax paid can be complicated because in addition to current tax payable, the appli-
cation of tax effect accounting can give rise to deferred tax assets and deferred tax liabilities. Further, some of the
movements in the current and deferred tax accounts might not be reflected in the income tax expense recog-
nised in profit or loss. Certain gains and losses and associated tax effects are recognised in OCI and accumulated
in equity accounts. For example, as explained in chapter 6, deferred tax may arise from a revaluation of property,
plant and equipment that causes a difference between the book value and tax base of those assets, thereby
resulting in a charge for income tax being made to the Revaluation Surplus account. As a result, it is often sim-
pler to reconstruct the Deferred Tax Liability account to determine the allocation of income tax expense. We can
use this reconstruction to determine the deferred component of income tax expense recognised in profit or loss,
if this is not already identified in the statement of profit or loss and other comprehensive income.
Deferred Tax Liability
Opening balance 5 000

Tax effect recognised in OCI 600
Closing balance 8 600 Income Tax Expense 3 000
8 600 8 600
The above summarised general ledger account can be reconstructed from the comparative statements of
financial position (opening and closing balances) and the statement of profit or loss and other compre-
hensive income. The income tax expense shown in the reconstruction of the Deferred Tax Liability account
is the deferred component of income tax expense — that is, the amount of income tax expense pertaining
to the movement in deferred tax balances.
• The movement in the Deferred Tax Liability account for Violet Inc. can be summarised as follows:
Opening balance $5 000

+ Tax recognised directly in OCI 600
+ Income tax expense (deferred component) 3 000
Closing balance $8 600

The current component of income tax expense can then be calculated by deducting the deferred com-
ponent of income tax expense from the total income tax expense recognised in profit or loss. The current
component of income tax expense for Violet Inc. can be calculated as follows:
Income tax expense $30 000

− Deferred component of income tax expense (3 000)
Current component of income tax expense $27 000
The opening balance of Current Tax Payable of $14 000 is increased by the current component of
income tax expense, $27 000. If no payments were made, the closing balance would be $41 000. However,
as the closing balance is only $16 000, we can conclude that the amount of income tax paid must have
been $25 000. To illustrate, the movement in Violet Inc.’s Current Tax Payable account may be summarised
as follows:

+ Income tax expense 27 000
− Income tax paid 25 000
For Violet Inc., the amount of income tax paid consists of the final balance in respect of the previous
year’s current tax payable, and instalments paid in respect of the current year.
Summarising cash flows from operating activities
The operating activities section of Violet Inc.’s statement of cash flows for the year are presented using the
direct method in figure 17.7.
VIOLET INC.
Statement of Cash Flows (extract)

Cash receipts from customers $ 791 000
Cash paid to suppliers and employees (679 700)
Cash generated from operations 111 300
Interest received* 5 050
Interest paid** (3 800)
Income taxes paid (25 000)
Net cash from operating activities $ 87 550
* May be classified as investing ** May be classified as financing
FIGURE 17.7 Cash flows from operating activities (direct method)
The presentation of Violet Inc.’s cash flows from operating activities under the indirect method is shown
in figure 17.8. The statement commences with profit before tax and shows the gross amount of tax paid as
a separate item. Similarly, it is necessary to adjust for the full amount of the interest income and interest
expense so that amount of cash received or paid for these items is disclosed in full in the statement of cash
flows. In this illustration, the increase in wages and salaries payable of $1000 and the decrease in other
expenses payable of $1200 are combined as one line item and shown as a net reduction of $200.
17.5.2 Cash flows from investing activities

Determining cash flows from investing activities requires identifying cash inflows and outflows relating to
the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
The comparative statements of financial position of Violet Inc. in figure 17.6 show that plant has
increased by $15 000, land by $2000 and intangibles by $15 000. To determine the cash flows relating to
these increases, it is necessary to analyse the underlying transactions.

VIOLET INC.

Profit before tax $ 104 000
Adjustment for:
Depreciation 25 000
Interest income (5 000)
Gain on sale of plant (4 000)
Increase in accounts receivable (9 000)
Increase in inventory (5 000)
Increase in prepayments (1 500)
Increase in accounts payable 3 000
Decrease in other payables (200)
Interest received* 5 050
Interest paid** (3 800)
* May be classified as investing ** May be classified as financing
FIGURE 17.8 Cash flows from operating activities (indirect method)
The plant and equipment reported in the statement of financial position is net of accumulated depreciation.
The net increase reflects the recording of purchases, disposals and depreciation of plant and equipment. Using
the data provided, the analysis of the movement in plant and equipment (net of accumulated deprecia-
tion) is as follows:

Purchases 50 000
Disposals (10 000)
Depreciation for year (25 000)
The additional information provided in figure 17.6 states that the acquisitions were made for cash during
the period, so no adjustment is necessary for year-end payables. The cash paid for equipment purchases for
the year is $50 000 (note (a) in figure 17.6). Any payables for plant and equipment purchases outstanding at
the beginning of the period would need to be added to purchases and any payables for plant and equipment
outstanding at the end of the period would need to be deducted to calculate the amount of cash paid for
plant and equipment during the period.
Plant with a carrying amount of $10 000 was sold, as stated in additional information (a) of figure 17.6.
This amount is shown as a deduction from the net carrying amount plant and equipment.
The gain or loss on disposal of plant is the difference between the carrying amount and the proceeds on
the sale of plant. Thus, the proceeds on sale of plant can be calculated as:
Carrying amount of plant sold + Gain on disposal of plant

or
− Loss on disposal of plant
For Violet Inc., the calculation is as follows:
$10 000 + 4000 = $14 000
However, the proceeds from the sale of plant equals the cash inflow for the year only if there are no
receivables outstanding arising from the sale of plant at either the beginning or end of the year. If receiv-
ables for the sale of plant exist, the cash inflow is determined using the approach that was previously
outlined for sales revenue and interest receivable. For simplicity, it is assumed that Violet Inc. had no
receivables outstanding, at the beginning or end of the year, arising from the sale of plant.

Land increased by $2000 during the year, as shown in the comparative statements of financial position.
This increase relates to the gain on revaluation of land reported in the statement of profit or loss and other
comprehensive income. Thus the movement in land does not affect cash flows from investing activities.
The comparative statements of financial position for Violet Inc. show that the movement in intangibles
equals the additional cash acquisitions made during the period, as detailed in the additional information
presented in figure 17.6. Note, however, that the movement in intangibles equals the cash outflows for the
year because there were no related accounts payable at the beginning or end of the year. If payables exist,
the cash outflow is determined using the approach that was previously outlined for cash paid to suppliers
and employees.
Using the above information, the cash flows from investing activities reported in Violet Inc.’s statement
of cash flows for 2017 are presented in figure 17.9.
VIOLET INC.

Purchase of intangibles $ (15 000)
Purchase of equipment (50 000)
Proceeds from sale of plant 14 000
Net cash used in investing activities $ (51 000)
FIGURE 17.9 Cash flows from investing activities
17.5.3 Cash flows from financing activities

Determining cash flows from financing activities requires identification of cash flows that resulted in
changes in the size and composition of contributed equity and borrowings.
Violet Inc.’s comparative statements of financial position report an increase in borrowings of $10 000.
The additional information (c) in figure 17.6 confirms that the increase arose from an additional bor-
rowing received in cash. It would normally be necessary to analyse the net movement in borrowings in
order to identify whether the movement reflects repayments and additional borrowings, and whether any
new borrowings arose from non-cash transactions, such as entering into a finance lease (see chapter 12).
If the entity had issued shares during the period this would be reflected in a change in share capital. An
alternative source of information about capital contributions is the statement of changes in equity. Any
share issues for non-cash consideration, such as shares issued as part of a dividend reinvestment scheme,
should be deducted from the movement in share capital to determine cash proceeds from share issues.
Violet Inc.’s share capital is unchanged at $200 000, as shown in figure 17.6.
Dividends distributed by the entity can be identified by analysing the change in retained earnings. Profit
increases retained earnings and losses decrease retained earnings. Dividends decrease retained earnings.
Any non-cash dividends should be deducted from total dividends to determine cash dividends paid. Infor-
mation about dividends is also reported in the statement of changes in equity. The movement in Violet
Inc.’s retained earnings of $24 000 reflects:
Profit for the period $ 74 000

Dividends (paid in cash) (50 000) ((d) in figure 17.6)
Net movement $ 24 000
Using the previous information, the financing cash flow section of Violet Inc.’s statement of cash flows
for 2017 is presented in figure 17.10.
VIOLET INC.

Proceeds from borrowings $ 10 000
Dividends paid* (50 000)
Net cash used in financing activities $ (40 000)
*Dividends paid may be classified as an operating cash flow.
FIGURE 17.10 Cash flows from financing activities

All that remains to complete the statement of cash flows for Violet Inc. is the determination of the net increase
or decrease in cash held, and to use this net change to reconcile cash at the beginning and end of the year.
The complete statement of cash flows for Violet Inc. (using the direct method for reporting cash flows
from operating activities) is shown in figure 17.11. The balance of cash at year-end of $56 550 shown
in figure 17.11 agrees with the cash at bank balance shown in the statement of financial position at 31
December 2017 in figure 17.6. There are no cash equivalents such as short-term deposits.
VIOLET INC.

Cash receipts from customers $ 791 000
Cash paid to suppliers and employees (679 700)
Interest received 5 050
Interest paid (3 800)
Purchase of intangibles $ (15 000)
Purchase of plant (50 000)
Net cash used in investing activities (51 000)
Proceeds from borrowings $ 10 000
Dividends paid (50 000)
Net cash used in financing activities (40 000)
Net decrease in cash and cash equivalents (3 450)
Cash and cash equivalents at beginning of year 60 000
Cash and cash equivalents at end of year $ 56 550
FIGURE 17.11 Complete statement of cash flows of Violet Inc.
17.5.4 The worksheet approach

This section introduces the use of a worksheet to prepare a statement of cash flows and applies it to more
complex financial statements. Figure 17.12 presents the financial statements and additional information
for Silber GmbH. The worksheet is presented in figure 17.13, followed by an explanation of each recon-
ciling adjustment. Finally, figure 17.14 illustrates the statement of cash flows using the indirect method of
presenting cash flows from operating activities.
FIGURE 17.12 Financial statements and additional information of Silber GmbH
SILBER GMBH

Cash € 60 000 € 69 800 € 9 800
Short-term deposits 120 000 140 000 20 000
Accounts receivable, net 140 000 190 000 50 000
Inventory 130 000 155 000 25 000
Prepayments 16 000 19 000 3 000
Interest receivable 300 200 (100)
Investment in associate 40 000 45 000 5 000
Land 80 000 120 000 40 000
Plant 300 000 420 000 120 000
Accumulated depreciation (50 000) (65 000) (15 000)
Intangibles 90 000 60 000 (30 000)
€926 300 € 1 154 000 €227 700
(continued)

SILBER GMBH

Accrued liabilities 14 000 12 000 (2 000)
Current tax payable 28 000 32 000 4 000
Borrowings 120 000 180 000 60 000
Share capital 600 000 680 000 80 000
€926 300 € 1 154 000 €227 700
SILBER GMBH
Revenue
Sales revenue € 1 600 000
Share of profits of associate 10 000
€ 1 628 000
Expenses
Cost of sales €960 000
Wages and salaries 240 000
Depreciation — plant 40 000
Impairment — intangibles 30 000
Doubtful debts 8 000
Other expenses 132 000 1 422 000
Other comprehensive income —
Total comprehensive income € 141 000
Other information used in worksheet:

(a) Changes in equity:
Retained
Share capital earnings
Balance at 31 December 2016 € 600 000 € 60 300
Profit for the year — 141 000
Dividends — cash — (36 300)
— reinvested under dividend scheme 30 000 (30 000)
Cash share issue 50 000 —
Balance at 31 December 2017 € 680 000 € 135 000
(b) Investment in associate (equity method)

Balance at 31 December 2016 € 40 000
Share of profit of associate 10 000
Dividend received (5 000)
(c) Land
Additional land acquired € 40 000
Finance provided by vendor (35 000)
Cash paid € 5 000

(d) Plant
Acquisitions € 180 000
Cash paid 171 000
Accounts payable outstanding at year-end 9 000
€ 180 000
Disposals — cost 60 000
Proceeds received in cash 43 000
(e) Intangibles
There were no acquisitions or disposals.
Impairment write-down € 30 000
2016 2017
(f) Accounts payable comprises:
Purchase of inventory € 49 000 € 56 000
Purchase of plant 15 000 9 000
Other purchases 20 000 25 000
Balance at 31 December € 84 000 € 90 000
(g) Accrued liabilities comprises accruals for:

Wages, salaries and other expenses $ 12 800 € 9 900
Interest expense 1 200 2 100
Balance at 31 December € 14 000 € 12 000
(h) Increase in borrowings of €60 000 reflects:

Land vendor finance € 35 000
Additional cash borrowing 25 000
€ 60 000
(i) Income tax expense comprises:

Currently payable € 60 000
Movement in deferred tax 5 000
€ 65 000
(j) Movement in current tax payable:
Payments made (56 000)
FIGURE 17.13 Worksheet for statement of cash flows
SILBER GMBH
Statement of Cash Flows Worksheet
for year ended 31 December 2017
Reconciling items
Balance Balance
31.12.16 Debits Credits 31.12.17
Cash € 60 000 (28) € 9 800 € 69 800
Short-term deposits 120 000 (29) 20 000 140 000
Accounts receivable, net 140 000 (2) 50 000 190 000
Interest receivable 300 (13) 100 200
Inventory 130 000 (3) 25 000 155 000
Prepayments 16 000 (4) 3 000 19 000
Investment in associate 40 000 (7) 5 000 45 000
Land 80 000 (18) 5 000 120 000
(19) 35 000
Plant 300 000 (9) 8 000 (21) 43 000 420 000
(20) 180 000 (22) 25 000
Accumulated depreciation (50 000) (22) 25 000 (10) 40 000 (65 000)
Intangibles 90 000 (11) 30 000 60 000
€926 300 € 1 154 000
(continued)

SILVER GMBH
Statement of Cash Flows Worksheet
Reconciling items
Balance Balance
31.12.16 Debits Credits 31.12.17
Accounts payable € 84 000 (27) € 6 000 (5) € 12 000 € 90 000
Accrued liabilities 14 000 (6) 2 900 (14) 900 12 000
Current tax payable 28 000 (16) 4 000 32 000
Deferred tax liability 20 000 (17) 5 000 25 000
Borrowings 120 000 (19) 35 000 180 000
(23) 25 000
Share capital 600 000 (24) 50 000 680 000
(25) 30 000
Retained earnings 60 300 (15) 65 000 (1) 206 000 135 000
(25) 30 000
(26) 36 300
€926 300 € 1 154 000
Statement of cash flows data

Operating activities
Profit before tax (1) €206 000 € 206 000
Increase in accounts receivable (2) € 50 000 (50 000)
Increase in inventory (3) 25 000 (25 000)
Increase in prepayments (4) 3 000 (3 000)
Increase in accounts payable (5) 12 000 12 000
Decrease in accrued liabilities (6) 2 900 (2 900)
Share of profits of associate (7) 10 000 (10 000)
Interest income (8) 10 000 (10 000)
Gain on sale of plant (9) 8 000 (8 000)
Depreciation — plant (10) 40 000 40 000
Impairment — intangibles (11) 30 000 30 000
Interest expense (12) 12 000 12 000
Cash generated from operations 300 000 108 900 191 100
Interest received (8) 10 000 10 100
(13) 100
Dividend received from associate (7) 5 000 5 000
Interest paid (14) 900 (12) 12 000 (11 100)
Income tax paid (16) 4 000 (15) 65 000 (56 000)
(17) 5 000
Net cash from operating activities 325 000 185 900 139 100
Investing activities
Purchase of land (18) 5 000 (5 000)
Purchase of plant (20) 180 000 (186 000)
(27) 6 000
Proceeds from sale of plant (21) 43 000 43 000
Net cash used in investing
activities 43 000 191 000 (148 000)
Financing activities
Proceeds from borrowings (23) 25 000 25 000
Proceeds from share issue (24) 50 000 50 000
Payment of cash dividends (26) 36 300 (36 300)
Net cash flows from financing
activities 75 000 36 300 38 700
Net increase in cash and cash
equivalents 443 000 413 200 € 29 800
Increase in cash (28) 9 800
Increase in short-term deposits (29) 20 000
€443 000 €443 000

Explanations of the reconciling adjustments made in compiling the statement of cash flows worksheet
in figure 17.13 are presented below.
A — Profit before tax
When using the indirect method of presenting cash flows from operating activities, the starting point is
profit before tax. Accordingly, adjustment (1) for €206 000 is made between retained earnings and the
cash flow (operating activities) section of the worksheet to reflect the profit before tax for the year; and a
separate adjustment (15) is made for income tax expense.
B — Increase in net accounts receivable
The net increase in accounts receivable of €50 000 reflects the excess of sales revenue over the cash col-
lected from receivables. It must therefore be deducted from profit before tax (adjustment (2)). Because the
indirect method is being used, there is no need to include separate adjustments for bad debts written off,
changes in any allowance for doubtful debts or discounts allowed. Such adjustments are only necessary to
determine cash flows from customers under the direct method.
C — Increase in inventory
The increase in inventory of €25 000 represents the amount by which purchases of inventory exceed the
amount included in profit or loss as cost of sales. It is deducted from profit before tax in calculating cash
from operating activities (adjustment (3)).
D — Increase in prepayments
The increase in prepayments of €3000 is an operating cash outflow during the period that is not reflected
in profit before tax (adjustment (4)).
E — Movement in accounts payable
As per additional information item (f) in figure 17.12, accounts payable comprises:
Increase
Amount arising from the:

Purchase of inventory and services € 69 000 € 81 000 €12 000 (Adjustment (5))
Purchase of plant 15 000 9 000 (6 000) (Adjustment (27))
€ 84 000 € 90 000 € 6 000
The increase in accounts payable arising from the purchase of inventory and services reflects the amount
by which the purchases exceed the payments. The increase in accounts payable is added to operating profit
before tax because it does not involve an operating cash outflow for the period (adjustment (5)). In this
example, the increase in accounts payable partly offsets the increase in inventory reflected in adjustment (3).
The reduction in accounts payable arising from the purchase of plant of €6000 increases the cash out-
flow for the purchase of plant as shown in the investing cash activities section of the cash flow worksheet
(adjustment (27)).
F — Movement in accrued liabilities
As per additional information item (g) in figure 17.12, accrued liabilities comprise:
Increase
Amount arising from:

Wages, salaries and other expenses € 12 800 € 9 900 € (2 900) (Adjustment (6))
Accrued interest 1 200 2 100 900 (Adjustment (14))
€ 14 000 € 12 000 € (2 000)
The reduction in accrued liabilities for wages, salaries and other expenses increases operating cash out-
flows for the year and is reflected in adjustment (6). The increase in accrued interest payable is the amount
by which interest expense exceeds the amount of interest paid and is reflected in adjustment (14), as part
of the calculation of interest paid.
G — Share of profits of associate
As per additional information item (b) in figure17.12, the investment in associate (accounted for under
the equity method) increased by €5000, comprising the share of profits of the associate of €10 000, net
of a dividend received of €5000. Adjustment (7) includes the €5000 dividend received in net cash from

operating activities but excludes the share of profits from cash generated from operations because it does
not represent a cash flow.
H — Interest income
When completing the worksheet, interest income is initially transferred out of profit before tax in order to
arrive at cash generated from operations (adjustment (8)) and shown as a separate item (interest received).
The reduction in interest receivable of €100 (adjustment (13)) is added to the interest income to calculate
interest received, as shown in the operating activities section of the worksheet. Alternatively, the interest
received could be classified as an investing activity.
I — Gain on sale of plant
Note that the accumulated depreciation for the plant that has been sold is transferred to the plant account
(adjustment (22)). This transfer reflects the following journal entries:

Plant Cr 25 000
(Closing accumulated depreciation against the plant account on
disposal of the plant)
The carrying amount of the plant that was sold is €35 000 (being the difference between its cost and
accumulated depreciation, per additional information item (d) in figure 17.12). The gain on disposal is
the amount by which the proceeds on disposal exceed the carrying amount of the plant. Silber GmbH
would have made the following combined journal entry to record the sale of the plant:
Cash Dr 43 000
Plant Cr 35 000
Gain on Disposal Cr 8 000
(Disposal of plant)
Plant is reduced by the net amount of €35 000, which is represented in the worksheet as a credit adjust-
ment to plant for the cash proceeds from the sale, €43 000 (Cr), and the debit adjustment against plant
for the gain on disposal of €8000 (Dr). Gain on disposal of plant of €8000 is not a cash inflow, so it is
deducted from profit before tax in arriving at net cash from operating activities (adjustment (9)). A separate
adjustment is made for the proceeds from sale of plant of €43 000 as an investing cash flow. The reduction
in plant for plant sold of €60 000 comprises the following adjustments:
Proceeds on sale of plant € 43 000 Cr (Adjustment (21))

Accumulated depreciation € 25 000 Cr (Adjustment (22))
Gain on sale € 8 000 Dr (Adjustment (9))
Cost of plant sold €60 000 Cr Net effect on Plant
J — Depreciation of plant and impairment of intangibles

Depreciation charged in the current period reduces profit before tax and increases the accumulated depreci-
ation in the statement of financial position. The recognition of an impairment loss for intangibles reduces
profit before tax and reduces the net carrying amount of intangibles in the statement of financial position.
Depreciation expenses and impairment losses are not cash flows. Accordingly, they are added back to
profit before tax to calculate cash from operating activities (depreciation expense of €40 000, adjustment
(10); and impairment loss of €30 000, adjustment (11)).
K — Interest expense
Interest expense is initially transferred from profit before tax to a separate item for interest paid (adjust-
ment (12)). It is then reduced by the increase in accrued interest €900 (adjustment (14)) to calculate interest
paid (see explanation F). Alternatively, the interest cash outflow could be classified as a financing activity.
L — Income tax paid
Income tax expense of €65 000 (adjustment (15)) is reduced by the increase in current tax payable of €4000
(adjustment (16)) and the increase in deferred tax liability of €5000 (adjustment (17)) to determine the income
tax paid (€56 000). In this example, there are no tax charges — such as on revaluation surplus — accumulated
in equity accounts. This is evident because there are no items of other comprehensive income (see figure 17.12).

M — Purchase of land and plant
Additional land was acquired at a cost of €40 000, of which €35 000 was financed by the vendor. Adjust-
ment (18) records the cash outflow of €5000. The vendor-financed purchases are reflected in adjustment (19)
between land and borrowings.
Plant acquisitions for the year are €180 000 (adjustment (20)). This amount is increased by the reduction
in plant accounts payable of €6000 (adjustment (27)) as discussed in explanation E.
N — Proceeds from borrowings
The cash proceeds from borrowings of €25 000 (adjustment (23)) is calculated as the increase in borrow-
ings of €60 000 (€180 000 − €120 000) reduced by €35 000, being the vendor-financed purchase of land
(adjustment (19)); see explanation M.
O — Proceeds from share issue and payment of cash dividends
To determine the proceeds from share issue (adjustment (24)), the increase in share capital of €80 000
(€680 000 − €600 000) is reduced by the €30 000 reinvested dividends (adjustment (25)), which did not
involve a cash flow. Similarly, cash flows from financing activities include only the €36 300 of dividends
paid in cash (adjustment (26)).
P — Increase in cash and short-term deposits
Short-term deposits held by Silber GmbH are cash equivalents. The increase of €9 800 and €20 000 in cash
and short term deposits, respectively, are shown in the worksheet as the increase in cash and cash equiva-
lents for the period (adjustments (28) and (29), respectively).
Figure 17.14 illustrates the statement of cash flows for Silber GmbH for the year ended 31 December
2017 (without comparatives).
FIGURE 17.14 Statement of cash flows of Silber GMBH
SILBER GMBH

Profit before tax € 206 000
Adjustments for:
Depreciation 40 000
Impairment of intangibles 30 000
Gain on sale of plant (8 000)
Share of profits of associate (10 000)
Interest income (10 000)
Increase in receivables (50 000)
Increase in inventory (25 000)
Increase in prepayments (3 000)
Increase in accounts payables 12 000
Decrease in accrued liabilities (2 900)
Interest received 10 100
Dividend received from associate 5 000
Interest paid (11 100)
Net cash from operating activities € 139 100
Purchase of land (Note A) (5 000)
Purchase of plant (186 000)
Net cash used in investing activities (148 000)
Cash flow from financing activities
Proceeds from borrowings 25 000
Proceeds from share issue (Note B) 50 000
Dividends paid (Note B) (36 300)
Net cash from financing activities 38 700
(continued)

Net increase in cash and cash equivalents 29 800

Cash and cash equivalents at beginning of year (Note C) 180 000
Cash and cash equivalents at end of year (Note C) € 209 800
Notes:
A Land
During the year, land was acquired at a cost of €40 000, of which €5000 was paid in cash and €35 000 was
financed by the vendor.
B Dividends
During the year, shareholders elected to reinvest dividends of €30 000 under the company’s dividend reinvestment
scheme. (This information will be reported in the company’s statement of changes in equity. A cross-reference to
that statement may be used instead of this note.)
C Cash and cash equivalents
Cash and cash equivalents included in the statement of cash flows comprise the following amounts reported in the
statement of financial position:
2017 2016
Cash € 69 800 € 60 000
Short-term deposits 140 000 120 000
€209 800 € 180 000
The note shows both the current and prior period comparative figures. It is customary to show the cur-
rent period first, followed by the comparative figures, reading from left to right. However, comparative data
were presented in the worksheets to facilitate working from left to right in calculating movements in line
items used to determine cash flows.
LO6 17.6 OTHER DISCLOSURES

IAS 7 prescribes additional disclosures in the notes to the financial statements, including information
about the components of cash and cash equivalents, changes in ownership interests of subsidiaries and
other businesses, and non-cash investing and financing transactions. Additional information is often nec-
essary to obtain a complete understanding of the change in an entity’s financial position because not all
transactions are simple cash transactions. Significant changes can result from the acquisition or disposal of
subsidiaries or other business units, or from financing and investing transactions that do not involve cash
flows in the current period.
17.6.1 Components of cash and cash equivalents

The components of cash and cash equivalents must be disclosed and reconciled to amounts reported
in the statement of financial position. The reconciliation provides better transparency of how items are
reported in the financial statements. In some cases, cash and cash equivalents may include a bank over-
draft. The end-of-period amount of cash and cash equivalents reported in the statement of cash flows may
differ from that reported in the statement of financial position because the cash and short-term deposits
are reported as current assets while the overdraft is a liability. Figure 17.15 illustrates the reconciliation
between cash and cash equivalents in the statement of cash flows with the corresponding items reported in
the statement of financial position for BHP Billiton.
Paragraph 48 requires disclosure of the amount of significant cash and cash-equivalent balances held
that are not available for general use. This may include cash held by a foreign subsidiary that is subject to
foreign exchange controls. Figure 17.15 illustrates disclosures made by BHP Billiton in accordance with
paragraph 48.
17.6.2 Changes in ownership interests of subsidiaries and

other businesses
Part 4 of this book deals with the financial reporting of consolidated groups of entities. When a parent
entity obtains control of another entity, or loses control of an existing subsidiary, the comparative con-
solidated statement of financial position of the group before and after the acquisition or disposal will
frequently reflect significant changes in the assets and liabilities arising from the acquisition or disposal.
Financial statement users need to be aware of the effects of changes in ownership and control in order to
understand the change in financial position of the consolidated group.
IAS 7 specifies additional reporting requirements relating to changes in control of subsidiaries and other
businesses.

Note 7 Cash and cash equivalents
For the purpose of the consolidated cash flow statement, cash equivalents include highly liquid investments
that are readily convertible to cash and with a maturity date of less than 90 days, bank overdrafts and
interest bearing liabilities at call.
2015 2014 2013

US$M US$M US$M
Cash and cash equivalents comprise:

Cash 931 1 726 2 521
Short term deposits 5 822 7 077 3 156
Total cash and cash equivalents(a)(b)(c) 6 753 8 803 5 677
Bank overdraft and short-term borrowings (140) (51) (10)
Total cash and cash equivalents, net of overdrafts 6 613 8 752 5 667
(a) Cash and cash equivalents include US$493 million (2014: US$738 million; 2013: US$674 million), which is
restricted by legal or contractual arrangements.
(b) Cash and cash equivalents include US$50 million (2014: US$600 million; 2013: US$794 million), which is subject
to restrictions imposed by governments where approval is required to repatriate cash out of a country.
(c) Cash and cash equivalents include US$6 553 million denominated in USD, US$58 million denominated in CAD,
US$33 million denominated in GBP, US$17 million denominated in AUD and US$92 million denominated in other
currencies (2014: US$8 360 million denominated in USD, US$48 million denominated in CAD, US$26 million
denominated in GBP, US$100 million denominated in AUD and US$269 million denominated in other currencies;
2013: US$5 205 million denominated in USD, US$71 million denominated in CAD, US$18 million denominated in
GBP, US$125 million denominated in AUD and US$258 million denominated in other currencies).
FIGURE 17.15 Disclosures about cash and cash equivalents for BHP Billiton at 30 June 2015
Paragraph 39 requires the aggregate cash flow effects of obtaining control of subsidiaries or other busi-
nesses to be reported as one item in the investing activities section of the statement of cash flows. When
an entity obtains control of a subsidiary or other business, any cash and cash equivalents acquired are
deducted from the cash consideration paid in determining the cash flow effects of obtaining control. For
example, Major plc obtained control over Minor plc by acquiring all of the ordinary shares of Minor plc.
Major plc paid consideration of £1 500 000 in cash. Minor plc held cash and cash equivalents of £100 000
at the time of the acquisition. Thus, the net cash flow effect of Major plc obtaining control of Minor plc is
a cash outflow of £1 400 000 (i.e. £1 500 000 − £100 000). This would be reported in the investing activ-
ities section of Major plc’s consolidated statement of cash flows.
Similarly, paragraph 39 of IAS 7 requires the aggregate cash flow effects of losing control of subsidiaries
or other businesses to be reported as one item in the investing activities section of the statement of cash
flows. If an entity loses control of a subsidiary or other business, any cash and cash equivalents held by
that subsidiary or other business at the time of the disposal are deducted from the cash consideration
received in reporting the cash flow effects of losing control. For example, if Major plc sold its interest in
several subsidiaries for a total cash consideration of £8 000 000, and those subsidiaries held cash and
cash equivalents of £100 000, Major plc would report a net cash inflow of £7 900 000 for the proceeds
from the sale of subsidiaries in the investing activities section of its statement of cash flows. Figure 17.16
illustrates the application of paragraph 39 of IAS 7 in the investing activities section of Major plc’s state-
ment of cash flows.
2017 2016
£’000 £’000

Payments for property, plant and equipment (5 500) (4 800)
Proceeds from sale of subsidiaries (net of cash held) 7 900
Payment for purchase of subsidiary (net of cash acquired) (1 400) —
Proceeds from the sale of property, plant and equipment 1 100 1 300
Net cash from (used in) investing activities 2 100 (3 500)
FIGURE 17.16 Investing activities section of statement of cash flows of Major plc for the year ended
31 December 2017

Separate presentation of the cash flow effects of transactions to obtain or to surrender control of subsid-
iaries or other businesses is required. The cash flow effects of transactions resulting in the loss of control,
such as the sale of a subsidiary, are not deducted from the cash flows of transactions that obtain control,
such as the acquisitions of a subsidiary. Both the aggregate cash flow effects of obtaining control of sub-
sidiaries and other businesses and the aggregate cash flow effects of losing control of subsidiaries and
other businesses are reported separately in the investing activities section of the statement of cash flows as
Paragraph 40 of IAS 7 prescribes disclosure of the aggregate amounts of each of the following items:
(a) the total consideration;
(b) how much of the consideration comprises cash and cash equivalents;
(c) the amount of cash and cash equivalents held by the subsidiaries or other businesses; and
(d) the amount of other assets and liabilities held by the subsidiaries or other businesses, summarised by
each major category.
Separate disclosures must be made for subsidiaries and other businesses over which control has been
obtained, and those over which control has been lost. Disclosures provided by Major plc in accordance
with paragraph 40(a)–(c) are shown in figure 17.17.
During the year Major plc obtained control of Minor plc by acquiring all of the ordinary shares of Minor
plc. All of the consideration was paid in cash. Details of the consideration and analysis of the cash flows are
summarised below:
Total consideration (included in cash flows from investing activities) £1 500 000
Cash acquired in subsidiary (included in cash flows from investing activities) (100 000)
Net cash flows on acquisition £1 400 000
During the year Major plc sold its retail business for total consideration of £9 000 000. Details of the
consideration and analysis of the cash flows are summarised below:
Total consideration, comprising cash and equity investments £9 000 000

Cash consideration (included in cash flows from investing activities) £8 000 000
Cash acquired in subsidiary (included in cash flows from investing activities) (100 000)
Net cash flows on disposal of the business £7 900 000
FIGURE 17.17 Selected disclosures about transactions resulting in the acquisition or loss of control over
other entities by Major plc for the year ended 31 December 2017
17.6.3 Non-cash transactions

Not all investing or financing transactions involve current cash flows. However, non-cash investing and
financing activities need to be understood because they can significantly affect the financial position of an
entity. Examples include:
• acquisition of assets by means of a finance lease or by assuming other liabilities
• acquisition of assets or an entity by means of an equity issue
• conversion of debt to equity
• conversion of preference shares to ordinary shares
• refinancing of long-term debt
• payment of dividends through a dividend reinvestment scheme.
Investing and financing transactions that do not involve the payment or receipt of cash and cash equiv-
alents are not reported in the statement of cash flows. However, paragraph 43 of IAS 7 requires disclosure
‘elsewhere in the financial statements in a way that provides all the relevant information about these
investing and financing activities’.
Figure 17.18 illustrates BHP Billiton’s disclosure on non-cash investing and financing activities in the
notes to its financial statements. The acquisition of plant and equipment by a finance lease is a non-cash
Note 37 Notes to the consolidated cash flow statement
2015 2014 2013

Significant non-cash investing and financing transactions U$M U$M U$M
Property, plant and equipment acquired under finance leases 10 501 Nil
Property, plant and equipment acquired under vendor financing arrangements Nil Nil 49
FIGURE 17.18 Non-cash investing and financing activities of BHP Billiton for the year ended 30 June 2015

transaction that increases plant and equipment (leased plant and equipment) and borrowings (lease
liabilities). The other non-cash transactions, reported in aggregate, are vendor-financed purchases of
property, plant and equipment.
17.6.4 Disclosures that are encouraged but not required

The following disclosures are specifically encouraged by paragraph 50 of IAS 7:
• the amount of undrawn borrowing facilities that may be available to pay for future operating activities
or to settle commitments, and any restrictions on their use;
• the distinction between aggregate cash flows for increases in operating capacity and aggregate cash
flows that are required to maintain operating capacity; and
• cash flows arising from the operating, investing and financing activities of each reportable segment.
SUMMARY
IAS 7 Statement of Cash Flows is a disclosure standard requiring the presentation of a statement of cash
flows as an integral part of an entity’s financial statements. The statement of cash flows is particularly
useful to investors, lenders and others when evaluating an entity’s ability to generate cash and cash equiv-
alents, and to meet its obligations and pay dividends. The statement is required to report cash flows clas-
sified into operating, investing and financing activities, as well as the net movement in cash and cash
equivalents during the period. Net cash flows from operating activities may be presented using either the
direct or the indirect method. IAS 7 requires additional information to be disclosed about investing and
financing activities that do not involve cash flows and are therefore excluded from a statement of cash
flows. The standard also requires additional disclosures relating to the cash flow effects of obtaining or
losing control of subsidiaries and other businesses.
1. What is the purpose of a statement of cash flows?
2. How might a statement of cash flows be used?
3. What is the meaning of ‘cash equivalent’?
4. Explain the required classifications of cash flows under IAS 7.
5. What sources of information are usually required to prepare a statement of cash flows?
6. Explain the differences between the presentation of cash flows from operating activities under the
direct method and their presentation under the indirect method. Do you consider one method to be
more useful than the other? Why?
7. The statement of cash flows is said to be of assistance in evaluating the financial strength of an entity,
yet the statement can exclude significant non-cash transactions that can materially affect the financial
strength of an entity. How does IAS 7 seek to overcome this issue?
8. An entity may report profits over a number of successive years and still experience negative net cash
flows from its operating activities. How can this happen?
9. An entity may report losses over a number of successive years and still report positive net cash flows
from operating activities over the same period. How can this happen?
10. What supplementary disclosures are required when a consolidated statement of cash flows is being
prepared for a group that has obtained or lost control of a subsidiary?
References
BHP Billiton 2015, Annual Report 2015, www.bhpbilliton.com.
Loftus, J., Leo, K., Boys, N., Daniliuc, S., Luke, B., Hong, A., and Byrnes, K. 2015, Financial Reporting,
John Wiley & Sons Australia.
Exercise 17.1 CASH RECEIVED FROM CUSTOMERS

★ At 31 December 2016, Ruby Inc. had net accounts receivable of $180 000. At 31 December 2017, accounts
receivable were $220 000 and sales for the year amounted to $1 800 000. Doubtful debts expense was
$55 000 for the year. Discount allowed was $35 000 for the year.
Required
Calculate cash received from customers by Ruby Inc. for the year ended 31 December 2017.

Exercise 17.2 CASH PAYMENTS TO SUPPLIERS
★ Purple Ltd had the following balances:
31 Dec 2016 31 Dec 2017

Inventory £170 000 £210 000
Accounts payable for inventory
purchases 50 000 65 000
Cost of sales was £1 700 000 for the year ended 31 December 2017.
Required
Calculate cash payments to suppliers for the year ended 31 December 2017.
Exercise 17.3 INVESTING CASH FLOWS

★ The following information has been compiled from the accounting records of Navy Inc. for the year ended
31 December 2017:
Purchase of land, with the vendor financing $150 000 for 2 years $350 000
Purchase of plant 250 000
Sale of plant:
Carrying amount 50 000
Cash proceeds 42 000
Required
Determine the amount of investing net cash outflows Navy Inc. would report in its statement of cash flows
for the year ended 31 December 2017.
Exercise 17.4 FINANCING CASH FLOWS

★ The following information has been compiled from the accounting records of Mustard Ltd for the year
ended 31 December 2017:
Dividends — paid $200 000

Dividend reinvested under a reinvestment scheme 120 000
Additional cash borrowing 250 000
Issue of shares — cash 300 000
— dividend reinvestment 120 000
Required
Determine the amount of net cash from financing activities Mustard Ltd would report in its statement of
cash flows for the year ended 31 December 2017.
Exercise 17.5 PREPARATION OF A STATEMENT OF CASH FLOWS

★ A summarised comparative statement of financial position of Black Inc. is presented below:
31 Dec 2016 31 Dec 2017

Cash $ 25 000 $ 45 000
Trade receivables 50 000 65 000
Investments in financial assets 40 000 50 000
Plant 130 000 180 000
$200 000 $280 000
Trade accounts payable $ 6 000 $ 4 000
Interest payable 7 000
Current tax payable 20 000 28 000
Share capital 100 000 130 000
$200 000 $280 000

(a) There were no disposals of plant during the year.
(b) There were no purchases or sales of investments in financial assets during the year. Gains and losses on
changes in the fair value of investments in financial assets are recognised in profit or loss.
(c) Black Inc. settled a loan (borrowings) of $30 000 by issuing ordinary shares. There were no other
repayments of borrowings.
(d) Profit for the year was $101 000, interest expense was $14 000, and income tax expense was $31 000.
There were no items of other comprehensive income.
(e) A $23 000 dividend was paid during the year.
(f) Service revenue for the year was $300 000. There was no other revenue.
(g) Black Inc. classifies interest as an operating activity.
Required
1. Using the indirect method of presenting cash flows from operating activities, prepare a statement of
cash flows in accordance with IAS 7 for the year ended 31 December 2017.
2. Prepare the operating section of the statement of cash flows using the direct method.
Exercise 17.6 PRESENTATION OF A STATEMENT OF CASH FLOWS

★ A summarised comparative statement of financial position of Denim Ltd is presented below, together with
the statement of profit or loss and other comprehensive income for the year ended 31 December 2017:
31 Dec 2016 31 Dec 2017

Cash £ 30 000 £ 68 000
Inventory 30 000 32 000
Investments in shares 35 000 40 000
Plant 125 000 150 000
£243 000 £325 000
Accounts payable £ 39 000 £ 43 000
Accrued interest 3 000 5 000
Deferred tax liability — 1 500
Investment revaluation reserve — 3 500
£243 000 £325 000

Sales £ 700 000

Gross profit 217 000
Distribution costs (62 000)
Administration expenses (74 000)
Interest expense (6 000)
Gain on revaluation of investments (net of tax) 3 500
Total comprehensive income £ 55 500
(a) There were no disposals of investments or plant during the year.
(b) A dividend of £23 000 was paid during the year.
(c) Revaluations gains and losses on Denim Ltd’s investments are recognised in other comprehensive
income and accumulated in equity. The deferred tax liability is in relation to investments.
(d) Accounts payable is for purchases of inventory.

(e) Borrowings of £35 000 were repaid during the year.
(f) Denim Ltd classifies interest as an operating activity.
Required
Using the direct method of presenting cash flows from operating activities, prepare a statement of cash
flows in accordance with IAS 7 for the year ended 31 December 2017.
Exercise 17.7 PREPARATION OF A STATEMENT OF CASH FLOWS

★★ A comparative statement of financial position of Aqua Ltd is presented below:
31 Dec 2016 31 Dec 2017

Cash £ 20 000 £ 18 000
Inventory 100 000 160 000
Land (at valuation) 150 000 162 000
Plant (at cost) 460 000 520 000
£824 000 £ 944 000
Accounts payable £ 50 000 £ 55 000
Accrued interest 12 000 16 000
Other accrued liabilities 45 000 43 000
Provision for employee benefits 38 000 42 000
Dividend payable — 60 000
Borrowings 195 000 105 000
Deferred tax liability 58 000 39 000
Revaluation surplus 12 000 20 000
£824 000 £ 944 000

Sales £ 3 580 000

Cost of sales (2 864 000)
Dividend income 4 000
Distribution expenses (185 000)
Administrative expenses (160 000)
Other expenses (40 000)
Gain on asset revaluation (net of tax) 8 000
Total comprehensive income £ 248 000
(a) The increase in land is the result of a revaluation. The increase to the revaluation surplus is net of
deferred tax of £4000.
(b) Plant with a carrying amount of £60 000 (cost £85 000, accumulated depreciation £25 000) was sold
for £76 000.
(c) Accounts payable at 31 December 2017 include £22 000 for plant acquisitions.
(d) There were no additional borrowings during the year.
(e) The increase in share capital of £30 000 arose from the company’s dividend reinvestment scheme.
(f) Dividends declared out of profits for the year were: interim dividend £64 000, final dividend £60 000.
Dividends are classified as financing cash flows.
(g) Aqua Ltd classifies interest as an operating activity.

Required
1. Using the direct method of presenting cash flows from operating activities, prepare a statement of cash
2. Using the indirect method, prepare the operating activities section of the statement of cash flows in
accordance with IAS 7.
Exercise 17.8 PREPARING A STATEMENT OF CASH FLOWS WITH NOTES

★★ The statement of profit or loss and other comprehensive income and comparative statements of financial
position of Blue Inc. were as follows:
W
BLUE INC.
as at 31 December
2016 2017
Current assets
Cash at bank $ 16 000 $ 22 000
Cash deposits (30-day) 40 000 70 000
Interest receivable 2 000 3 000
Inventory 194 000 200 000
Prepayments 13 000 9 000
363 000 405 000
Non-current assets
Land 230 000 290 000
Plant 600 000 700 000
Investments in associate 80 000 92 000
Brand names 120 000 90 000
890 000 992 000
Total assets $ 1 253 000 $ 1 397 000
Current liabilities
Accrued liabilities 85 000 92 000
Current portion of long-term borrowings 20 000 20 000
325 000 351 000
Provision for employee benefits 40 000 43 000
173 000 221 000
Equity
755 000 825 000
Total liabilities and equity $ 1 253 000 $ 1 397 000
BLUE INC.
Sales $ 1 780 000
Cost of sales (1 030 000)
Share of profits of associate 20 000
Total income 780 000
(continued)

Expenses
Salaries and wages (352 000)
Depreciation (50 000)
Discount allowed (8 000)
Doubtful debts (6 000)
Other (includes loss on impairment of brand names $30 000) (186 000)
Total comprehensive income $ 110 000
The following additional information has been extracted from the accounting records of Blue Inc.:
1. 30-day cash deposits are used in the course of the daily cash management of the company.
2. Movement in allowance for doubtful debts:
Balance 31 December 2016 $ 12 000
Charge for year 6 000
Bad debts written off (2 000)
Balance 31 December 2017 $ 16 000
3. Land
Additional cash purchase $ 60 000
4. Plant
Purchases for year (including $50 000 financed by the vendor) $150 000
5. Disposals
Cost of disposals $ 50 000
6. Investments in associate accounted for under the equity method
Share of profit $ 20 000
Dividends received 8 000
7. Accounts payable
Includes amounts owing in respect of plant purchases:
31 December 2016 $ 12 000
31 December 2017 18 000
8. Accrued liabilities
Includes accrued interest payable:
31 December 2016 $ 4 000
31 December 2017 5 000
Interest is classified as an operating activity.
9. Income tax expense comprises:
Current tax payable $ 42 000
Deferred tax 5 000
Income tax expense $ 47 000
10. Dividends paid
Under a dividend reinvestment scheme, shareholders have the right to receive additional
shares instead of dividends.
Dividends paid comprise:
Dividends paid in cash during the year $ 40 000
Dividends reinvested 30 000
Total dividends $ 70 000
Required
1. Using the direct method of presenting cash flows from operating activities, prepare a statement of cash
2. Prepare any notes to the statement of cash flows that you consider are required by IAS 7.
3. Prepare the operating activities section of the statement of cash flows using the indirect method of pres-
entation in accordance with IAS 7 for the year ended 31 December 2017.

Accounting researchers have been looking into the informa- associated with annual stock returns. Clinch et al. (2002)
tion content — that is, decision usefulness — of the statement interpret the association of various components of the direct
of cash flows. In addition, accounting research has attempted and indirect method with annual returns as evidence in their
to assess whether cash flows are as useful as earnings and usefulness in predicting future CFO. Consistent with this
accruals. For the purpose of understanding the various view they find that the usefulness of these components for
research findings described below, it will be constructive first investors is increasing with their predictive ability.
to establish the link between earnings (E), accruals (ACCR) Barth et al. (2001) expand the analysis of the predicta-
and operating cash flows (CFO). E = CFO + ACCR. Note bility of future cash flows using a large US sample during
that ACCR includes items such as changes in inventory, 1987–1996. They find that 1-year-ahead CFO is positively
receivables and payables, as well as other items that appear related to current and lagged earnings (up to 6 years). The
under the indirect method. magnitude of the relation, however, diminishes over time.
In one of the earlier studies of cash flows, Wilson (1986) They further show that components of current ACCR (e.g.,
develops a model for the link between surprises in E, CFO changes in inventory and receivables) have predictive ability
and ACCR and abnormal stock returns. Specifically, abnormal with respect to next year’s CFO incrementally to that of
stock returns are measured as the sum of returns in the 2 current CFO. Interestingly, they find that depreciation and
days around the earnings announcement and 9 days around amortisation — non-cash expenses — also have predictive
the filing day of the quarterly report. Employing a sample ability for future cash flows. Barth et al. (2001) then fur-
of 322 observations in 1981 and 1982 Wilson (1986) finds ther explore the finding that current and prior earnings can
that abnormal stock returns are positively associated with predict future CFO. Specifically, they break current and two
surprises in earnings and CFO, but negatively related to the lags of earnings into their CFO and ACCR aggregate compo-
surprise in the current portion of ACCR. This is consistent nents. Here they find that while current and lagged CFO pre-
with CFO and ACCR being useful to investors. dict future CFO, past aggregate ACCR do not, only present
While the findings in Wilson (1986) suggest that this is the ACCR. Nevertheless, when past aggregate ACCR are broken
case, Bernard and Stober (1989) re-examine the evidence. In into the various components Barth et al. (2001) show that
contrast to Wilson (1986), Bernard and Stober (1989) look these provide incremental predictive ability over current and
at a longer period, 1977–1984, and assemble a much larger past CFO. The overall conclusion is that the structure of the
sample. Looking at the 9-days window centred at the filing indirect method for CFO is quite useful for predicting future
date of the financials, they find no evidence of association cash flows. Consistent with this, the various components of
between abnormal stock returns and cash flows. Because ACCR are found to be associated with market value of equity
earnings announcements take place prior to the filing day, and stock returns.
Bernard and Stober (1989) conclude that, conditional on In a more recent study, Clacher et al. (2013) investigate the
knowing earnings, investors ignore cash flow information. value relevance of core direct cash flows, which they define as
The above-mentioned studies were conducted before the cash receipts from customers and cash paid to suppliers and
introduction of the cash flow standard, SFAS, in the US. SFAS 95 employees. Using a sample of 459 Australian listed firms,
(now ASC 230) (FASB, 1987) was the first to set formal they compare the value relevance of core cash flows before
requirements for a cash flow statement with its three parts and after the adoption of IFRS Standards. They find that core
(operating cash flows (CFO), investing cash flows (CFI) and cash flows are correlated with the value of the firm (i.e, value
financing cash flows (CFF)). Livnat and Zarowin (1990) were relevant) before the adoption of IFRS Standards. After adop-
among the first to examine the value relevance of the three tion of IFRS Standards, core cash flows remain value relevant
parts although they also employ pre-standard data. Their for firms in all industries and increase significantly in value
main findings are as follows. First, they show that cumulative relevance for industrial firms.
abnormal annual stock returns (CAR) are positively associated Although earnings and accruals are useful in that they are
with their estimates of CFO and ACCR. Second, when CFF associated with stock returns, Cheng et al. (1996) argue that
and CFI are added as explanatory variables, they show that the relative information role of earnings is lower if earnings
CAR is positively (negatively) related to CFF (CFI) although are more transitory. Using a large dataset from 1988 to 1992,
with a low magnitude. Third, they show that within CFO the authors regress abnormal annual stock returns on earn-
cash collections from customers are positively related to ings, change in earnings, CFO and change in CFO. They find
CAR, but cash payments to suppliers, employees and interest that these variables are positively related to abnormal stock
are negatively related to CAR. Overall, therefore, Livnat and returns. This is consistent with both earnings and cash flows
Zarowin (1990) demonstrate the usefulness of the compo- being useful to investors. However, the association between
nents of the cash flow statement. the earnings variables and abnormal stock returns are weaker
Clinch et al. (2002) examine the usefulness of the direct when earnings take large extreme values (a proxy for transi-
and indirect methods for CFO. They take advantage of Aus- tory earnings). The explanation for this is that large earning
tralian rules from the time before the adoption of IFRS® changes are not seen as credible or sustainable and so inves-
Standards, which required the preparation of the statement tors rely more heavily on cash flows.
of cash flows that is accompanied by disclosures of both All the papers mentioned so far examine the usefulness
methods. Their sample consists of 648 firm-year observa- of cash flows with respect to stock prices and returns. How-
tions between 1992 and 1997. They provide evidence that ever, cash flow information may also be used by credit ana-
some components of both direct CFO and indirect CFO are lysts and investors in debt markets. Using data reported

under SFAS 95, Billings and Morton (2002) examine the link Cheng, C.A., Liu, C.S. and Schaefer, T.F., 1996. Earnings
between cash-based interest coverage ratio and credit ratings permanence and the incremental information content of
while controlling for other common risk measures (e.g. cash flows from operations. Journal of Accounting Research,
CAPM’s Beta). The authors find that the cash-based interest 173–181.
coverage ratio has incremental explanatory power for ratings. Clacher, I., De Ricquebourg, A.D. and Hodgson, A.,
This suggests that rating agencies employ cash flow informa- 2013. The value relevance of direct cash flows under
tion in forming their rating assessments. International Financial Reporting Standards. ABACUS,
49(3), 367–395.
Clinch, G., Sidhu, B. and Sin, S., 2002. The usefulness
References of direct and indirect cash flow disclosures. Review of
Accounting Studies, 7(4), 383–404.
Barth, M.E., Cram, D.P. and Nelson, K.K., 2001. Accruals Financial Accounting Standards Board (FASB), 1987.
and the prediction of future cash flows. The Accounting Statement of Financial Accounting Standards No. 95.
Review, 76(1), 27–58. Norwalk, CT: FASB.
Bernard, V.L. and Stober, T.L., 1989. The nature and amount Livnat, J. and Zarowin, P., 1990. The incremental
of information in cash flows and accruals. The Accounting information content of cash-flow components. Journal of
Review, 64(4), 624–652. Accounting and Economics, 13(1), 25–46.
Billings, B.K. and Morton, R.M., 2002. The relation between Wilson, G.P., 1986. The relative information content of
SFAS No. 95 cash flows from operations and credit risk. accruals and cash flows: Combined evidence at the
Journal of Business Finance & Accounting, 29(5–6), earnings announcement and annual report release
787–805. date. Journal of Accounting Research, 24(3), 165–200.
516 PART 3
2 Presentation
Elements and disclosures
18 Operating segments
ACCOUNTING IFRS 8 Operating Segments
STANDARDS
IN FOCUS

OBJECTIVES
1 discuss the objectives of financial reporting by segments
2 identify the types of entities that are within the scope of IFRS 8
3 explain and evaluate the controversy surrounding the issuance of IFRS 8
4 identify operating segments in accordance with IFRS 8
5 distinguish between operating segments and reportable segments
6 apply the definition of reportable segments
7 explain the disclosure requirements of IFRS 8
8 analyse the disclosures made by companies applying IFRS 8 in practice
9 discuss the outcome of the post-implementation review of IFRS 8.
CHAPTER 18 Operating segments 517

LO1 18.1 OBJECTIVES OF FINANCIAL REPORTING
BY SEGMENTS
In Europe, the introduction of IFRS 8 Operating Segments was controversial, as a result of which the pro-
cess to endorse IFRS 8 in the European Union was not completed until November 2007, a year after the
standard had been published (see section 18.3).
IFRS 8 is primarily a disclosure standard and is particularly relevant for large organisations that operate
in different geographic locations and/or in diverse businesses.
Paragraph 1 of IFRS 8 sets out the standard’s core principle:
An entity shall disclose information to enable users of its financial statements to evaluate the nature and finan-
cial effects of the business activities in which it engages and the economic environments in which it operates.
Many entities operate in different geographical areas or provide products or services that are subject to
differing rates of profitability, opportunities for growth, future prospects and risks. Information about an
entity’s operating segments is relevant to assessing the risks and returns of a diversified or multinational
entity where often that information cannot be determined from aggregated data. Therefore, segment infor-
mation is regarded as necessary to help users of financial statements:
• better understand the entity’s past performance
• better assess the entity’s risks and returns
• make more informed judgements about the entity as a whole.
Many securities analysts rely on the segment disclosures to help them assess not only an entity’s past
performance but also to help them predict future performance. Analysts use these assessments to deter-
mine an entity’s share price. Segment disclosures are widely regarded as some of the most useful disclo-
sures in financial statements because of the extent to which they disaggregate financial information into
meaningful and often revealing groupings. For example, an entity may appear profitable on a consolidated
basis, but segment disclosures may reveal that one part of the business is performing poorly while another
part is performing well. The part that is performing poorly may be significant to the entity as a whole and
over time continued poor performance by that part (or segment) may cause the entire entity’s performance
to suffer. This is the kind of information that has an impact on an entity’s share price because analysts
frequently focus on predicting future cash flows in making their share price determinations.
On the other hand, preparers of financial statements may not wish to reveal too much information on
a disaggregated basis to their competitors. Some may consider the disclosure requirements of IFRS 8 to
be too revealing. For example, a user may be able to determine an entity’s profit margin by segment when
reading the segment disclosures. This is a key reason why it is unlikely that entities would volunteer to dis-
close segment information (see section 18.2). Another reason is that it is often a time-consuming exercise
to prepare the segment disclosures.
IFRS 8 was the first standard subject to a post-implementation review, which was completed in 2013 and
is discussed later in the chapter (see section 18.9)
LO2 18.2 SCOPE

IFRS 8 applies to the financial statements of an entity ‘whose debt or equity instruments are traded in a
public market’ or ‘that files, or is in the process of filing, its financial statements with a securities com-
mission or other regulatory organisation for the purpose of issuing any class of instruments in a public
market’ (IFRS 8 paragraph 2). Most commonly, ‘traded in a public market’ would mean a public stock
exchange such as the London Stock Exchange or the Hong Kong Stock Exchange.
Where financial statements contain both consolidated financial statements and the parent’s separate
financial statements, segment information is required only for the consolidated financial statements (IFRS
8 paragraph 4). However, if consolidated financial statements are not prepared, and the entity is within the
scope of the standard, it must apply the standard in its separate or individual financial statements (IFRS 8
paragraph 2(a)).
If an entity voluntarily chooses to disclose segment information then it must fully comply with IFRS
8; otherwise it must not describe the disclosed information as segment information (IFRS 8 paragraph
3). Voluntary disclosure may occur, for example, where a large company that is not listed, but has a large
number of dependent users such as a number of minority shareholders, employees and creditors, elects to
provide segment information.
LO3 18.3 A CONTROVERSIAL STANDARD

18.3.1 Overview
In January 2006, the International Accounting Standards Board (IASB®) issued Exposure Draft (ED) 8 Operating
Segments, which it proposed as a replacement to IAS 14 Segment Reporting. The ED was part of the IASB’s

programme for achieving convergence with standards issued by the US Financial Accounting Standards Board
(FASB) and essentially adopted the requirements of the FASB Statement of Financial Accounting Standards
No. 131 (SFAS 131) Disclosures about Segments of an Enterprise and Related Information. The major change from
IAS 14 was adoption of the management approach to identifying segments as the only acceptable approach.
ED 8 was finally issued as a new standard, IFRS 8 Operating Segments, in November 2006. IFRS 8 was appli-
cable for annual reporting periods beginning on or after 1 January 2009, with early adoption permitted.
18.3.2 Reasons for the controversy

In Europe, the replacement of IAS 14 with IFRS 8 was highly controversial, mainly because of the manage-
ment approach allowed by IFRS 8 compared with the more prescriptive approach previously required by
IAS 14. The management approach in IFRS 8 requires segment information to be reported externally based
on how information is reported internally to the company’s management (see section 18.4). In contrast, IAS
14 contained very prescriptive requirements as to what should be reported and how. The European Parlia-
ment is required to endorse all IASB standards and IFRIC® Interpretations in order for the standards and
interpretations to come into effect. The European Financial Reporting Advisory Group (EFRAG) reviews
the proposed standards and makes its recommendations to the European Commission as to whether or
not the parliament should endorse the standards and interpretations. When ED 8 was issued, concern was
expressed about the management approach by many commentators to both the IASB and EFRAG. After
the IASB issued IFRS 8, the European Commission sought further feedback, by means of a questionnaire,
on whether or not the European Parliament should endorse IFRS 8. The questions focused on the man-
agement approach, the lack of mandatory disclosure requirements and whether these were perceived as
positive or negative by commentators.
A paper prepared and presented by Nicolas Véron, Research Fellow at Bruegel (a European think-tank
created to contribute to the quality of economic policy making in Europe), argued that IFRS 8 should not
be endorsed. The paper (Véron, 2007) argued that the success of IFRS® Standards thus far can be attributed
both to market (investor) demand and to European Union (EU) leadership and that convergence with US
GAAP ‘is far from universally accepted as an appropriate framework for setting the current standard-set-
ting agenda’. The paper contended that ‘segment information is one of the most vital aspects of financial
reporting for investors and other users’ and is also inherently divisive between preparers of financial state-
ments on the one hand, who want to control the information, and users on the other, who want it to be
specifically objective. The risks and rewards approach to identifying segments (previously contained in
IAS 14) arguably meets the needs of users while the management approach arguably meets the needs of
preparers, although both approaches may be consistent (as envisaged by IAS 14). The paper argues
that the discretion permitted by IFRS 8 in determining the content of segment profit or loss and segment
assets and in making or not making certain disclosures (e.g. disclosure of liabilities, statement of profit or
loss and other comprehensive income line items and geographical information) contrasts with the prescribed
measurement and disclosure requirements of IAS 14, favouring preparers over users. The paper quotes from
various respondents’ letters to the IASB, particularly those of analysts, who did not support changing IAS 14
and moving to a standard based on SFAS 131, because they regarded SFAS 131 as inferior to IAS 14.
It is also notable that two IASB board members dissented from the issuance of IFRS 8 (refer to the dis-
senting opinion in IFRS 8) because of the lack of definition of segment profit or loss and because IFRS 8
does not require consistent attribution of assets and profit or loss to segments. In addition, these board
members also believed that the changes from IAS 14 were not justified by the need for convergence with
US GAAP because IAS 14 is a disclosure standard and therefore does not affect the reconciliation of IFRS
amounts to US GAAP.
The preparer’s viewpoint is argued, for example, in the submission by the Association of German Banks
to the European Commission’s questionnaire referred to above (Bundesverband Deutscher Banken 2007).
This letter argues that IFRS 8 should be endorsed and that the information provided under the manage-
ment approach will be more relevant and reliable because it will, inter alia, enable investors to evaluate
the entity on the same basis as that used by management in its decision making and that any concerns
about understandability are addressed by the reconciliation requirements of IFRS 8.
Despite the objections, IFRS 8 was finally endorsed by the European Parliament in November 2007. In
its endorsement resolution, the European Parliament stated that the IASB should carry out a review of the
new standard 2 years after its implementation. Further, the Parliament’s requirement that the European
Commission ‘follow closely the application of IFRS 8 and (to) report back to Parliament no later than
2011,1 inter alia regarding reporting of geographical segments, segment profit or loss, and use of non-IFRS
measures, underlines that if the Commission discovers deficiencies in the application of IFRS 8 it has a
duty to rectify such deficiencies’.
The message from the European Parliament to European companies is therefore that entities will be watched
closely to determine whether they are taking advantage of the discretionary approach of IFRS 8 in order to con-
trol reported information. Refer to section 18.9 for a discussion of the IASB’s post-implementation review of IFRS 8.
1 At
the time of writing (October 2015), no report had yet been issued

LO4 18.4 IDENTIFYING OPERATING SEGMENTS
An operating segment is defined in paragraph 5 of IFRS 8 as a component of an entity:
(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 make
decisions about resources to be allocated to the segment and assess its performance; and
(c) for which discrete financial information is available.
The chief operating decision maker (CODM) refers to the function of allocating resources and assessing
performance of the operating segments, and not necessarily to a manager with a specific title. That func-
tion may be carried out by a group of people, for example, an executive committee. Generally, an operating
segment has a segment manager who is directly accountable to the CODM. As with the CODM, the term
‘segment manager’ identifies a function, not necessarily a manager with a specific title. A single manager
may be the segment manager for more than one operating segment and the CODM may also be the seg-
ment manager for one or more operating segments. When an entity has a matrix structure, for example,
with some managers responsible for different product and service lines and other managers responsible
for specific geographic areas, and the CODM regularly reviews the operating results for both sets of com-
ponents, the entity uses the core principle (see section 18.1 and Illustrative Example 18.2) to determine its
operating segments (IFRS 8 paragraph 10).
Figure 18.1 summarises the key decision points in identifying operating segments.
Step 2
Step 1 Can the
component
generate revenue No
Identify the CODM
and incur expenses
from its business
activities?
Yes
Are the Step 3

component’s
operating results
regularly reviewed by the CODM No
as a basis for resource
allocation and
performance
assessment?
Yes
Step 4
The
Is discrete
Determine whether the component
Yes financial information No
operating segment is not an
available for the
is reportable operating
component?
segment
FIGURE 18.1 Identifying operating segments under IFRS 8

Source: Ernst & Young (2009, p. 9). © 2009 EYGM Limited. All rights reserved.

The following examples illustrate the steps in identifying operating segments.
ILLUSTRATIVE EXAMPLE 18.1 Identifying operating segments under IFRS 8 — the four steps
Sargsyan has a chief executive officer (CEO), a chief operating officer (COO) and an executive com-
mittee comprising the CEO, COO and the heads (general managers) of three business units — units X, Y
and Z. Every month, financial information is presented to the executive committee for each of business
units X, Y and Z and for Sargsyan as a whole in order to assess the performance of each business unit
and of the company as a whole. Units X, Y and Z each generate revenue and incur expenses from their
business activities. Unit Y derives the majority of its revenue from Unit Z. Corporate headquarter costs
that are not allocated to units X, Y or Z are also reported separately each month to the executive com-
mittee in order to determine the results for Sargsyan as a whole.
Step 1: Identify the CODM
In this case, the CODM is likely to be the executive committee, since it is this group that regularly
reviews the operating results of all business units and the company as a whole. However, if the business
unit heads only join the committee meetings to report on their specific business unit and then leave the
meeting, and the CEO and COO are the only people who review all the business units and the company
as a whole, and are the ones who make resource allocation decisions, for example, about changing the
structure of the business units, then the CODM would be the CEO and COO. In practice, this would
not likely make any difference to the identification of the operating segments since the operating results
information regularly reviewed by the entire committee is likely to be identical to that reviewed by the
CEO and COO (see step 2).
Step 2: Can the component generate revenue and incur expenses from its business activities?
For units X and Z, the answer is clearly yes. For Unit Y, the answer is also yes — even though its revenue
is derived internally this does not prevent it from being identified as an operating segment (IFRS 8
paragraph 5(a)). For the corporate headquarters, the answer is no as it does not derive revenues; it only
incurs costs. Therefore, the corporate headquarters would not be identified as an operating segment and
would not require further assessment.
Step 3: Are the component’s operating results regularly reviewed by the CODM as a basis for resource
allocation and performance assessment?
Yes, the operating results for units X, Y and Z are regularly reviewed by the CODM.
Step 4: Is discrete financial information available for the component?
Yes, discrete financial information is available for units X, Y and Z.
Conclusion
Units X, Y and Z are identified as Sargsyan’s operating segments.
ILLUSTRATIVE EXAMPLE 18.2 Identifying operating segments under IFRS 8 — matrix structure
Lothian has a chief executive officer (CEO), a chief operating officer (COO) and an executive com-
mittee comprising the CEO, COO and the heads (general managers) of three business units organised
according to the company’s main products — units X, Y and Z. The company also operates in two
distinct geographic regions — the United Kingdom and North America. The heads of these geographic
regions attend executive committee meetings, have input into decisions about the distribution of the
company’s products into their geographic regions and give their views on the performance of the com-
pany’s products in their regions. However, the CEO can override any decisions made by the committee.
Every month, financial information is presented to the executive committee for each of business units
X, Y and Z, geographic regions UK and North America and for Lothian as a whole in order to assess the
performance of each business unit, each geographic region and of the company as a whole. Corporate
headquarter costs that are not allocated to units X, Y or Z or to the geographic regions are also reported
separately each month to the executive committee in order to determine the results for Lothian as a
whole. There is necessarily an overlap between the financial information presented for each of units X,
Y and Z and UK and North American geographic regions because the product performance reported for
each unit is reported again, with that of the other two product units, by geographic region.
Step 1: Identify the CODM
In this case, the CODM is likely to be the CEO, since he or she has overriding decision making authority.
Step 2: Can the component generate revenue and incur expenses from its business activities?
For units X, Y and Z, the answer is clearly yes. For the geographic regions, the answer is also yes, even
though the revenues are generated from deployment of the products from units X, Y and Z in the

regions. For the corporate headquarters, the answer is no as it does not derive revenues; it only incurs
costs. Therefore, the corporate headquarters would not be identified as an operating segment and would
not require further assessment.
Step 3: Are the component’s operating results regularly reviewed by the CODM as a basis for
resource allocation and performance assessment?
For units X, Y, Z, and the geographic regions, the answer is yes.
Step 4: Is discrete financial information available for the component?
For units X, Y, Z, and the geographic regions, the answer is yes.
Conclusion
This leaves the entity potentially having two sets of operating segments — units X, Y and Z, and geo-
graphic regions UK and North America. It is in this situation that paragraph 10 of IFRS 8 directs the entity
to the core principle of the standard. This means management must exercise judgement consistent with
the management approach founded on what is important to the CODM. For example, if the CEO uses the
information and advice provided by the three business unit general managers in order to make decisions
about the allocation of resources to those business units, such as whether to invest in new production
technologies, but only looks to the geographical region heads for insight into regional product perfor-
mance, then perhaps the CODM focuses more on the information provided by the three product line
business units than the geographical information when allocating resources and assessing performance.
LO5 18.5 IDENTIFYING REPORTABLE SEGMENTS

18.5.1 The basic criteria
Paragraph 11 of IFRS 8 requires that an entity report separately information about each operating seg-
ment that:
(a) has been identified as an operating segment in accordance with the four steps discussed above, or results
from aggregating two or more of those segments in accordance with specific aggregation criteria; and
(b) exceeds the specified quantitative thresholds.
An entity must report separately information about an operating segment that meets any of the fol-
lowing quantitative thresholds:
(a) its reported revenue is 10% or more of the combined revenue of all operating segments (revenue
includes both external and internal revenue)
(b) its reported profit or loss is, in absolute terms, 10% or more of the greater of (1) the combined reported
profit of all operating segments that reported a profit, and (2) the combined reported loss of all oper-
ating segments that reported a loss
(c) its assets are 10% or more of the combined assets of all operating segments.
If management believes that information about an operating segment would be useful to users, it may treat
that segment as a reportable segment even if the quantitative thresholds are not met (IFRS 8 paragraph 13).
18.5.2 The aggregation criteria

The aggregation criteria in paragraph 12 provide that two or more operating segments may be aggregated
into a single operating segment if aggregation is consistent with the core principle of the standard, the seg-
ments have similar economic characteristics and the segments are similar in each of the following respects:
(a) the nature of the products and services
(b) the nature of the production processes
(c) the type or class of customer for their products and services
(d) the methods used to distribute their products or provide their services
(e) if applicable, the nature of the regulatory environment, for example, banking, insurance or public utilities.
An entity may combine operating segments that do not meet the quantitative thresholds to produce a
reportable segment only if the segments have similar economic characteristics and meet the above aggrega-
tion criteria (IFRS 8 paragraph 14).
Paragraph 15 of IFRS 8 requires that an entity must identify operating segments until at least 75% of the
entity’s consolidated external revenue is included in reportable segments.
Paragraph 16 of IFRS 8 states that business activities and operating segments that are not reportable
must be combined and disclosed as ‘all other segments’ separately from the reconciling items required by
paragraph 28 (see section 18.7.5).
Note that IFRS 8 does not distinguish between revenues and expenses from transactions with third par-
ties and those from transactions within the group for the purposes of identifying operating segments (IFRS
8 paragraph 5). Therefore, in an entity with internal vertically integrated businesses, it is possible that such
internal businesses might be identified as operating segments under IFRS 8.

IFRS 8 provides additional guidance to entities regarding the maximum number of reportable segments
— indicating that ten is a reasonable maximum (IFRS 8 paragraph 19).
Figure 18.2 summarises the key decision points in identifying reportable segments, and follows on from
figure 18.1
Step 5
Do some
operating segments Yes
From figure 18.1
meet all the aggregation
criteria?
Aggregate
No operating segments
if desired
Step 6
Do some
Yes operating segments
exceed the 10% quantitative
thresholds?
No
Step 7
Do
Combine some operating
operating Yes segments have similar
segments if economic characteristics
desired and meet a majority of
the aggregation
criteria?
No
Step 8
Do the
reportable
segments identified Yes
account for 75% of
consolidated
revenue?
No
These are Identify additional operating segments

reportable (and if appropriate, aggregate with other
segments to reportable segments) until external
be disclosed revenue of all segments > 75% of
consolidated revenue
Aggregate remaining segments and other

activities into ‘all other segments’ category
FIGURE 18.2 Identifying reportable segments under IFRS 8

Source: Ernst & Young (2009, p. 12). © 2009 EYGM Limited. All rights reserved.

LO6 18.6 APPLYING THE DEFINITION OF
REPORTABLE SEGMENTS
Building on illustrative example 18.1, the following example illustrates how Sargsyan identifies its
reportable segments under IFRS 8.
ILLUSTRATIVE EXAMPLE 18.3 Identifying reportable segments under IFRS 8
Sargsyan has identified units X, Y and Z as operating segments (see illustrative example 18.1). The fol-
lowing additional information is provided:
Total
operating Corporate Other Total Sargsyan
Unit X Unit Y Unit Z segments headquarters businesses (consolidated)
$’000 $’000 $’000 $’000 $’000 $’000 $’000
Revenue 200 100 400 700 — 230 850

(80 earned
from
Unit Z)
Profit/(loss) 50 30 100 180 (25) 20 165

(10 earned
from
Unit Z)
Assets 800 300 950 2 050 250 200 2 500
Management has determined that units X, Y and Z do not meet the aggregation criteria of IFRS 8.
Unit Z has no inventory on hand at year-end in respect of purchases from unit Y.
Quantitative thresholds: note that the quantitative thresholds are in respect of the totals for the oper-
ating segments — not the total for Sargsyan (IFRS 8 paragraph 13):
Revenue Profit Assets

% of total % of total % of total
Unit X 29% 28% 39%

Unit Y 14% 17% 15%
Unit Z 57% 55% 46%
Therefore, all three units meet all three of the quantitative thresholds. (Note that only one threshold
needs to be met.) Thus, all three units are reportable segments.
The next question is whether the reportable segments account for 75% of consolidated revenue. This
test is applied to the external revenues of the segments (IFRS 8 paragraph 15). Total consolidated rev-
enue (after inter-segment eliminations) is $850 000. Total external operating segment revenue is: Unit
X: $200 000; Unit Y: $20 000 and Unit Z: $400 000, giving a total of $620 000. This constitutes 73%
of total consolidated revenue, which is below the 75% requirement. Therefore, additional operating seg-
ments need to be identified. Management will need to further analyse the ‘other businesses’ and identify
another reportable segment from that component.
LO7 18.7 DISCLOSURE

18.7.1 Overall approach
IFRS 8 sets out a general approach to disclosure and largely allows management to determine what is
disclosed and how the amounts disclosed are measured based on those measures used by the CODM for
determining resource allocation and for assessing performance.
The general principle of disclosure is set out in paragraph 20 of IFRS 8, which is, in effect, a restatement
of the core principle of the standard:
An entity shall disclose information to enable users of its financial statements to evaluate the nature and finan-
cial effects of the business activities in which it engages and the economic environments in which it operates.

To give effect to this principle, paragraph 21 of IFRS 8 requires an entity to disclose:
(a) general information on segments identified for reporting;
(b) reported segment profit or loss, including information about specified revenues and expenses included in
reported profit or loss, segment assets and segment liabilities (if reported to the CODM) and the basis of
measurement; and
(c) reconciliations of the totals of segment revenues, reported segment profit or loss, segment assets, segment
liabilities and other material segment items to the corresponding entity amounts in the financial statements.
18.7.2 General information

An entity is required to disclose:
(a) the factors used to identify the entity’s reportable segments, including the basis of organisation, for
example, whether management has chosen to organise the entity by different products and services,
geographical areas, regulatory environments, or a combination of factors, and whether segments have
been aggregated;
(b) the judgements made by management in applying the aggregation criteria (discussed in section 18.5.2),
including a brief description of the operating segments that have been aggregated and the economic
indicators that were considered in determining that the aggregated operating segments share similar
characteristics; and
(c) the types of products or services from which each reportable segment derives its revenues.
18.7.3 Information about profit or loss, assets and liabilities

Paragraph 23 of IFRS 8 states that an entity shall report ‘a measure’ of profit or loss for each reportable seg-
ment. An entity is also required to disclose a measure of total assets and total liabilities for each reportable
segment, but only if such amounts are regularly reported to the CODM.
These measures are those used by the CODM for the purposes of making decisions about allocating
resources to the segment and assessing its performance (IFRS 8 paragraph 25). In other words, whatever the
CODM uses to measure and assess the operating segment is what is disclosed under IFRS 8. This extends to the
allocation of amounts of profit or loss and assets and liabilities to segments. If the CODM uses information
based on amounts that are allocated to segments, then those amounts should be allocated for the purposes
of disclosing ‘a measure’. If the CODM does not use that information, the amounts should not be allocated.
In respect of segment profit or loss, certain line items are also required to be disclosed only if these items
are included in the measure of segment profit or loss reported to the CODM, or are otherwise regularly
provided to the CODM:
(a) revenues from external customers
(b) inter-segment revenues
(c) interest revenue
(d) interest expense
(e) depreciation and amortisation
(f) material items of income and expense disclosed in accordance with paragraph 97 of IAS 1
(g) the entity’s interest in the profit or loss of associates and joint ventures accounted for by the equity method
(h) income tax expense or income
(i) material non-cash items other than depreciation and amortisation (IFRS 8 paragraph 23).
Interest revenue and interest expense may be reported on a net basis only if a majority of the segment’s
revenues are from interest and the CODM relies primarily on net interest revenue to assess the perfor-
mance of the segment. This may be the case, for example, in the banking industry.
In respect of segment assets, certain line items are also required to be disclosed if these items are included
in the measure of segment assets reported to the CODM, or are otherwise regularly provided to the CODM:
(a) the amount of investment in associates and joint ventures accounted for by the equity method
(b) the amounts of additions to non-current assets (with certain exceptions) (IFRS 8 paragraph 24).
The notable feature of these disclosure requirements is the lack of prescription. If the items listed (with
the exception of a measure of segment profit or loss, which must always be disclosed) are reported to the
CODM, then they must be disclosed. This means that what is not reported internally is not disclosed exter-
nally. Furthermore, how the amount is measured internally is used for external measurement purposes,
even if the measurement basis is not in accordance with IFRS.
18.7.4 Measurement
Because management has discretion about measurement, IFRS 8 requires disclosure of how the entity has
determined the measures of profit or loss, and, if applicable, assets and liabilities, for each reportable seg-
ment (IFRS 8 paragraph 27). This includes:
(a) the basis of accounting for any transactions between reportable segments;
(b) if not apparent from the required reconciliations (see section 18.7.5), the nature of any differences
between the measurements of total reported segment profit or loss and the entity’s profit or loss before

income taxes and discontinued operations (i.e. the profit or loss reported in the statement of profit
or loss and other comprehensive income in accordance with IFRSs). For example, if the CODM uses
concepts such as ‘cash profit’ for measuring the segment profit or loss, the entity would need to dis-
close how ‘cash profit’ is determined and how it differs from the IFRS measure of profit before income
taxes and discontinued operations. This could include, for example, the fact that the CODM deter-
mines ‘cash profit’ to be profit or loss before fair value movements, depreciation and amortisation, and
impairment charges;
(c) if not apparent from the required reconciliations, the nature of any differences between the meas-
urements of total reported segment assets and the entity’s assets. For example, this could include
accounting policies and policies for allocation of jointly used assets in determining segment assets;
(d) if not apparent from the required reconciliations, the nature of any differences between the measure-
ments of total reported segment liabilities and the entity’s liabilities. For example, this could include
accounting policies and policies for allocation of jointly used liabilities in determining segment
liabilities;
(e) the nature of any changes from prior periods in the measurement methods used to determine segment
profit or loss, including the financial effect, if any, of those changes. For example, if the CODM decides
to change the measure of segment profit or loss used from one that excludes fair value movements to
one that includes fair value movements, this fact would need to be disclosed together with the impact
on reported segment profit or loss; and
(f) the nature and effect of any asymmetrical allocations to reportable segments. For example, an entity
might allocate depreciation expense to a segment without allocating the related depreciable assets to
that segment.
18.7.5 Reconciliations
An entity is required to provide reconciliations of all of the following:
(a) the total of the reportable segments’ revenues to the entity’s revenue. In illustrative example 18.3,
ignoring the identification of additional segments to meet the 75% threshold, this would be a recon-
ciliation of total segment revenues of $700 000 to Sargsyan’s revenue of $850 000;
(b) the total of the reportable segments’ measures of profit or loss to the entity’s profit or loss before
income tax and discontinued operations (or, if items such as income tax are allocated to segments,
to profit or loss after income tax). In illustrative example 18.3, ignoring the identification of addi-
tional segments to meet the 75% threshold, this would be a reconciliation of total segment profits of
$180 000 to Sargsyan’s profit of $165 000;
(c) the total of the reportable segments’ assets (if reported) to the entity’s assets. In illustrative example 18.3,
ignoring the identification of additional segments to meet the 75% threshold, this would be a recon-
ciliation of total segment assets of $2.05 million to Sargsyan’s assets of $2.5 million;
(d) the total of segment liabilities (if reported) to the entity’s liabilities; and
(e) the total of segment amounts for every other material item of information disclosed to the corre-
sponding amount for the entity.
All material reconciling items must be separately identified and described. For example, in illustrative
example 18.3, assuming the amounts are material, the entity would need to disclose its reconciliation of
total segment profits to Sargsyan’s profit as follows:
$’000
Total segment profits: 180
Less: Inter-segment profit (10)
Less: Corporate headquarters costs not allocated to reportable segments (25)
Add: Profit from other businesses not identified as reportable segments 20
Total Sargsyan profit 165
18.7.6 Entity-wide disclosures

The following disclosures apply to all entities subject to IFRS 8, including those that have only one report-
able segment (unless the information is already provided as part of the reportable segment information).
• Information about products and services: revenues from external customers for each product and
service or for each group of similar products and services. In this case, the amount of revenues
must be based on the financial information used to produce the entity’s financial statements, not
based on amounts reported to the CODM. If the information is not available and the cost to develop
it would be excessive, the entity need not disclose the information but it must state this fact (IFRS
8 paragraph 32). This requirement is potentially onerous in that it is possible that one reportable
segment includes numerous products and/or services.

• Information about geographical areas: revenues from external customers and non-current assets (i)
attributed to/located in the entity’s country of domicile and (ii) attributed to/located in foreign countries.
If revenues or non-current assets attributed to/located in an individual foreign country are material,
those revenues/assets shall be disclosed separately. The entity must also disclose the basis for attributing
revenues from external customers to individual countries. In this case, as in paragraph 32, the amount
of revenues and assets must be based on the financial information used to produce the entity’s financial
statements. If the information is not available and the cost to develop it would be excessive then the
entity need not disclose the information but it must state this fact (IFRS 8 paragraph 33).
• Information about major customers: if revenues from transactions with a single external customer
account for 10% or more of an entity’s total revenues, disclose that fact, the total amount of revenues
from each such customer, and the reportable segment or segments reporting the revenues. The identity
of the customer or customers does not have to be disclosed.
18.7.7 Comparative information

There are a few circumstances in which comparative information must be restated or otherwise taken into
account.
(a) If an operating segment was a reportable segment for the immediately preceding prior period but is not
for the current period, and management decides that the segment is of continuing significance, informa-
tion about that segment must continue to be reported in the current period (IFRS 8 paragraph 17).
(b) If an operating segment becomes a reportable segment for the current period, comparative information
must be restated to reflect the newly reportable segment, even if that segment did not meet the criteria
for reportability in the prior period. This is required unless the information is not available and the
cost to develop it would be excessive (IFRS 8 paragraph 18).
(c) If an entity changes any of its segment measures, including how segment profit or loss is determined,
or changes the allocation of income, expenses, assets or liabilities to segments, without a change to the
composition of its reportable segments, the general principles of IAS 1 for changes in presentation or
classification apply (see chapter 16). Therefore, comparative information would be restated, unless this
is impracticable (IAS 1 paragraph 41).
(d) If an entity changes the structure of its internal organisation in a manner that causes the composition
of its reportable segments to change, the corresponding information for prior periods, including interim
periods, must be restated. This applies unless the information is not available and the cost to develop it
would be excessive (IFRS 8 paragraph 29). Note that in this case the exemption from restatement applies
to each individual item of disclosure. This could result in restatement of some items and not of others.
(e) If an entity changes the structure of its internal organisation in a manner that causes the composi-
tion of its reportable segments to change and the corresponding information for prior periods is not
restated, the entity must disclose the segment information for the current period on both the old and
the new basis. This applies unless the information is not available and the cost to develop it would be
excessive (IFRS 8 paragraph 30).
LO8 18.8 APPLYING THE DISCLOSURES IN PRACTICE

Figure 18.3 contains extracts from the 2014 annual report of Daimler AG, a company listed on the Frank-
furt and Stuttgart stock exchanges.
Firstly, note how the company describes the segmentation of its activities into its principal business
activities and specific product lines. The company then goes on to describe how its segment measures are
determined, the impact of various restructuring initiatives and significant transactions, followed by the
required quantitative information, including reconciliations.
FIGURE 18.3 Extracts from Daimler AG’s annual report — Segment Reporting Note
1. Segment reporting
Reportable segments. The reportable segments of the Group are Mercedes-Benz Cars, Daimler Trucks, Mercedes-Benz Vans,
Daimler Buses and Daimler Financial Services. The segments are largely organized and managed separately according to
nature of products and services provided, brands, distribution channels and profile of customers.
The vehicle segments develop and manufacture passenger cars and off-road vehicles, trucks, vans and buses. Mercedes-Benz
Cars sells passenger cars and off-road vehicles under the Mercedes-Benz brand and small cars under the smart brand. Daimler
Trucks distributes its trucks under the brand names Mercedes-Benz, Freightliner, FUSO, Western Star, Thomas Built Buses and
BharatBenz. The vans of the Mercedes-Benz Vans segment are primarily sold under the brand name Mercedes-Benz and also
under the Freightliner brand. Daimler Buses sells completely built-up buses under the brand names Mercedes-Benz and Setra.
In addition, Daimler Buses produces and sells bus chassis. The vehicle segments also sell related spare parts and accessories.
(continued)

The Daimler Financial Services segment supports the sales of the Group’s vehicle segments worldwide. Its product portfolio
mainly comprises tailored financing and leasing packages for customers and dealers. The segment also provides services such
as insurance, fleet management, investment products and credit cards, as well as various mobility services.
Management and reporting systems. The Group’s management reporting and controlling systems principally use
accounting policies that are the same as those described in Note 1 in the summary of significant accounting policies
according to IFRS.
The Group measures the performance of its operating segments through a measure of segment profit or loss which is
referred to as “EBIT” in our management and reporting system.
EBIT comprises gross profit, selling and general administrative expenses, research and non-capitalized development costs,
other operating income and expense, and our share of profit/loss from equity-method investments, net, as well as other
financial income/expense, net. Although amortization of capitalized borrowing costs is included in cost of sales, it is not
included in EBIT.
Intersegment revenue is generally recorded at values that approximate third-party selling prices.
Segment assets principally comprise all assets. The industrial business segments’ assets exclude income tax assets, assets from defined
benefit pension plans and other post-employment benefit plans, and certain financial assets (including liquidity).
Segment liabilities principally comprise all liabilities. The industrial business segments’ liabilities exclude income tax
liabilities, liabilities from defined benefit pension plans and other post-employment benefit plans, and certain financial
liabilities (including financing liabilities).
Daimler Financial Services’ performance is measured on the basis of return on equity, which is the usual procedure in the
banking business.
The residual value risks associated with the Group’s operating leases and finance lease receivables are generally borne by
the vehicle segments that manufactured the leased equipment. Risk sharing is based on agreements between the respective
vehicle segments and Daimler Financial Services; the terms vary by vehicle segment and geographic region.
Non-current assets consist of intangible assets, property, plant and equipment and equipment on operating leases.
Capital expenditures for property, plant and equipment and intangible assets reflect the cash effective additions to these
property, plant and equipment and intangible assets as far as they do not relate to capitalized borrowing costs, goodwill and
finance leases.
Depreciation and amortization may also include impairments as far as they do not relate to goodwill.
Amortization of capitalized borrowing costs is not included in the amortization of intangible assets or depreciation
of property, plant and equipment since it is not considered as part of EBIT.
Reconciliation. Reconciliation includes corporate items for which headquarters are responsible. Transactions between the
segments are eliminated in the context of consolidation and the eliminated amounts are included in the reconciliation.
The effects of certain legal proceedings are excluded from the operative results and liabilities of the segments if such items
are not indicative of the segments’ performance, since their related results of operations may be distorted by the amount and
the irregular nature of such events. This may also be the case for items that refer to more than one reportable segment.
Reconciliation also includes corporate projects and equity interests not allocated to the segments. If the Group hedges
investments in associated companies for strategic reasons, the related financial assets and earnings effects are generally not
allocated to the segments.
Information related to geographic areas. With respect to information about geographical regions, revenue is allocated to
countries based on the location of the customer; non-current assets are presented according to the physical location of these
assets.
Mercedes-Benz Cars. In 2014, in the segment Mercedes-Benz Cars the restructuring of the Group’s sales organization had an
effect of €81 million (see also Note 5). Furthermore, the segment profit of Mercedes-Benz Cars includes in profit/loss from
equity-method investments an impairment of €30 million (2013: €174 million) on an investment in the area of alternative
drive systems.
Daimler Trucks. In January 2013, Daimler Trucks decided on workforce adjustments in Germany and Brazil, which were continued
in 2014. Expenses recorded in this regard and for the restructuring of the Group’s sales organization amounted to €165 million in 2014
(2013: €116 million). In 2014, the optimization programs led to a cash outflow of €170 million (2013: €50 million) (see also Note 5).
Mercedes-Benz Vans. In 2014, profit/loss from equity method investments for the segment Mercedes-Benz Vans includes the
reversal of an impairment on the investment in FBAC of €61 million (2013: €0 million). In addition, the restructuring of the
Group’s sales organization affected Mercedes-Benz Vans by an amount of €17 million.
Daimler Buses. Expenses from the measures described under Daimler Trucks and from the restructuring of the Group’s sales
organization impacted Daimler Buses in 2014 with a total amount of €14 million. In the previous year, the expenses of
€39 million included effects from the optimization programs in Western Europe and North America (see also Note 5).
Daimler Financial Services. The interest income and interest expenses of Daimler Financial Services are included in revenue
and cost of sales, and are presented in Notes 4 and 5.
Table ↗ E.87 presents segment information as of and for the years ended December 31, 2014 and 2013.

E.87
Segment information
Daimler
Mercedes- Daimler Mercedes- Daimler Financial Total Consolidated
Benz Cars Trucks Benz Vans Buses Services Segments Reconciliation Group
In millions of euros
2014
External revenue 70 899 30 302 9 601 4 155 14 915 129 872 — 129 872
Intersegment revenue 2 685 2 087 367 63 1 076 6 278 –6 278 —
Total revenue 73 584 32 389 9 968 4 218 15 991 136 150 –6 278 129 872
Segment profit (EBIT) 5 853 1 878 682 197 1 387 9 997 755 10 752
thereof profit/loss from
equity-method
investments 103 –1 63 1 –15 151 746 897
thereof expenses
from compounding of
provisions and changes
in discount rates –247 –70 –20 –11 –4 –352 –1 –353
Segment assets 51 950 20 181 5 895 3 562 105 454 187 042 2 593 189 635
thereof equity-method
investments 936 545 97 8 30 1 616 678 2 294
Segment liabilities 34 811 12 131 4 349 2 622 97 837 151 750 –6 699 145 051
Additions to non-current
assets 10 949 1 896 1 004 507 9 899 24 255 10 24 265
thereof investments in
intangible assets 1 238 77 115 13 20 1 463 — 1 463
thereof investments
in property, plant and
equipment 3 621 788 304 105 23 4 841 3 4 844
Depreciation and
amortization of
non-current assets1 4 562 1 435 452 225 3 368 10 042 15 10 057
thereof amortization of
thereof depreciation
of property, plant and
equipment1 2 446 766 197 75 14 3 498 3 3 501
1
Includes impairments of property, plant and equipment of €93 million from the planned sale of selected sites of the Group’s sales network, of which
€64 million relates to Mercedes-Benz Cars, €13 million to Daimler Trucks, €14 million to Mercedes-Benz Vans and €2 million to Daimler Buses.
Daimler
Mercedes- Daimler Mercedes- Daimler Financial Total Consolidated
Benz Cars Trucks Benz Vans Buses Services Segments Reconciliation Group
2013
External revenue 61 883 29 431 9 021 4 044 13 603 117 982 — 117 982
Intersegment revenue 2 424 2 042 348 61 919 5 794 –5 794 —
Total revenue 64 307 31 473 9 369 4 105 14 522 123 776 –5 794 117 982
Segment profit (EBIT) 4 006 1 637 631 124 1 268 7 666 3 149 10 815
thereof profit/loss from
equity-method
investments –127 69 3 1 1 –53 3 398 3 345
thereof expenses
from compounding of
provisions and changes
in discount rates –57 –20 –8 –3 –5 –93 –2 –95
(continued)

Segment assets 46 752 21 105 5 578 3 256 89 370 166 061 2 457 168 518
thereof equity-method
investments 706 2 109 2 6 13 2 836 596 3 432
Segment liabilities 28 917 11 005 3 987 2 403 82 774 129 086 –3 931 125 155
Additions to non-current
assets 11 110 1 960 1 196 384 8 301 22 951 70 23 021
thereof investments in
thereof investments
in property, plant and
equipment 3 710 839 288 76 19 4 932 43 4 975
Depreciation and
amortization of
non-current assets 3 857 1 457 375 200 2 824 8 713 35 8 748
thereof amortization of
intangible assets 961 316 65 23 11 1 376 — 1 376
thereof depreciation
of property, plant and
equipment 1 972 784 151 72 14 2 993 –1 2 992
E.88
Reconciliation to Group figures
2014 2013
Total of segments’ profit (EBIT) 9 997 7 666
Result from the disposal of the investment in RRPSH 1 006 —
Equity-method investments
Remeasurement of the investment in Tesla 718 —
Remeasurement and sale of the investment in EADS — 3 397
Other income from equity-method investments1 28 1
Other corporate items –1 039 –331
Eliminations 42 82
Group EBIT 10 752 10 815
Amortization of capitalized borrowing costs2 –9 –4
Interest expense –715 –884
Profit before income taxes 10 173 10 139
Total of segments’ assets 187 042 166 061
Carrying amount of equity-method investments3 678 596
Income tax assets4 4 028 1 939
Unallocated financial assets (including liquidity) and assets from pensions and similar obligations4 13 886 14 560
Other corporate items and eliminations –15 999 –14 638
Group assets 189 635 168 518
Total of segments’ liabilities 151 750 129 086
Income tax liabilities4 47 61
Unallocated financial liabilities and liabilities from pensions and similar obligations4 9 661 11 551
Other corporate items and eliminations –16 407 –15 543
Group liabilities 145 051 125 155
1 Mainly comprises the Group’s proportionate share of profits and losses of BAIC Motor.
2 Amortization of capitalized borrowing costs is not considered in the internal performance measure “EBIT” but is included in cost of sales.
3 Mainly comprises the carrying amount of the investment in BAIC Motor.
4 Industrial business.
Reconciliations. Reconciliations of the total segment amounts to the respective items included in the consolidated financial
statements are shown in table ↗ E.88.

Other corporate items in the reconciliation of the total segments’ profit to Group EBIT. In 2014, the line item other corporate
items comprises expenses of €600 million in connection with the ongoing EU Commission antitrust proceedings concerning
European commercial vehicle manufacturers as well as further expenses in connection with legal proceedings. This line item
also includes expenses of €212 million from the hedging of the Tesla share price (2013: €0 million) and income of €88 million
from the sale of the Tesla shares (2013: €0 million), as well as expenses of €118 million from the measurement of the RRPSH
put option (2013: €60 million). In the prior year, a loss of €140 million was disclosed in connection with the disposal of the
remaining shares in EADS, which was reported within other financial income/expense, net.
Revenue and non-current assets by region. Revenue from external customers and non-current assets by region are shown in
table ↗ E.89.
E.89
Revenue and non-current assets by region
Revenue Non-current assets
2014 2013 2014 2013
Western Europe 43 722 41 123 40 519 38 371
thereof Germany 20 449 20 227 32 882 32 070
United States 33 310 28 597 18 161 14 839
Other American countries 9 550 10 168 2 778 2 496
Asia 29 446 24 481 1 859 1 667
thereof China 13 294 10 705 79 41
Other countries 13 844 13 613 2 282 1 954
129 872 117 982 65 599 59 327
Source: Daimler AG (2014, pp. 264–268).
Points to note about figure 18.3:

1. The ‘measure’ of segment result that is reported to the CODM is referred to as ‘EBIT’ and comprises gross
profit, selling and general administrative expenses, research and non-capitalised development costs,
other operating income and expense, share of profit/loss from equity-method investments, net, as well
as other financial income/expense, net. This means that this is the measure considered relevant to and
therefore reported to the CODM for the segments. The segment result is reconciled to the IFRS profit
before income taxes as required by paragraph 28 of IFRS 8.
2. There is disclosure of segment assets and liabilities. This means that these are reported internally to the
CODM.
3. The disclosures required by paragraph 23 of IFRS 8 are provided, other than segment interest expense/
income and segment income tax expense/income, which are presumably not reported internally to
the CODM.
4. The company has reported revenue from external customers by geographic area in accordance with
paragraph 33(a) of IFRS 8. This information shows that the company’s revenue base is highly geograph-
ically diversified (based on the location of the customer).
5. The other entity-wide disclosures required by paragraphs 32 and 33 are also given. However, there is no dis-
closure of the information about major customers as required by paragraph 34. Presumably this is because
there is no single external customer whose revenues amount to 10% or more of the company’s total revenues.
LO9 18.9 RESULTS OF THE POST-IMPLEMENTATION

REVIEW OF IFRS 8
As noted in section 18.1, IFRS 8 was the first standard to have been subject to a post-implementation
review (PIR) by the IASB. The first phase of the PIR consisted of an initial assessment of the issues related
to IFRS 8 and consultation with interested parties about these issues. That initial phase identified the
areas of focus to be considered. As a second step of the PIR, the IASB issued in July 2012 its first due
process document, Request for Information – Post-implementation Review: IFRS 8 Operating Segments, which
was intended to formally gather information from the IASB’s constituents about their experience with
implementing IFRS 8.
In July 2013, the IASB issued its Report and Feedback Statement – Post-implementation Review: IFRS 8 Oper-
ating Segments, which summarised the PIR process, the feedback received and conclusions reached by the

IASB. The IASB found that preparers, auditors, accounting firms, standard setters and regulators were gen-
erally supportive of the standard, although some improvements were suggested for its application. How-
ever, feedback from investor groups was mixed, with investors being more positive about the benefits of
the standard when segment information is aligned to the measures used by management elsewhere in the
financial statements and other information accompanying them.
Based on all of the feedback, the IASB concluded that the benefits of applying the standard were largely
as expected and that overall the standard achieved its objectives and has improved financial reporting.
However, the IASB acknowledged that some issues could be considered for improvement and warrant
further investigation. The areas identified for potential improvement and amendment comprise requests
for implementation guidance and requests for improved disclosures.
The IASB confirmed that any proposed changes to IFRS 8 would be assessed within the context of its
more general review of disclosure requirements and would also take into account concerns about disclo-
sure overload.
SUMMARY
IFRS 8 Operating Segments is primarily a disclosure standard and is particularly relevant for large organisa-
tions that operate in different geographical locations and/or in diverse businesses. Information about an
entity’s segments is relevant to assessing the risks and returns of a diversified or multinational entity where
often that information cannot be determined from aggregated data.
1. Segment disclosures are widely regarded as some of the most useful disclosures in financial state-
ments because of the extent to which they disaggregate financial information into meaningful and
often revealing groupings. Discuss this assertion by reference to the objectives of financial reporting
by segments.
2. Explain what the ‘management approach’ used in IFRS 8 means.
3. Evaluate whether the reconciliations required by paragraph 28 of IFRS 8 address a concern about lack
of comparability between entities caused by management’s ability to select any measurement basis it
chooses in reporting segment information.
References
Bundesverband Deutscher Banken 2007, Endorsement of IFRS 8 Operating Segments — analysis of potential
impacts, response from the Association of German Banks, 28 June.
Daimler AG 2014, Annual Report, Daimler AG, www.daimler.com.
Ernst & Young 2009, IFRS 8 Operating Segments: implementation guidance, www.ey.com.
Véron, N. 2007, EU adoption of the IFRS 8 standard on operating segments, presented to the Economic
Monetary Affairs Committee of the European Parliament, 19 September.
Exercise 18.1 DEFINING OPERATING SEGMENTS

★ IFRS 8 sets out four key steps that need to be followed in order to identify an operating segment.
Required
List the four key steps.
Exercise 18.2 AGGREGATING OPERATING SEGMENTS

★★ Company B is a listed manufacturing company. It produces most of its products in Australia but exports
90% of these products to the United States, Canada and Germany. It has only one main product line:
scientific equipment. Company B is organised internally into two main business units: local and export.
The export business unit is in turn divided into two sub-units: North America and Germany (North America
includes Canada). Each business unit reports separate financial and operational information to the chief
executive officer (CEO) and chief financial officer (CFO) who are identified as the CODM. The results of
the two business units are then aggregated to form the consolidated financial information. Details of the
identified operating segments are as follows:

United States Canada Germany Australia
Economic and Stable Stable. Closely related Stable Stable

political conditions to US environment
Relationships Closely linked to Closely linked to US Self-sustaining Self-sustaining
between Canadian operations Operations
operations
Proximity of Closely linked to Closely linked to US Not close to other Not close to
operations Canadian operations operations operations other operations
Special risks None None Stricter regulations Small market
Exchange control None None None None
regulations
Currency risks None Low Low Low to medium
Required
Identify which operating segments, if any, meet the aggregation criteria of IFRS 8 paragraph 12. Give rea-
sons for your answer.
Exercise 18.3 IDENTIFYING REPORTABLE SEGMENTS

★ Using the information from exercise 18.2, identify Company B’s operating segments.
Exercise 18.4 DISCLOSURES

★★ Company X has three reportable segments, A, B and C, which represent distinct geographical areas. The
CODM receives financial information about the geographical areas. Segment A produces Product P and
Product Y. Segment B produces Product P only. Segment C produces Product Y and sells Service Z. The
following financial information about each segment is reported to the CODM:
• revenues from external customers
• earnings before interest, depreciation and amortisation and tax (EBITDA)
• depreciation and amortisation.
Required
State whether each of the following statements is true or false, by reference to the relevant requirements
of IFRS 8:
1. Company X must disclose EBITDA for each reportable segment.
2. Company X must disclose total assets for each reportable segment.
3. Company X must reconcile the total EBITDA of Segments A, B and C to its reported IFRS profit before
income tax and discontinued operations.
4. Company X must disclose total liabilities for each reportable segment.
5. Company X must disclose depreciation and amortisation for each reportable segment.
6. Company X must disclose revenue from external customers for each of Product P, Product Y and Service Z.
Exercise 18.5 REPORTABLE SEGMENTS, ALLOCATING AMOUNTS TO SEGMENTS

★★ Company A is a listed diversified retail company. Its stores are located mainly in Australia. It has three
main types of stores: general department stores, liquor stores and specialist toy stores. Each of these stores
has different products, customer types and distribution processes. Company A has three business units:
general department stores, liquor stores and specialist toy stores.
For the year ended 30 June 2013 each business unit reported the following financial information to
Company A’s CODM:
General
department stores Liquor stores Toy stores All segments
$m $m $m $m
Revenue 400 100 50 550

Segment result (profit) 15 7 4 26
Assets 900 200 100 1 200

All three business units earn their revenue from external customers. Total consolidated revenue of Com-
pany A for the year ended 30 June 2013 is $800 million. Included in general department stores’ revenue
is $50 million of revenue from toy stores. As at the end of the reporting period toy stores owed general
department stores $45 million. This amount is included in general department stores’ assets. Within the
general department stores business unit there are five different legal entities including legal entities Y and
Z. As at 30 June 2013 legal entity Z owed $23 million to legal entity Y. These amounts have not been elim-
inated in determining the assets of the general department stores segment. Inter-segment asset balances are
reported to the CODM but are not used by the CODM as the basis for determining reportable segments.
Intra-segment assets are reported to the CODM and are eliminated in determining reportable segments.
Required
State whether the following statements are true or false. Give reasons for your answers.
1. Company A has three reportable segments.
2. The revenue figure that should be used by the general department stores segment for the purposes of
determining whether or not it is a reportable segment is $350 million.
3. Company A must disclose the toy stores segment liabilities after deducting the $45 million owed to
general department stores.
4. The assets figure that should be used by the general department stores segment for the purposes of
7. Company A must disclose a reconciliation of total segment assets to its consolidated assets of $1132 million.
Exercise 18.6 ANALYSING THE SEGMENT INFORMATION

★★★ Company A is a listed diversified manufacturing company. It is listed on the London Stock Exchange and
produces most of its products in China and India. Its markets are in the European Union and the Asia–
Pacific region. It produces three types of products and services: home furniture; office furniture and soft
furnishings.
The CODM has determined that Company A’s operating segments should be based on geographical
markets and has identified the reportable segments as listed below. The following information is reported
to the CODM for each of the markets:
1. earnings before interest, depreciation and amortisation and taxation (EBITDA)
2. revenues from external customers.
The following table sets out the financial information provided to the CODM for the year ended 31
December 2014. Each operating segment has been identified as a reportable segment. All amounts are in
pounds.
United Australia and

France Germany Kingdom India China New Zealand
£ £ £ £ £ £
Revenue from external

customers 22 300 000 35 654 000 21 587 600 5 325 000 7 324 800 8 763 400
Inter-segment revenue — — — 10 000 000 7 324 800 —
EBITDA 6 400 000 7 325 000 5 325 000 5 324 000 7 625 000 2 325 000
Other information disclosed in the company’s 31 December 2014 financial statements:

(a) Total consolidated revenue: £125 000 000.
(b) Inter-segment revenues represent wholesale sales from China and India to the other operating
segments.
(c) Net profit before taxation: £25 625 000.
(d) Total consolidated assets: £1 041 670 000.
(e) Revenue from external customers for each type of product is:
(i) Home furniture: £78 525 000.
(ii) Office furniture: £17 700 000.
(iii) Soft furnishings: £28 775 000.
Required
Analyse Company A’s business with reference to its reported segment information. Show all workings to
support your analysis.
534 PART 3 Presentation and Disclosures

The academic literature on segment reporting has focused They identify firms that under SFAS 14 disclosed foreign
on how managers select reportable segments and which to segments in the 5 years before the change in the rule and
aggregate with other segments (i.e., conceal). Another point followed these firms over the first 5 years under SFAS 131.
of interest has been the effect of the changes in the rules This results in a large sample of 4773 firm-year observations.
governing segment reporting on reportable segments and They find evidence that suggests that foreign operations in
resultant information environment. As discussed earlier in non-disclosing firms (firms that did not disclose at least two
this chapter, the change from IAS 14 to IFRS 8 was hotly foreign segments in the first 2 years of SFAS 131) are less
debated. The main concern was with respect to the man- profitable and that the valuation of these firms is lower than
agement approach adopted by IFRS 8, which may be more that of firms that are identified as disclosers. While this is
prone to managerial discretion than IAS 14. The change consistent with the presence of agency cost to disclosure, the
in IFRS followed a similar change in 1998 in the US from evidence also suggests that SFAS 131 avails more latitude for
SFAS 14 (FASB, 1976) to SFAS 131 (now ASC 280) (FASB, managers to conceal poor performance.
1997); hence many US studies are quite relevant to assessing Has the move to the management approach been suc-
the change in rules. (For a comparison between the various cessful? In the US several studies have documented an
standards, see Nichols et al., 2013; this is also a good review increase in the number of reported segments under SFAS 131
paper on segment reporting.) (e.g., Herrmann and Thomas, 2000; Berger and Hann, 2003;
The analytical paper of Hayes and Lundholm (1996) pro- Botosan and Stanford, 2005). A similar trend is observed fol-
vides some initial guidance on the issue of managers’ dis- lowing the adoption of IFRS 8. Nichols et al. (2012) look at
cretion regarding which segments to report separately and a sample of 326 large EU companies and find that in 62%
which to conceal. In their model a disclosing manager is there has been no change in the number of reported seg-
aware that segment information is used by a competitor. In ments under IFRS 8 than under IAS 14. However, 27% (11%)
the face of this competition, the disclosing manager prefers of sample firms increased (decreased) the number of reported
to aggregate segments so the competitor cannot infer which segments. The average increase is 0.35 segments. Leung and
line of business is the more profitable one. However, if seg- Verriest (2015) find that the effect of IFRS 8 on the number of
ment profitability is similar, there is little loss to the manager reported segments, controlling for other confounding forces,
in disclosing the segments separately because (s)he is indif- is positive for both geographical and business segments. Their
ferent as to the competitor’s action. sample includes 1178 European firms in 2008 and 2009, of
The proprietary cost argument identified by Hayes and which 737 (632) report geographical (business) segments.
Lundholm (1996) explains why profitable segments may be Even if the number of reported segments has increased
concealed. The reaction of a competitor to a disclosure of under new rules, it is not clear that the overall informative-
segment information is expected to be more harmful when ness of financial statements has consequently improved.
a segment generates abnormal profit. The latter, in turn, is Both Nichols et al. (2012) and Leung and Verriest (2015)
more likely in less competitive industries (e.g., in a duopoly). document a decline in overall items disclosed under IFRS 8,
Harris (1998) examines this prediction employing several suggesting there may be less information available to users of
proxies for the degree of competition within an industry. Her segment reporting. Interestingly, Leung and Verriest (2015)
sample consists of 929 multi-segment firms between 1987 find that the decline in the amount of information provided
and 1991. She first shows that the number of reported seg- under IFRS 8 is more pronounced in firms that provided
ments (under old US rules) is lower than the actual number little disclosure under IAS 14.
of industries a sample firm operates in. This suggests that Botosan and Stanford (2005) further examine this issue by
many segments are not separately reported by sample firms. looking at the effect of SFAS 131 on analysts. Specifically, they
More importantly, the degree to which segments are unre- collect data on 615 firms in 1998 that reported a single seg-
ported increases as competition weakens. ment under old US rules but multi-segment under new rules.
Managers may also have an incentive to conceal poorly They compare this sample to two other samples. The first is
performing lines of business, owing to agency costs. Berger of 1945 firms that remained single-segment and the second
and Hann (2007) posit that managers wishing to avoid including 592 firms that matched the main sample industry
scrutiny and criticism by boards and investors could do so membership based on three-digit SIC code numbers. Botosan
by aggregating poor- with well-performing segments. Their and Stanford (2005) present evidence that suggests that dis-
results are based on a comparison of segment reporting in closure under new rules increased the amount of information
the US before and after SFAS 131 and are consistent with the common to all analysts. However, they do not find conclusive
presence of agency cost, but are mixed with respect to propri- evidence on reduction in overall uncertainty and forecast error
etary costs. Bens et al. (2011) employ a unique data review to that financial analysts face following the new disclosure rules.
further explore the aggregation issue and find that agency and Ettredge et al. (2005) investigate a similar question using a
proprietary costs drive aggregation when a firm discloses sev- different approach. They argue that if the new disclosure rules
eral segments, but not when it reports a single segment. Hope are more informative, this should be reflected in a stronger
and Thomas (2008) also report results that are consistent association between current stock returns and future earnings.
with agency costs. Under SFAS 131 companies can reduce the That is predicated on the notion that stock returns are based
number of foreign segments they report relative to SFAS 14. on investors’ expectation of future performance. Their sample
Hope and Thomas (2008) conjecture that firms that stopped is large, containing 6827 firms and 21698 firm-year observa-
reporting geographical segments are poor-performing firms. tions between 1995 and 2001. They find that the association

between stock returns and future earnings is larger following Financial Accounting Standards Board (FASB), 1997.
the adoption of SFAS 131. This suggests the management Disclosures about segments of an enterprise and related
approach provides more useful information. Information. Statement of Financial Accounting Standards
No. 131. Norwalk, CT: FASB.
Harris, M., 1998. The association between competition and
References managers’ business segment reporting decisions. Journal of
Accounting Research, 36(1), 111–28.
Bens, D.A., Berger, P.G., and Monahan, S.J., 2011. Discretionary Hayes, R.M., and Lundholm, R., 1996. Segment reporting to
disclosure in financial reporting: An examination the capital market in the presence of a competitor. Journal
comparing internal firm data to externally reported segment of Accounting Research, 34(2), 261–79.
data. The Accounting Review, 86(2), 417–449. Herrmann, D., and Thomas W.B., 2000. An analysis of
Berger, P.G., and Hann, R., 2003. The impact of SFAS no. segment disclosures under SFAS No.131 and SFAS No. 14.
131 on information and monitoring. Journal of Accounting Accounting Horizons, 14(3), 287–302.
Research, 41(2), 163–223. Hope, O.K., and Thomas, W.B., 2008. Managerial empire
Berger, P.G., and Hann, R., 2007. Segment profitability building and firm disclosure. Journal of Accounting Research,
and the proprietary and agency Costs of disclosure. The 46(3), 591–626.
Accounting Review, 82(4), 869–906. Leung, E., and Verriest, A., 2015. The impact of IFRS 8 on
Botosan, C.A., and Stanford, M., 2005. Managers’ motives to geographical segment information. Journal of Business
withhold segment disclosures and the effect of SFAS No. Finance & Accounting, 42(3–4), 273–309.
131 on analysts’ information environment. The Accounting Nichols, N., Street D., and Cereola, S., 2012. An analysis of
Review, 80(3), 751–772. the impact of applying IFRS 8 on the segment disclosures
Ettredge, M.L., Kwon, S.Y., Smith, D.B., and Zarowin, P.A., of European blue chip companies. Journal of International
2005. The impact of SFAS No. 131 business segment data Accounting Auditing and Taxation, 21(2), 79–105.
on the market’s ability to anticipate future earnings. The Nichols, N.B., Street, D.L., and Tarca, A., 2013. The impact
Accounting Review, 80(3), 773–804. of segment reporting under the IFRS 8 and SFAS 131
Financial Accounting Standards Board (FASB), 1976. Financial management approach: A research review. Journal of
reporting for segments of a business enterprise. Statement of International Financial Management & Accounting, 24(3),
Financial Accounting Standards No. 14. Norwalk, CT: FASB. 261–312.
536 PART 3 Presentation and Disclosures

19 Other key notes
disclosures
ACCOUNTING IAS 24 Related Party Disclosures

STANDARDS IAS 33 Earnings per Share
IN FOCUS

OBJECTIVES
1 explain the potential effect of related party relationships
2 explain the objective and scope of IAS 24
3 identify an entity’s related parties
4 identify relationships that do not give rise to a related party relationship as envisaged under IAS 24
5 describe and apply the disclosures required by IAS 24
6 explain why a government-related entity has a partial exemption from related party disclosures
7 explain the objective of IAS 33
8 discuss the application and scope of IAS 33
9 discuss the components of basic earnings per share and examine how it is measured
10 explain the concept of diluted earnings per share and how it is measured
11 explain the need for retrospective adjustment of earnings per share
12 describe and apply the disclosure requirements of IAS 33.
CHAPTER 19 Other key notes disclosures 537

INTRODUCTION
Regardless of the industry or geographical location of an entity, there are two key aspects of disclosures
that are commonly found in an entity’s financial statements in accordance with IFRS® Standards — related
party disclosures under IAS 24 Related Party Disclosures and earnings per share disclosures under IAS 33
Earnings per Share. Given the widespread application and importance to a user of an entity’s financial state-
ments, we will discuss the main requirements of both these standards in this chapter.
LO1 19.1 RELATED PARTY DISCLOSURES

It is not uncommon in business for entities to establish relationships with other entities and individ-
uals, to interact with those parties, and to have outstanding balances and commitments with them.
For example, groups of entities may conduct their business activities through subsidiary organisations,
associated entities or joint venture operations. If an entity engages in transactions with other closely
connected entities there is a danger that the economics of the transaction may not be the same had
the transaction been negotiated by independent parties in an arm’s length arrangement. For example,
an entity might have an incentive to shift risks and returns in the form of profits or losses, income or
expense flows, or assets or liabilities to a party that it is able to influence or control. Paragraph 6 of
IAS 24 explains that related parties may enter into transactions on terms and conditions that would
not apply to unrelated parties. For example an entity might transact with an associate on more or less
favourable terms than it would use with another, unrelated individual or entity. Thus, a related party
association has the potential to have an impact on the profit or loss and financial position of an entity
that might not otherwise occur.
Paragraph 9 of IAS 24 provides a definition of when one party is considered to be related to another
party which includes close family members of a reporting entity, situations where control, joint control, or
significant influence exists, and where a person or entity is a member of the key management personnel
of a reporting entity.
The simple existence of a related party relationship has the potential to affect transactions with other
parties. As an example, a subsidiary entity might operate on the instructions of its parent entity. Accord-
ingly, knowledge of business relationships, related party transactions, outstanding balances and commit-
ments with related parties may affect assessments of the business risks faced by entities. For these reasons,
IAS 24 requires identification and disclosure of related parties, including related party transactions and any
outstanding balances and commitments.
LO2 19.1.1 Objective and scope

As mentioned, IAS 24 applies to the identification of related party relationships and transactions and out-
standing balances and commitments with related parties. It is used to identify the circumstances in which
the disclosure of these items should occur, and the relevant disclosures to make.
The objective of IAS 24 as outlined in paragraph 1 is to ensure that an organisation’s financial state-
ments contain the disclosures necessary to an understanding of the potential effect of transactions and
outstanding balances and commitments with related parties.
An alternative to the disclosure of related parties, transactions, balances and commitments could be
to restate the events as though they had occurred between independent parties in arm’s length transac-
tions. However, in many instances valuation of the events and their impacts would be very difficult, if not
impossible, to determine as comparable transactions simply may not exist. Thus the objective of disclosing
related party information is to ensure that the users of financial statements are provided with sufficient
knowledge to enable them to undertake an independent assessment of the risks and opportunities facing
entities which engage in related party transactions.
The major issues that must be considered, when determining the disclosures necessary to provide
sufficient knowledge to financial statement users, include identifying related parties and related party
arrangements, and deciding on the type and extent of the disclosure to be made. So, in summary, IAS 24
is applied in identifying related party relationships and transactions, identifying outstanding balances
and commitments between related parties, and determining when and what related party disclosures
must be made.
Paragraphs 3 and 4 of IAS 24 note that related party relationships, transactions, outstanding balances
and commitments are disclosed in the consolidated and separate financial statements of a parent, venturer
or investor presented in accordance with IFRS 10 Consolidated Financial Statements or IAS 27 Separate Finan-
cial Statements. However, intragroup transactions and balances are eliminated from consolidated financial
statements.

LO3 19.1.2 Identifying related parties
IAS 24 considers close family who are able to control or significantly influence the activities of the other
‘related’ entity to be related parties. This relationship is detailed in paragraph 9 of IAS 24. If any of the
conditions in paragraph 9 apply to an entity then it is regarded as a related party.
Definition of a related party
The conditions indicating whether one party is considered to be related to another are summarised in
table 19.1.
TABLE 19.1 Definition of a related party — IAS 24 (paragraph 9a, b)
Part a — A person or a close member of the person’s family is related to a reporting entity if that person:
(i) has control or joint control of the reporting entity
(ii) has significant influence over the reporting entity
(iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting
entity
Part b — An entity is related to a reporting entity if any of the following conditions apply:
(i) The entity and the reporting entity are members of the same group
(ii) The entity is an associate or joint venture of the entity (or an associate or joint venture of a member
of a group of which the other entity is a member)
(iii) Both entities are joint ventures of the same third party
(iv) An entity is a joint venture of a third entity and the other entity is an associate of the third entity
(v) The entity is a post-employment benefit plan for the benefit of employees of either the reporting
entity or an entity related to the reporting entity. If the reporting entity is 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 part (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
Source: IAS 24, paragraph 9.
A close member of the family of a person

Under paragraph 9, close family members are those who may be expected to influence or be influenced
by that person in their dealings with the entity. Thus, in determining who to consider close family mem-
bers, judgement is required. However, a person’s children, spouse or domestic partner, children of the
spouse or domestic partner, and dependants of the person or of their spouse or domestic partner, are
always to be considered close family members of a person, regardless of whether they are expected to
influence or be influenced by that person. Therefore, the close family members definition is an example
of IFRS Standards combining an underlying principle with a rule-based approach in determining rele-
vant disclosures.
Control, joint control, significant influence
Control is deemed to be when an investor is exposed, or has rights to variable returns from its involve-
ment in the investee and has the ability to affect those returns through its power over the investee. Joint
control is the contractually agreed sharing of control of an arrangement. Significant influence is the power
to participate in the financial and operating policy decisions of an entity, and may be gained by share
ownership, statute or agreement.
Determining whether a close family relationship has related party disclosure consequences is demon-
strated in illustrative example 19.1.

ILLUSTRATIVE EXAMPLE 19.1 Close family members with control or significant influence
Xavier is married to Yvonne and he has a controlling investment in Alpha Ltd. Yvonne holds an invest-
ment in Bracken Ltd that gives her significant influence over that company. In this relationship:
Xavier Yvonne
Control Significant influence
Alpha Ltd Bracken Ltd
• Bracken Ltd is a related party of Alpha Ltd as Xavier controls Alpha Ltd and his close family member
(his wife, Yvonne) has significant influence over Bracken Ltd.
• Alpha Ltd is a related party of Bracken Ltd as Yvonne has significant influence over Bracken Ltd and
her close family member (her husband, Xavier) controls Alpha Ltd.
• If Xavier only has significant influence over Alpha Ltd, then Alpha Ltd and Bracken Ltd are not
regarded as related entities under IAS 24.
Note: Several of the illustrative examples included in this chapter are derived from similar examples of
the Illustrative Examples appendices of IAS 24 and IAS 33.
Key management personnel

Under paragraph 9, key management personnel of the entity or the entity’s parent are related parties. Key
management personnel are people who have authority and responsibility for planning, directing and con-
trolling an entity’s activities either directly or indirectly. This includes directors whether they are executive
or otherwise.
An example of key management personnel identified by Billabong International Ltd, and disclosed in its
2014 annual report, is shown in figure 19.1.
FIGURE 19.1 Billabong International Ltd’s key management personnel
(a) Directors
The following persons were Directors of Billabong International Limited during the financial year:
(i) Non-Executive Chairman
Non-Executive Chairman
Ian Pollard
(ii) Executive Directors
Executive Directors
Neil Fiske Managing Director and Chief Executive Officer (CEO) from 21 September 20l3
Launa Inman Managing Director and CEO until 2 August 2013
Paul Naude President of the Americas (President Americas) until 5 August 2013
(iii) Non-Executive Directors
Non-Executive Directors
Tony Froggatt Director until 4 November 2013

Gordon Merchant AM Director
Howard Mowlem Director
Jason Mozingo Director from 4 November 2013
Colette Paull Director until 30 January 2014

Sally Pitkin Director

Jesse Rogers Director from 23 July 2013 until 4 November 2013
Keoni Schwartz Director from 23 July 2013 until 4 November 2013
Matthew Wilson Director from 4 November 2013
(b) Other key management personnel

The following persons also had authority and responsibility for planning, directing and controlling
the activities of the Group, directly or indirectly, during the financial year:
Other Key Management Personnel (KMP) Employer
Paul Burdekin Acting General Manager, Billabong Group Asia GSM (Operations) Pty Ltd
Pacific (GM Asia Pacific) from 3 March 2014. Role
confirmed 17 July 2014.
Franco Fogliato General Manager, Billabong Group Europe GSM Europe Pty Ltd
(GM Europe) until 2 November 2013.
Colin Haggerty Group Executive - Global Retail from 5 July 2012 GSM (Operations) Pty Ltd
until 19 November 2013. During the year also
performed the role of Acting President Americas
from 19 November 2012 to 4 October 2013.
Ed Leasure Acting President Americas (President Americas) Burleigh Point, Ltd
from 8 October 2013. Role confirmed
10 December 2013.
Peter Myers Chief Financial Officer (CFO) from 14 January GSM (Operations) Pty Ltd
2013. During the year also performed the role of
Acting Chief Executive Officer from 5 August 2013
to 21 September 2013.
Shannan North General Manager, Billabong Group Asia Pacific GSM (Operations) Pty Ltd
(GM Asia Pacific) until 3 March 2014, then Global
President, Brand Billabong from 3 March 2014.
Jean-Louis Rodrigues Acting General Manager, Billabong Group Europe GSM Europe Pty Ltd
(GM Europe) from 25 September 2013. Role
confirmed 10 December 2013.
Jeffrey Streader Global Chief Operating Officer (COO) from Burleigh Point, Ltd
4 May 2014.
Source: Billabong International Ltd (2014).
Determining whether a party is related to a member of key management personnel is demonstrated in

ILLUSTRATIVE EXAMPLE 19.2 Key management personnel
Jack has a 100% interest in Henty Ltd and he is also a member of the key management personnel of
Courier Ltd. Persimmon Ltd has a controlling interest in Courier Ltd.
In this set of circumstances:
• For Courier Ltd’s financial statements, Henty Ltd is a related entity because Jack controls Henty Ltd
and he is also a member of the key management personnel of Courier Ltd
• For Henty Ltd’s financial statements, Courier Ltd is a related entity because Jack controls Henty Ltd
and he is also a member of Courier Ltd’s key management personnel.
An associate of the entity

Under paragraph 9, any party that is determined to be an associate of the reporting entity is also consid-
ered to be a related party. An associated entity is one that is subject to the significant influence of another
party as described in IAS 28 Investments in Associates and Joint Ventures. An associate includes subsidiaries of
the associate (paragraph 12).

A joint venture
Any relationship that is determined to be a joint venture as defined in IAS 28 is regarded as a related party.
A joint venture includes subsidiaries of the joint venture. For example, an investor that jointly controls a
joint venture is related to the joint venture’s subsidiary (paragraph 12).
Post-employment benefit plan
A post-employment benefit plan includes pensions and other retirement benefits and post-employment
life insurance and medical care. IAS 24 does not provide an indication of why post-employment benefit
plans are defined as related parties. However, it is likely that an entity sponsoring a post-employment
benefit plan is likely to have either control or significant influence over the plan. There may also be obli-
gations or commitments outstanding at the end of a reporting period.
LO4 19.1.3 Relationships that are not related parties

Although the existence of related parties relationships are not uncommon in normal business life, there
are many transactions and events between parties that do not necessarily give rise to a related party rela-
tionship as envisaged under IAS 24. For example, an employee of a large retailer such as Billabong Inter-
national Ltd might purchase goods on normal trading terms in a Billabong store. It would be exceedingly
difficult for all such transactions to be identified and recorded, and the benefit of reporting them to users
is likely to be trivial. Further, in deciding whether a relationship exists that is subject to the disclosure
requirements of IAS 24, paragraph 10 makes it clear that it is the substance, and not merely the legal form
of a relationship or transaction, that is important. In this context, paragraph 11 identifies relationships that
are not regarded as related parties. For instance, entities are not related parties simply because they have
a director or a member of key management personnel in common, or because they share joint control in
a joint venture. Similarly, parties an entity engages with for a significant volume of its business are not
related parties to the entity simply as a result of the economic dependence that may arise.
LO5 19.1.4 Disclosures

In order for users of financial statements to form a view about the effects of the related party relation-
ships of an entity, paragraph 13 of IAS 24 requires the disclosure of the relationship where control exists,
irrespective of whether there have been transactions between the parties. If there have been transactions,
then the nature of the relationship together with sufficient information to enable an understanding of the
potential effect of the transactions on the financial statements must be disclosed.
Related party transactions and related party relationships
If the relationship is between parent and subsidiary entities, the identification of the parties is in addition to
the disclosure requirements of IFRS 12 Disclosure of Interests in Other Entities, IAS 27 Separate Financial Statements
and IAS 28. If the parent entity or the ultimate controlling entity does not make financial statements publicly
available, then under paragraph 13 of IAS 24 the name of the closest parent that does so must be disclosed.
All entities
To assist users of financial statements to form their view about the effects of related party relationships on
an entity, a range of information is required to be disclosed separately for each parent, entity with joint
control or significant influence, subsidiary, associate, joint venture in which the entity is a venturer, key
management personnel, and other related parties. The minimum disclosures are detailed under paragraph
18 and are summarised below.
(a) the amount of the transactions
(b) the amount of the outstanding balances and commitments including:
(i) their terms and conditions and whether they are secured, and the nature of the settlement consid-
eration to be provided
(ii) details of any guarantees provided or received
(c) provisions for doubtful debts related to outstanding balances
(d) the expense recognised during the period in respect of bad or doubtful debts due from related parties.
A major focus of the disclosure requirements of IAS 24 is directed towards revealing the remuneration
arrangements made for key management personnel. These requirements are intended to improve the trans-
parency of related party relationships with directors and influential senior executives. These disclosures,
contained in paragraph 17, are required in total and for each of a range of categories and are shown below:
(a) short-term employee benefits
(b) post-employment benefits
(c) other long-term benefits
(d) termination benefits
(e) share-based payment.
The key management personnel compensation disclosures provided by Billabong International Ltd in its
2014 annual report are shown in figure 19.2.

(c) Key management personnel compensation
2014 2013
$ $
Short-term employee benefits 7 017 192 7 671 090

Long-term employee benefits — long service leave 48 899 44 390
Termination benefits 3 087 799 735 374
Post-employment benefits 134 440 148 593
Share-based payments (1 231 383) (130 286)
9 056 947 8 469 161
Detailed remuneration disclosures are provided in the Remuneration Report.
FIGURE 19.2 Billabong International Ltd — key management personnel compensation

Source: Billabong International Ltd (2014, p. 137–138).
Examples of related party transactions that must be disclosed include the purchases or sales of goods
or services whether incomplete or finished, and the acquisition or disposal of assets including property.
Lease arrangements, transfers of research and development, transfers under licence agreements or finance
arrangements including loans and equity contributions require disclosure. Provisions of guarantees, com-
mitments including executory contracts, and the settlement of liabilities on behalf of the entity or by the
entity on behalf of a related party must also be disclosed.
An example of transactions with related parties and key management personnel is shown in the notes
accompanying Billabong’s 2014 annual report and is summarised in figure 19.3.
(e) Other transactions with Directors and other key management personnel
Directors of Billabong International Limited
During 2013 a subsidiary of the Company leased a retail store in South Africa from the wife of
Director P. Naude. The rental agreement was based on normal commercial terms and conditions.
FIGURE 19.3 Billabong International Ltd — transactions with directors and other key management
personnel
Source: Billabong International Ltd (2014, Note 33, p. 140).
LO6 19.1.5 Government-related entities

Numerous countries, for example, China, Germany, France, Russia and Eastern European nations, have a
sizeable number of entities that are controlled by the government. Often the practical difficulties and costs
for government-controlled entities of complying with the extensive disclosure requirements of IAS 24 are
likely to outweigh the benefits to financial statement users. Accordingly, paragraph 25 provides an exemp-
tion from some of the disclosure requirements for transactions between entities that are controlled, jointly
controlled or significantly influenced by a government and with other entities that are related because they
are controlled by the same government.
If an entity chooses to apply the exemption, it is still required to identify the government to which it is
related and to provide a range of other relevant disclosures. These include: the nature of the relationship;
the nature and amount of each individually significant transaction; and either a qualitative or a quantita-
tive indication of the extent of other transactions that are, in aggregate, significant.
LO7 19.2 EARNINGS PER SHARE

Earnings per share, commonly known as EPS, is a ratio that is calculated by comparing an entity’s profit
with the number of ordinary shares it has on issue. The earnings per share ratio is used to compare the
after-tax profit available to ordinary shareholders of an entity on a per share basis, with that of other entities.
The purpose of this section is to examine and understand the earnings per share information that is
presented in a reporting entity’s financial statements. In an effort to improve the information provided by
reporting entities, and with the objective of improving the consistency of comparisons between entities
and across different time periods, IAS 33 prescribes the principles for the computation and the presenta-
tion of earnings per share.
Under paragraph 10 of IAS 33, the approach taken to the calculation of the earnings per share ratio is
to divide profit or loss (earnings) attributable to ordinary shareholders of a parent entity, by the weighted

average number of ordinary shares the entity has on issue (outstanding) during the reporting period.
‘Profit’ is the numerator (top line) in the calculation and ‘outstanding shares’ is the denominator (bottom
line). The resultant ratio is known as ‘basic earnings per share’, and the objective of providing this infor-
mation is to show a measure of the interests of an ordinary shareholder in the performance (profit) of an
entity across a reporting period.
The earnings per share ratio has other important uses including as an indicator of future performance
and growth. Earnings revisions which impact earnings per share, whether they indicate improvements
or downgrades, provide information to the market and are usually reflected in a changing share price.
Earnings per share is also often used as a key performance indicator when determining the remuneration
entitlements of directors and executives. For example, Billabong International Ltd uses earnings per share
targets as performance hurdles when determining entitlements to long-term incentive bonuses. Billabong
International Ltd’s remuneration approach is presented in figure 19.4.
Awards under the ELTIP vest only if the performance hurdles are satisfied in the relevant performance
period. The performance periods are summarised in the table below:
% of award Performance
Grant Performance hurdle that vests Period
EPS performance 2.0 cents per share 50% Financial year

4.0 cents per share 100% ended 30 June 2016
2013–14 TSR performance 50th percentile or above 50% 1 January 2014 until
relative to 75th percentile or above 100% 30 September 2016
comparator group
50% of awards are based on Executives meeting the Group’s 3-year EPS performance targets. EPS is
a financial indicator of the Group’s earnings in the final year of the performance period. In previous
periods the EPS performance hurdle was determined based upon 3-year compound growth rates
in EPS from a base year. However, due to the significant changes to the capital structure of the
Group, the Board has selected EPS (rather than the growth rate of EPS) as the appropriate internal
performance metric.
FIGURE 19.4 Billabong International Ltd’s remuneration report

Source: Billabong International Ltd (2014, p. 37).
The utility of earnings per share has been criticised because of the flexibility that entities have in choosing
accounting methods when determining their profit. While accounting policy choice enables entities to select
the accounting methods that are the most appropriate to reflect their actual business operations, it results
in inconsistencies between entities in the determination of their profit. For example, entities may select
the depreciation method that best reflects the pattern of usage of their physical assets (see IAS 16 Property,
Plant and Equipment, paragraph 60). If one entity chooses the straight-line method then a constant charge
is made against its profit across the useful life of its assets. However, if another entity selects the dimin-
ishing balance method, then the expense charged against its profit will decrease over its assets’ useful lives.
Therefore, it must be recognised that earnings per share data disclosed by reporting entities have limita-
tions because of the different accounting methods that can be used in the determination of profit. Further-
more, it is not uncommon for entities to disclose so-called ‘adjusted earnings’ measures, accompanied by
adjusted earnings per share. Comparing such non-GAAP measures across companies requires insight into
the adjustments made. Entities disclosing adjusted earnings per share measures should therefore reconcile
the adjusted earnings to the profit or loss measure applied under IAS 33 (paragraphs 73 and 73A).
Another limitation to the utility of the earnings per share ratio for comparison purposes is that it can
be altered simply by changing the number of shares used in the denominator. The focus taken in IAS 33
is that a consistently determined denominator in the earnings per share calculation enhances financial
reporting (paragraph 1). Despite the limitations of earnings per share as an indicator of the performance
of an entity, it is widely used in share analysis.
LO8 19.2.1 Scope

IAS 33 applies to the computation and presentation of earnings per share by reporting entities whose
shares are publicly traded, or of entities that are in the process of issuing ordinary shares that will be
traded in public markets (paragraph 1).
Under paragraph 4, if an entity presents both consolidated and separate financial statements, the IAS
33 disclosures need only be determined on the basis of consolidated information. As the parent entity
earnings per share information may be helpful to some users, entities have the option of also disclosing
earnings per share figures for the parent entity. However this information can only be presented in the

parent’s separate financial statements and not in the consolidated financial statements (IAS 33 BC para-
graphs 5, 6). The earnings per share information presented by Nestlé Group in its 2014 income statement
is presented in figure 19.5.
Earnings per share (in CHF)
Basic earnings per share 16 4.54 3.14

Diluted earnings per share 16 4.52 3.13
FIGURE 19.5 Earnings per share disclosed in income statement of Nestlé Group
Source: Nestlé Group (2014, p. 58) [only the EPS disclosures].
LO9 19.2.2 Basic earnings per share

As mentioned, earnings per share is measured by dividing profit (or loss) attributable to ordinary share-
holders by the weighted average number of ordinary shares outstanding during the period. This measure-
ment approach, which results in a ratio known as ‘basic’ earnings per share (paragraph 9), is demonstrated
in figure 19.6.
Profit attributable to ordinary shareholders of the parent entity

Weighted average number of ordinary shares outstanding during the reporting period
FIGURE 19.6 Basic earnings per share ratio
Earnings
The profit or loss (profit) that is used in the calculation of basic earnings per share must be from contin-
uing operations. It must also include any income or expense attributable to ordinary shareholders that
has been recognised in the reporting period. This will mean that any tax expense and any dividends on
preference shares that have been classified as liabilities will be deducted as part of the determination of
profit. Tax expense is a normal component of the profit of an entity, and therefore it is a normal part of the
calculation of profit. Preference dividends do not belong to the ordinary shareholders and therefore they
must be included in the profit calculation as a deduction. This approach to the determination of the profit
to be used in the calculation of earnings per share is outlined in paragraphs 12 and 13, and is demon-
strated in figure 19.7.
Profit before tax expense 100 000

Less: Tax expense (30 000)
Profit after tax 70 000
Less: Preference dividends (10 000)
Profit attributable to ordinary equity holders (earnings) 60 000 (numerator)
FIGURE 19.7 Earnings calculation to include tax expense and preference dividends
The preference dividends are to be on an after-tax basis, and for non-cumulative preference dividends
they are to include any amounts declared during the period. In respect of cumulative dividends, paragraph
14 requires the after-tax amount to be deducted whether or not a dividend is declared during the period.
Any cumulative dividends paid during the period but which relate to prior periods are not part of the
calculation.
If an entity presents discontinued operations under IFRS 5 Non-current Assets Held for Sale and Discon-
tinued Operations, the entity shall also disclose the earnings per share for the discontinued operations. An
entity may choose to disclose earnings per share from discontinued operations in the notes, instead of on
the face of the statement of comprehensive income.
Repurchases and conversion of preference shares
If an entity chooses to repurchase preference shares it has on issue, then the excess of the fair value of the
consideration paid over the carrying amount of the shares represents a return to preference shareholders
and a charge against retained earnings. Paragraph 16 requires this amount to be included in the calculation
of earnings per share, as a deduction when determining the profit attributable to ordinary shareholders.
Similarly, any excess of the fair value of the ordinary shares issued on conversion of preference shares
over the fair value of the ordinary shares issuable under the original conversion terms must be deducted in
calculating the profit attributable to ordinary shareholders (paragraph 17).

The treatment of cumulative and non-cumulative dividends is demonstrated in illustrative example 19.3.
ILLUSTRATIVE EXAMPLE 19.3 Non-cumulative and cumulative preference dividends
Poulos Ltd has 100 000 Class A preference shares on issue, each carrying a non-cumulative dividend
right of 3% of the $1 par value of the share. A non-cumulative dividend was declared during the
reporting period. The company also has 200 000 Class B preference shares outstanding which carry a
cumulative dividend right of 2% per share based on the par value of $1 per share. The company has a
profit for the period from continuing operations amounting to $1.5 million, and tax is payable at the
rate of 30%.
The earnings (profit attributable to ordinary shareholders) to be used in the calculation of basic earn-
ings per share for Poulos Ltd is calculated as shown below.
Determination of earnings to include tax expense and preference dividends
Calculation $
Profit before tax 1 500 000

Tax expense (450 000)
Profit after tax 1 050 000
Preference dividends (7 000)*
Profit attributable to ordinary equity holders 1 043 000
*([100 000 × 3%] + [200 000 × 2%])
Shares
As the earnings per share calculation is focused on the ordinary equity of an entity, the denominator
in the calculation contains only ordinary share capital. Because entities are able to make new share
issues during a reporting period, the number of shares on issue can increase. They are also able to
repurchase or cancel shares, which will decrease the number of shares on issue, and to split or to con-
solidate shares, which will vary the number of shares on issue. Other actions, including the conversion
of convertible preference shares or other convertible securities into ordinary shares, can also vary the
amount of shares outstanding. Accordingly, the number of ordinary shares that is used in the calcula-
tion of basic earnings per share is adjusted by a time-weighting factor, which is the number of days in
the reporting period that the shares are outstanding as a proportion of the total number of days in the
period (paragraph 20).
Shares are included in the calculation from the date that the consideration for shares is receivable (par-
agraph 21). For example, shares issued for cash is included when cash is receivable; ordinary shares issued
on the reinvestment of dividends are included when the dividends are reinvested; shares issued when debt
is converted or when the shares replace interest or principal on other financial instruments are included
from the date interest ceases to accrue. If ordinary shares are issued in exchange for the settlement of a
liability, then they are included from the settlement date or, if they are issued in exchange for services
rendered, they are included from the date of rendering the services. Any ordinary shares issued as consid-
eration for the acquisition of a non-cash asset are included in the calculation from the date on which the
acquisition is recognised; and if shares are issued as part of the consideration in a business combination,
they are included from the acquisition date as this reflects the date from which the acquiree’s profits are
included in the acquirer’s income.
Share consolidation and share repurchase
While a consolidation of shares will decrease the number of shares on issue, there is no corresponding
reduction in the entity’s resources. However, when a repurchase occurs, the entity’s resources (e.g. cash)
will also be reduced. Shares that are repurchased and held by the issuing entity are termed ‘Treasury’
shares. If a purchase of Treasury shares (share repurchase) occurs, then the weighted average number of
shares outstanding for the period in which the transaction takes place must be adjusted for the reduction
in the number of shares from the date of the event (paragraph 29).
The calculation of the weighted average number of ordinary shares where a new share issue and a share
repurchase have occurred during the period is demonstrated in illustrative example 19.4.

ILLUSTRATIVE EXAMPLE 19.4 Determining the weighted average number of shares
Singapore Ltd has 11 000 ordinary shares on issue at 1 January 2015, which is the beginning of its
reporting period, of which 500 have been repurchased in previous reporting periods. On 30 June 2015,
it issued a further 1000 ordinary shares for cash. On 1 November 2015, Singapore Ltd repurchased 300
shares at fair value in a market transaction.
Issued Treasury Shares

shares shares outstanding
1 January 2015 Balance at the beginning of the year 11 000 500 10 500
30 June 2015 Issue of new ordinary shares for cash 1 000 11 500
1 November 2015 Repurchase of issued shares 300 11 200
31 December 2015 Balance at the end of the year 12 000 800 11 200
The weighted average number of shares for use in the earnings per share calculation is determined as
follows:
= (10 500 × 6/12) + (11 500 × 4/12) + (11 200 × 2/12)
= 5250 + 3833 + 1867
= 10 950 shares
Contingently issuable shares

An entity may have contingently issuable shares outstanding. These are ordinary shares that the entity can
issue for little or no cash or other consideration once a specified condition has been satisfied (paragraph
5). If an entity has contingently issuable shares, then these must be treated as outstanding and they are
included in the calculation of basic earnings per share from the date when all necessary conditions have
been satisfied (paragraph 24). The impact of contingently issuable shares on diluted earnings per share is
discussed later (see section 19.2.3)
Bonus issues and share splits
If an entity announces a bonus issue of shares, or if it splits issued shares thereby increasing the number
of shares outstanding, there is usually no consideration involved and therefore no corresponding increase
in the entity’s resources. The number of ordinary shares outstanding before the event must be adjusted
for the proportionate change in the number of ordinary shares outstanding as if it had occurred at the
beginning of the earliest period presented in the financial statements (paragraph 28). For example, under
a two-for-one bonus issue, multiplying the number of ordinary shares outstanding before the bonus issue
determines the number of additional ordinary shares. The effect of a bonus issue of shares on the basic
earnings per share calculation is demonstrated in illustrative example 19.5.
ILLUSTRATIVE EXAMPLE 19.5 Bonus issue of shares
Jackson Ltd determined its profit attributable to ordinary shareholders for the reporting period ended 31
December 2015 as $360 000 (2014: $320 000). The number of ordinary shares on issue up to 30 April
2015 was 50 000. Jackson Ltd announced a two-for-one bonus issue of shares effective for each ordinary
share outstanding at 30 April 2015 on 1 May 2015.
Basic earnings per share is calculated as follows:
Bonus issue on 1 May 2015 50 000 × 2 = 100 000

360 000
Basic earnings per share 31 December 2015 = $2.40
50 000 + 100 000
320 000
Basic earnings per share 31 December 2014 = $2.13
50 000 + 100 000
Because the bonus shares were issued for no consideration, the event is treated as if it had occurred
before the beginning of the 2014 reporting period, the earliest period presented in the financial state-
ments (paragraph 28).

Rights issues
In a bonus issue as the shares are usually issued for no consideration there is an increase in the number of
shares outstanding, which is not accompanied by a corresponding increase in the resources of the issuing
entity. However, in a rights issue the exercise price is usually lower than the fair value of the shares issued.
This means that the rights issue includes a bonus element. In this case, the application guidance in IAS 33
(paragraph A2) requires that the number of ordinary shares used in the calculation of earnings per share, for
all periods before the rights issue, is to be the number of ordinary shares outstanding before the rights issue
multiplied by an adjustment factor. The components of the adjustment factor are shown in figure 19.8.
Fair value per share immediately before the exercise of rights

Theoretical ex-rights fair value per share
FIGURE 19.8 Adjustment factor for rights issues containing a bonus element
The ‘theoretical ex-rights fair value per share’ is calculated by adding the aggregate market value of the
shares immediately before the exercise of the rights to the proceeds from the exercise of the rights, and
then dividing by the number of shares outstanding after the exercise of the rights, as shown in figure 19.9.
Fair value of all outstanding shares immediately before the exercise of rights
+ total proceeds from the exercise of the rights
Number of shares outstanding after the exercise of the rights
FIGURE 19.9 Theoretical ex-rights value per share
Fair value is the share price at the close of the last day on which the shares were traded together with the
rights. The calculation of basic earnings per share where there is a rights issue during the period is demon-
strated in illustrative example 19.6.
ILLUSTRATIVE EXAMPLE 19.6 Rights issue
Georgiou Ltd determined its profit attributable to ordinary shareholders for the reporting period ended
31 December 2015 as $5000. At the beginning of the reporting period the company had 1000 ordinary
shares on issue. It announced a rights issue with the following details:
• date of rights issue, 1 January 2015
• last date to exercise rights, 1 March 2015
• one new share for each four outstanding (250 total)
• exercise price, $10
• market price of one share immediately before exercise on 1 March 2015, $12.
Determine the theoretical ex-rights value per share
Fair value of all outstanding shares immediately before the exercise of rights
+ total proceeds from the exercise of the rights
Number of shares outstanding after the exercise of the rights
($12 × 1000 shares) + ($10 × 250 shares)

= $11.60
1000 shares + 250 shares
Determine the adjustment factor
Fair value per share immediately before the exercise of rights $12
= 1.03
Theoretical ex-rights fair value per share $11.60
5000
Profit attributable to ordinary shareholders 30 June 2014 = $4.12
(1000 × 1.03 × 2/12) + (1250 × 10/12)

LO10 19.2.3 Diluted earnings per share
In addition to calculating the basic earnings per share ratio, if an entity has options, warrants, contingently
issuable shares or convertible securities, then it must also recognise the effect of potential dilution to its
earnings per share ratio. The potential dilution effect stems from assumptions that the entity’s convert-
ible securities are converted, its warrants or options are exercised or that its contingently issuable shares
are issued on the satisfaction of their specified conditions. Adjustments must be made to the profit (or
loss) attributable to the ordinary shareholders. The adjustments are for the after-tax amount of dividends,
interest or other income or expenses recognised in the reporting period in respect of the dilutive secur-
ities that would no longer arise if they were indeed converted into ordinary shares. Adjustments must
also be made to increase the weighted average number of ordinary shares outstanding to reflect what the
weighted average would have been, assuming that all potential ordinary shares (dilutive securities) had
been converted.
The information regarding potential (dilutive) ordinary shares appearing in the financial statements of
Billabong International Ltd is presented in figure 19.10.
(e) Information concerning the classification of securities

Performance shares and conditional rights
Performance shares and conditional rights granted to employees under the Billabong Executive Perfor-
mance Share Plan are considered to be potential ordinary shares and have not been included in the
determination of diluted earnings per share because they are anti-dilutive for the year ended 30 June
2014. The performance shares and conditional rights have also been excluded in the determination of
basic earnings per share. Details relating to the rights are set out in note 45.
Options
The 314 503 options granted on 31 October 2008 in relation to the Billabong Performance and
Retention Plan are not included in the calculation of diluted earnings per share because they are
anti-dilutive for the year ended 30 June 2014. These options could potentially dilute basic earnings
per share in the future.
The 42 259 790 options granted on 16 July 2013 to the Altamont Consortium are not included
in the calculation of diluted earnings per share because they are anti-dilutive for the year ended
30 June 2014. These options could potentially dilute basic earnings per share in the future.
The 29 581 852 options granted on 3 December 2013 to the C/O Consortium are not included
because they are anti-dilutive for the year ended 30 June 2014. These options could potentially dilute
basic earnings per share in the future.
The 1 200 000 options granted on 31 January 2014 to Pat Tenore, the founder of RVCA, are not
included in the calculation of diluted earnings per share because they are anti-dilutive for the year
ended 30 June 2014. These options could potentially dilute basic earnings per share in the future.
Deferred shares
Rights to deferred shares granted to executives under the Group’s short-term incentive scheme are
included in the calculation of diluted earnings per share assuming all outstanding rights will vest. The
rights are not included in the determination of basic earnings per share. Further information about
the rights is provided in note 45.
FIGURE 19.10 Billabong International Ltd — potential (dilutive) ordinary shares
Source: Billabong International Ltd (2014, Note 44, p. 154).
IAS 33 regards potential ordinary shares as dilutive only if their conversion to ordinary shares would
decrease earnings per share (or increase loss per share) from the continuing operations of an entity (para-
graph 41). Potential ordinary shares can be anti-dilutive. An anti-dilutive effect would occur if the conver-
sion of potential ordinary shares would increase earnings per share (paragraph 5).
In Figure 19.11 the disclosure of potential ordinary shares not being dilutive in UBS Group AG’s 2014
financial statements is presented.
If potential ordinary shares were to be converted, any dividends or interest payable in relation to those
dilutive securities would no longer arise. Instead the new ordinary shares would be entitled to participate
in profit. Therefore the profit must be increased to remove the impact of the dividends or interest that
would otherwise have been payable. Similarly any other income or charges such as transaction costs,
that are related to the potential ordinary shares and that have been included in profit, must be removed
(paragraph 33).
Any consequential changes in income or expenses arising as a result of the potential conversion of dilu-
tive securities must also be adjusted in determining the earnings amount used in the diluted earnings per
share ratio. Consequential changes may include a reduction in interest expense related to potential ordi-
nary shares resulting in an increase in profit (paragraph 35).

The table below outlines the potential shares which could dilute basic earnings per share in the future,
but were not dilutive for the periods presented.
% change from
Number of shares 31.12.14 31.12.13 31.12.12 31.12.13

Potentially dilutive instruments
Employee share-basad
compensation awards 94 335 120 117 623 624 233 256 208 (20)
Other equity derivative contracts 6 728 173 16 517 384 15 386 605 (59)
SNB warrants2 0 0 100 000 000
Total 101 063 293 134 141 008 348 642 813 (25)
2
These warrants related to the SNB transaction. The SNB provided a loan to a fund owned and controlled by the SNB
(the SNB StabFund), to which UBS transferred certain illiquid securities and other positions in 2008 and 2009. As part of
this arrangement, UBS granted warrants on shares to the SNB, which would have been exercisable if the SNB incurred a
loss on its loan to the SNB StabFund. In 2013, These warrants were terminated following the full repayment of the loan.
FIGURE 19.11 UBS Group AG — potential (non-dilutive) ordinary shares

Source: UBS Group AG (2014, Note 9, p. 438). Earnings.
Shares
The diluted earnings per share ratio must include an adjustment to increase the weighted average number
of ordinary shares that would be outstanding if all of the dilutive securities were converted into ordinary
shares. Paragraph 36 deems that the potential ordinary shares are to be regarded as having been converted
into ordinary shares at the beginning of the period or, if later, the date of the issue of the potential ordi-
nary shares.
The potential ordinary shares shall be weighted for the period that they are outstanding. If any of the
dilutive securities lapse or are cancelled, they are included in the calculation only for the portion of time
during which they are outstanding. Any dilutive securities 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 (paragraph 38). If the terms of dilutive securities include more than one basis
for conversion into ordinary shares, then under paragraph 39, the most favourable conversion rate or price
from the perspective of the security holder is used.
Dilutive potential ordinary shares
As mentioned, potential ordinary shares are regarded by IAS 33 as dilutive only if their conversion to
ordinary shares would decrease earnings per share or increase loss per share (paragraph 41). In deciding
whether potential ordinary shares are dilutive (or anti-dilutive) each issue or series of potential dilutive
securities is considered separately. The conversion, exercise or other issue of potential ordinary shares that
would have an anti-dilutive effect on earnings per share is not assumed in the calculation of diluted earn-
ings per share (paragraph 43).
When determining the dilutive effect of potential ordinary shares, each issue or series of dilutive
securities is considered in sequence from most dilutive to least dilutive (paragraph 44). This means that
the securities with the lowest earnings impact, per incremental share, are included in the calculation
before those securities with the highest earnings impact per incremental share. This generally means that
options and warrants are included first, because they do not usually affect the numerator (earnings) in
the ratio.
Options and warrants
The proceeds from options and warrants are regarded as received from the issue of ordinary shares at
the average market price during the period. Paragraphs 45–46 require that the difference between the
number of ordinary shares issued and the number that would have been issued at the average market price
be treated as an issue of ordinary shares for no consideration. The application guidance to IAS 33 indi-
cates that a simple average of the weekly or monthly closing prices of ordinary shares is usually adequate
for determining the average market price (paragraphs A4–A5). However, this approach will need to be
adjusted when shares prices fluctuate widely.
Options and warrants are regarded as dilutive if they would result in the issue of ordinary shares for less
than the average market price during the period (i.e. when they are ‘in the money’). The amount of the
dilution is determined as the average market price of ordinary shares during the period minus the issue
price. Employee share options and non-vested ordinary shares are regarded as options in the calculation of
diluted earnings per share (paragraph 48).

The effect of share options on basic and diluted earnings per share is demonstrated in illustrative
example 19.7.
ILLUSTRATIVE EXAMPLE 19.7 Effect of share options on earnings per share
Harlem Ltd determined its profit attributable to ordinary shareholders for the reporting period ended
30 June 2015 as $480 000. The average market price of the entity’s shares during the period is $4.00
per share. The weighted average number of ordinary shares on issue during the period is 1 000 000. The
weighted average number of shares under share options arrangements during the year is 200 000 and the
exercise price of shares under option is $3.50.
Earnings Shares Per share

$ $
Profit attributable to ordinary shareholders for the reporting
period ended 30 June 2015 480 000
Weighted average shares on issue during the period 1 000 000
Basic earnings per share 0.48
Diluted earnings per share is calculated as follows:
Weighted average number of shares under option 200 000
Weighted average number of shares that would have been
issued at average market price is (200 000 x $3.50) / $4.00 (175 000)
Diluted earnings per share 480 000 1 025 000 0.47
Convertible securities
If convertible preference shares are dilutive they are included in the diluted earnings per share calculation.
They are regarded as anti-dilutive if the amount of the dividend declared or accumulated in the current
period per ordinary share, obtainable on the conversion, exceeds basic earnings per share. Similarly, con-
vertible debt is regarded as anti-dilutive whenever its interest (net of tax and other changes in income or
expenses) per ordinary share obtainable on conversion, exceeds basic earnings per share.
Contingently issuable shares
Contingently issuable shares such as performance-based employee share options are regarded as out-
standing, and if their conditions are satisfied they are included in the calculation of diluted earnings per
share from the beginning of the period (or the date of the contingent share agreement, if later). If the
conditions are not satisfied, the number of contingently issuable shares that is included in the diluted
earnings per share calculation is based on the number of shares that would be issuable if the end of the
period were the end of the contingency period (paragraph 52).
If the number of contingently issuable ordinary shares is dependent on both future earnings and
future prices of ordinary shares, then the number of ordinary shares included in the diluted earnings per
share calculation is based on both conditions. That is, it is based on both earnings to date and on the
current market price of the ordinary shares at the end of the reporting period (paragraph 55). Unless
both conditions are met, contingently issuable shares are not included in the diluted earnings per share
calculation.
Contracts that may be settled in ordinary shares or cash
If an entity has issued a contract that may be settled in cash or ordinary shares at the entity’s option, then
under paragraph 58 it is assumed that the settlement will be in ordinary shares. As a result the potential
ordinary shares are included in the diluted earnings per share calculation if the effect is dilutive.
For contracts that can be settled in cash or in ordinary shares at the holder’s option, then the more
dilutive of either the cash settlement or the share settlement is used in the diluted earnings per share cal-
culation (paragraph 60). Such contracts could include an option that provides the holder with settlement
choice of cash or ordinary shares.
As mentioned, when determining the dilutive effect of potential ordinary shares, each issue or series of
dilutive securities is considered in sequence from most dilutive to least dilutive (paragraph 44). Securities
with the lowest earnings impact per additional share are included in the calculation first. Determining the
order in which to include dilutive securities is demonstrated in illustrative example 19.8.

ILLUSTRATIVE EXAMPLE 19.8 Calculation of weighted average number when more than one issue of potentially
dilutive securities exist
Bruin Ltd extracted the following information from its financial records in order to determine its basic
earnings per share and diluted earnings per share for its reporting period ended 31 December 2015.
Profit from continuing operations $16 400

Less: Dividends on preference shares (6 400)
Profit from continuing operations attributable to ordinary shareholders 10 000
Loss from discontinued operations (4 000)
Profit attributable to ordinary shareholders 6 000
Ordinary shares on issue 2 000

Average market price of one ordinary share during the period $ 7.50
Potential ordinary shares (potentially dilutive securities):
1. Options 10 000 with an exercise price of $6.00
2. Convertible preference shares 800 shares with an issue value of $100 entitled to a
cumulative dividend of $8 per share. Each preference
share is convertible to two ordinary shares.
Determine the increase in earnings attributable to ordinary shareholders on conversion of potential ordinary shares
Options
Increase in earnings $0
Additional shares issued for no consideration 10 000 × (7.50 − 6.00) / 7.50 2 000
Earnings per additional share $0
Convertible preference shares
Increase in earnings ($80 000 × 0.08) $6 400
Additional shares (2 × 800) 1 600
Earnings per additional share $4.00
The dilutive securities are included in the earnings per share calculation in the following order:
1. Options
2. Convertible preference shares
Determine dilutive effect of convertible securities
$ Shares $ per share
Profit from continuing operations attributable to
ordinary shareholders 10 000 2 000 5.00
Increase in earnings from options 0 2 000
10 000 4 000 2.50 Dilutive
Increase in earnings from convertible preference 6 400 1 600
shares* 16 400 5 600 2.93 Anti-dilutive
* As the convertible preference shares increased diluted earnings per share they would be considered anti-dilutive
and ignored in the calculation of diluted earnings per share.
Calculate basic EPS and diluted EPS

Basic EPS Diluted EPS
$ $
Profit from continuing operations attributable to ordinary shareholders 5.00 2.50
Loss from discontinued operations attributable to ordinary shareholders
($4 000/2 000) (2.00)
($4 000/4 000) (1.00)
Profit attributable to ordinary shareholders
($6 000/2 000) 3.00
($6 000/4 000) 1.50

LO11 19.2.4 Retrospective adjustments
Retrospective adjustments are made to restate the values of relevant items so that valid comparisons across
time can be made. If, for example, the number of issued shares increases during a reporting period as a
result of a bonus issue for no consideration, then the operating profit for the whole period in which the
bonus issue occurred will be attributable to the increased number of shares and not to the lesser number
of shares outstanding at the beginning of the reporting period.
IAS 33 paragraph 64 requires that if the number of ordinary shares or of potential ordinary shares out-
standing increases as a result of a:
• capitalisation
• bonus issue
• share split;
or if the number decreases as a result of a:
• consolidation (reverse share split); then,
the calculation of both basic earnings per share and diluted earnings per share must be adjusted retro-
spectively for all periods that are presented in the financial statements. The retrospective adjustment to the
number of shares also applies to the period from the end of the reporting period but before the financial
statements are authorised for issue. Further, basic and diluted earnings per share are both subject to ret-
rospective adjustment for the effects of any errors or adjustments resulting from changes in accounting
policies that are accounted for retrospectively.
LO12 19.2.5 Disclosures

The basic earnings per share and diluted earnings per share ratios must be presented in an entity’s state-
ment of profit or loss and other comprehensive income (paragraph 66) even if the amounts are negative
(paragraph 69). If the items of profit or loss are presented in a separate statement then the basic and
diluted earnings per share ratios are required to be presented in that separate statement. The two ratios
must be displayed with equal prominence, and they must be calculated for each class of ordinary shares
that have different rights to share in the profit of the period. If diluted earnings per share is presented for
one period, then it must be shown for all periods that are presented in the financial statements, even if it is
the same as the basic earnings per share. And, if the entity has a discontinued operation, then it must also
calculate and disclose the basic and diluted earnings per share ratios for the discontinued operation in the
statement of profit or loss and other comprehensive income.
Paragraphs 70–73 of IAS 33 prescribe various disclosures relating to earnings per share. The objective
of these disclosures is to provide sufficient additional information to assist financial statement users to
understand the composition of the earnings per share ratios.
For instance, Nestlé Group includes a reconciliation of the weighted average number of shares used in
its basic and diluted earnings per share calculation in Note 16 in its 2014 financial statements. The recon-
ciliations are presented in figure 19.12.
Reconciliation of weighted average number of shares outstanding (in millions

of units)
Weighted average number of shares outstanding used to calculate basic earnings
par share 3 188 3 191
Adjustment for share-based payment schemes, where dilutive 8 9
Weighted average number of shares outstanding used to calculate diluted
earnings per share 3 196 3 200
FIGURE 19.12 Reconciliation of weighted average number of shares — Nestlé Group

Source: Nestlé Group (2014, p. 117).
As discussed earlier (see sections 19.2.2 and 19.2.3), if, in addition to calculating basic and diluted earn-
ings per share, an entity uses a numerator other than the one required by IAS 33, then it must still use the
denominator as prescribed under IAS 33 (paragraph 73). These additional ratios must be displayed with
equal prominence as the prescribed basic EPS and diluted EPS ratios and presented in the notes to the
financial statements. The basis on which the numerator is determined, including whether the amounts per
share are before or after tax, must also be disclosed.
IAS 33 also encourages the voluntary disclosure of the terms and conditions of financial instruments
and contracts that incorporate terms and conditions affecting the measurement of basic and diluted earn-
ings per share.

SUMMARY
This chapter covers two common key disclosures in an entity’s IFRS Standards financial statements —
related party disclosures and earnings per share disclosures.
IAS 24 is a disclosure standard that defines related party relationships and prescribes the events, trans-
actions, balances and commitments that must be revealed in the financial statements and reports of dis-
closing entities. As related party relationships can be expected to affect the profit or loss or the financial
position of an entity, disclosures about them are particularly helpful to investors, lenders and other users
when they evaluate and assess the risks and opportunities facing entities. The main features of IAS 24 are
that it:
• considers key management personnel and their close family members to be related parties
• considers compensation benefits for key management personnel to be related party transactions.
Determining when related party relationships exist and identifying the circumstances in which disclo-
sures about such relationships must be disclosed involves a certain amount of judgement. In making that
judgement, entities must take into account the definitions of related parties provided in IAS 24. The defi-
nition of related parties includes:
• relationships affected by control or significant influence or joint venture arrangements
• key management personnel and close family members.
IAS 33 provides principles for the calculation and presentation of basic and diluted earnings per share.
Earnings per share is a ratio which is used to compare the after-tax profit available to ordinary share-
holders of an entity on a per share basis, with that of other entities. It is calculated by dividing profit or
loss (earnings) attributable to ordinary shareholders, by the weighted average number of ordinary shares
outstanding during a reporting period.
The objective of IAS 33 is to improve the information provided by reporting entities, and the consist-
ency of comparisons between entities and across different time periods.
The main features of the standard are that it requires:
• the profit (or loss) used in the calculation of basic earnings per share to be from continuing
operations. This means that any tax expense and dividends on preference shares that have been
classified as liabilities will be deducted as part of the determination of profit.
• the denominator in the calculation to contain only ordinary shares
• the number of ordinary shares used in the calculation of basic earnings per share to be adjusted
by a time-weighting factor which is the number of days in the reporting period that the shares are
outstanding as a proportion of the total number of days in the period.
In addition to calculating the basic earnings per share ratio, if an entity has options, warrants, contin-
gently issuable shares or securities that are convertible to ordinary shares, IAS 33 requires that the effect
of dilution must be recognised in the entity’s earnings per share. Adjustments to calculate diluted earnings
per share must be made to:
• the profit (or loss) attributable to the ordinary shareholders for the after-tax amount of dividends,
interest or other income or expenses that would no longer arise if the dilutive securities were converted
into ordinary shares
• increase the weighted average number of ordinary shares outstanding to reflect what the weighted
average would have been assuming that all potential ordinary shares (dilutive securities) had been
converted.
Related party disclosures
1. Why do standard setters formulate rules for the disclosure of related party relationships?
2. Explain why key management personnel are regarded as related parties.
3. Explain why a parent company and its subsidiary entities are regarded as related parties.
4. Distinguish between control, joint control and significant influence.
5. Explain how an entity determines whether a family member is a related party.
Earnings per share

1. What is the earnings per share ratio used for?
2. Why is a time-weighting factor used to determine the number of shares that is used in the calculation of
basic earnings per share?
3. What is the treatment applied to treasury shares when calculating the weighted average number of
shares used in the earnings per share calculation?
4. Distinguish between basic earnings per share and diluted earnings per share.
5. Explain the effect of potential ordinary shares on the calculation of diluted earnings per share.
6. Why are retrospective adjustments made to earnings per share ratios?

References
Billabong International Ltd 2014, 2014 Full Financial Report, Billabong International Limited, Australia,
www.billabongbiz.com.
Durkin, P. 2009, ‘Board forced to rethink exec pay’, Australian Financial Review, 9 November.
International Accounting Standards Board 2009, IAS 24 Related Party Disclosures, www.ifrs.org.
International Accounting Standards Board 2010, IAS 33 Earnings per Share, International Accounting
Standards Committee Foundation, London.
Nestlé Group, Annual Report 2014, http://www.nestle.com/asset-library/documents/library/documents/
financial_statements/2014-financial-statements-en.pdf.
UBS Group AG 2014, Annual Report 2014, www.ubs.com.
Williams, F. 2009, ‘Hegarty moving again’, Herald Sun, 20 March, p. 63.

★ Which of the following is the related party of an entity within the scope of IAS 24? Give reasons for your
answer.
(a) A person who has the authority to plan, direct and control the activities of the entity.
(b) The domestic partner and children of a director of the entity.
(c) The non-dependant sister of a director of the entity.
(d) A subsidiary company that is directly controlled by the entity.
(e) Dividend payment to employees who are holders of an entity’s shares.
Exercise 19.2 RECOGNITION PRINCIPLES

★ Jay Wendt is a newly appointed director of Armstrong Ltd, a listed company that organises major sporting
events. Jay has provided consultancy services to Armstrong Ltd for the past 10 years. In the most recent
financial year these services amounted to $500 000.
Required
Determine whether the consultancy service provided by Jay is a related party transaction that should be
disclosed in the financial statements of Armstrong Ltd. Explain your answer.
Exercise 19.3 DETERMINING WHETHER PARTIES ARE RELATED

★★ Jacques holds 100% of the shares in Cannes Ltd and he is also a director of Revoir Ltd. All of the shares in
Revoir Ltd are held by Baroque Ltd.
Required
Determine the related party relationships for Cannes Ltd.
Exercise 19.4 EFFECT OF RELATED PARTY DISCLOSURES

★★ The following is an extract illustrating the potential impact of disclosing information about the remunera-
tion arrangements of key management personnel.
Board forced to rethink exec pay

Large sharemarket-listed companies are being forced to review their remuneration practices after
almost a quarter of those in the top 200 that have already held their annual general meetings
suffered protest votes of 25 per cent or more from investors.
Nearly half the top 200 companies that have held their AGMs reported a protest vote of more
than 10 per cent against their pay plans, despite a big drop in bonus payments this year as boards
promised to rein in executive pay after the global financial crisis.
Source: Durkin (2009, p. 1).
Required
Identify the disclosures that IAS 24 requires to be provided regarding key management personnel. Do you
think the costs of making such disclosures outweigh the benefits? Explain your answer.

Exercise 19.5 COMPONENTS OF BASIC EARNINGS PER SHARE
★ Which of the following is a component of earnings used in the calculation of basic earnings per share?
Give reasons for your answer.
(a) Profit before tax expense
(b) Preference dividends declared during the period
(c) Income tax expense
(d) Profit from discontinued operations
(e) Prior year dividend paid to holders of cumulative preference shares
Exercise 19.6 BONUS ISSUE OF SHARES

★★ On 1 January 2013, Regis Ltd has 200 000 ordinary shares outstanding. On 1 March 2013, the company
announces a bonus issue of two shares for every share held on that date. By the end of the year Regis Ltd’s
profit attributable to ordinary shareholders amounts to $900 000 (2012: $600 000).
Required
Calculate the 2013 and 2012 basic earnings per share amounts that Regis Ltd must disclose in its financial
statements for the year ended 31 December 2013.
Exercise 19.7 THEORETICAL EX-RIGHTS VALUE

★★ Kenny Ltd has 30 000 ordinary shares on issue. The company announced a one-for-three rights issue with
an exercise price of $4 for each right. The market price of one ordinary share immediately before the exer-
cise of the rights was $6.
Required
Determine the theoretical ex-rights value per share.
Exercise 19.8 RIGHTS ADJUSTMENT FACTOR AND ADJUSTED BASIC EARNINGS PER SHARE
★★ Assume that in exercise 19.16 Kenny Ltd announced the rights issue at the beginning of its reporting
period (1 July 2014) and the last date for exercising the rights was 1 October 2014. Kenny Ltd announced
profit attributable to ordinary shareholders of $109 725 for the full reporting period.
Required
Use the theoretical ex-rights value per share determined in exercise 19.16 to calculate the adjustment
factor, and calculate adjusted basic earnings per share.
Exercise 19.9 EFFECT OF SHARE OPTIONS ON DILUTED EARNINGS PER SHARE

★★ Xenia Ltd determines its profit attributable to ordinary shareholders for the reporting period ended 30
June 2014 as $96 000. The company has calculated its weighted average number of ordinary shares on
issue during the period as 480 000. The weighted average number of shares under share options arrange-
ments during the period is 24 000.
The average market price of the entity’s shares during the period is $2.40 per share, and the exercise
price of shares under option is $1.50.
Required
Prepare a schedule setting out the calculation of basic earnings per share and diluted earnings per share.

IFRS® Standards prescribe, for each standard, a minimum disclosures reduce cost of capital while unfavourable disclo-
set of additional information that should be disclosed in the sures increase cost of capital. However, the effect of favour-
notes. A basic question that academics have pondered in this able disclosures is quite small (and much smaller than the
context is whether managers would like to provide disclosure effect of unfavourable disclosures), suggesting that investors
even without regulation (or in the case of regulated disclo- largely disregard positive corporate disclosures. The rather
sure, to provide disclosure above the required level). From a modest and mixed results may be due to the fact that theory
theoretical point of view, the answer seems to be yes. If inves- suggests a link between the precision of disclosure and cost
tors maintain that lack of disclosure implies that managers of capital, rather than a link between the favourableness of
withhold bad news, then managers will furnish disclosure disclosures and cost of capital.
to avoid being seen as bad performers (Grossman, 1981). Another interesting question that has attracted academic
However, in practice it seems that voluntary disclosure is scrutiny is whether recognition of a number in the main
not uniformly observed. One potential explanation of this statements is assessed differently than if, instead, the same
phenomenon is that managers who do not disclose may be number is disclosed only in the accompanying notes. This
concerned that providing too much disclosure may benefit has been termed as the “recognition versus disclosure” con-
other parties, such as competitors, trade unions or litigants cept. It should be nevertheless noted that disclosure in the
suing the corporation. Verrecchia (1983) argues that good notes can serve several purposes (Schipper, 2009), not just as
news may be withheld owing to such disclosure costs. Hence, an alternative to recognition in the main statements.
investors will not be certain if lack of disclosure is due to bad One reason a disclosed amount could be assessed dif-
news or withholding of potentially costly good news. In equi- ferently than a recognised amount is that the reliability of
librium firms release good news only if the benefit from the the two numbers differ. This can be the case if, for example,
good news exceeds the cost of its disclosure. Other firms will auditors scrutinise less carefully disclosed amounts than rec-
withhold information and will be assessed at the expected ognised ones. Barth et al. (2003) advance another reason
average value of non-disclosing firms. for possible differences in valuation effects of disclosed
One possible benefit of disclosures is a reduction in cost versus recognised amounts. They argue that disclosed-only
of equity capital. In the case of a single company, better dis- amounts may not be looked at by all investor types. Specif-
closure reduces information asymmetry and hence cost of cap- ically, sophisticated investors would look at disclosed infor-
ital. This is less clear when investors can diversify and invest mation while incurring some cost for exerting this effort.
in a large number of firms and so individual risk becomes In contrast, unsophisticated investors prefer to look at rec-
less of an issue. The theoretical model of Lambert et al. ognised amounts only. In such a case the degree to which
(2007) provides the necessary link between disclosure and disclosed information is impounded in price is a function of
cost of capital in a multi-security market. This is based on the number of sophisticated investors in the market. Limited
the argument that better disclosure helps investors to assess attention to disclosed amounts may also be relevant in this
the covariance between a firm’s future cash flows and that context (Hirshleifer and Teoh, 2003).
of the market as a whole. Because this covariance is a risk One of the more persuasive studies of recognition vs. dis-
factor for investors, more disclosure therefore reduces this risk, closure is conducted by Ahmed et al. (2006). The authors
increases current prices and reduces expected return. These examine accounting regulation of derivatives in the US.
disclosure effects are consistent with lower cost of capital. Under old US standards information about fair value of
Botosan (1997) empirically examines the link between vol- derivatives was comprehensively provided. However, while
untary disclosures in annual reports and cost of capital. She a subset of derivatives was recognised on the balance sheet
compiles a dataset of detailed disclosures made by 122 man- at fair value, other derivatives were either recognised at his-
ufacturing firms in 1990. Based on a long list of 46 potential torical cost or zero cost. For these derivatives disclosure in
disclosure elements Botosan (1997) calculates a disclosure the notes provided the relevant fair values. Under the new
score for each company. Each firm is then ranked according to rules, all derivatives have to be recognised at fair value on
its disclosure score. Botosan (1997) then computes a measure the balance sheet. Crucially for this research, fair values
of cost of equity capital by employing well-known valuation were consistently estimated under both old and new rules.
models. The main finding is that for firms with low level of Ahmed et al. (2006) analyse the link between fair values of
analyst following, higher disclosure rank is negatively related derivatives in 146 bank holding companies and the banks’
to cost of equity capital. This suggests that the information market value of equity (MVE). They find that disclosed
environment is rich for firms that are followed by many ana- fair values (under old rules) are not associated with MVE,
lysts; hence the incremental effect of voluntary disclosure while recognised fair values (under old rules) exhibit posi-
is small. In contrast, when the information environment is tive relation with MVE. The authors then look at 82 banks
poor, voluntary disclosures work to reduce cost of capital. that only disclosed fair values of derivatives under old rules
Kothari et al. (2009) extend this line of research by but then had to recognise them under new rules. They find
looking at the link between three measures for the cost of that recognised fair values (under new rules) are more
equity capital and the content of corporate disclosures. Using closely related to MVE than disclosed amounts under old
special software that analyses the content of these disclo- rules. This suggests that the value relevance of recognised
sures for 889 firms between 1996 and 2001, Kothari et al. fair values is greater than that of disclosed ones. Müller
(2009) classify these disclosures as either favourable or et al. (2015) provide corroborating results by taking advan-
unfavourable in nature. They find that favourable corporate tage of the fact that under IFRS Standards fair values of

investment properties may be either recognised or dis- Botosan, C.A., 1997. Disclosure level and the cost of equity
closed. Another interesting study on this issue is Aboody capital, The Accounting Review, 72(3), 323–349.
(1999). He examines a sample of 71 firms in the oil and Grossman, S. J. 1981. The informational role of warranties
gas industry, some of which had to recognise impairments and private disclosure about product quality, The Journal of
of their wells in the income statement and some that only Law & Economics, 24(3), 461–483.
needed to disclose these impairments. He finds evidence Hirshleifer, D. and Teoh, S.H., 2003. Limited attention,
suggesting that while recognised impairments affect stock information disclosure, and financial reporting, Journal of
prices, disclosed impairments do not. Accounting and Economics, 36(1), 337–386.
Taken together, the evidence on disclosure versus recog- Kothari, S.P., Li, X. and Short, J.E., 2009. The effect of disclosures
nition suggests that recognised amounts are more value rel- by management, analysts, and business press on cost of
evant than disclosed amounts. capital, return volatility, and analyst forecasts: A study using
content analysis, The Accounting Review, 84(5), 1639–1670.
Lambert, R., Leuz, C. and Verrecchia, R. E. 2007, accounting
References information, disclosure, and the cost of capital, Journal of
Accounting Research, 45: 385–420.
Aboody, D., 1996. Recognition versus disclosure in the oil Müller, M., Riedl, E.J. and Sellhorn, T., 2015. Recognition
and gas industry, Journal of Accounting Research, 21–32. versus disclosure of fair values, The Accounting Review,
Ahmed, A.S., Kilic, E. and Lobo, G.J., 2006. Does recognition 90(6), 2411–2447.
versus disclosure matter? Evidence from value-relevance Schipper, K., 2007. Required disclosures in financial
of banks’ recognized and disclosed derivative financial reports, The Accounting Review, 82(2), 301–326.
instruments, The Accounting Review, 81(3), 567–588. Verrecchia, R. 1983. Discretionary disclosure. Journal of
Barth, M.E., Clinch, G. and Shibano, T., 2003. Market Accounting and Economics, 5, 365–380.
effects of recognition and disclosure, Journal of Accounting
Research, 41(4), 581–609.
558 PART 3
2 Presentation
Elements and disclosures
Part 4
entities
Economic
21 Consolidation: wholly owned subsidiaries 577
22 Consolidation: intragroup transactions 605
24 Translation of the financial statements of foreign entities 679
Visit the companion website to access additional chapters

online at: www.wiley.com/college/picker
Online chapter C Associates and joint ventures
Online chapter D Joint arrangements
20 Consolidation:
controlled entities
ACCOUNTING IFRS 10 Consolidated Financial Statements

STANDARDS IFRS 12 Disclosure of Interests on Other Entities
IN FOCUS

OBJECTIVES
1 explain the meaning of consolidated financial statements
2 discuss the meaning and application of the criterion of control
3 discuss which entities should prepare consolidated financial statements
4 understand the relationship between a parent and an acquirer in a business combination
5 explain the differences in disclosure requirements between single entities and consolidated
entities.
CHAPTER 20 Consolidation: controlled entities 561

INTRODUCTION
The purpose of this chapter is to discuss the preparation of a single set of financial statements, referred to
as the consolidated financial statements. The preparation of consolidated financial statements views the
group as the economic entity that is of interest to users of financial statements. It involves combining the
financial statements of the individual entities so that they show the financial position and financial perfor-
mance of the group of entities, presented as if they were a single economic entity.
The first issue covered in this chapter is the determination of which entities are required to prepare consoli-
dated financial statements. This involves a discussion of the criterion for consolidation and its application to
economic situations. The second issue in this chapter is the accounting procedures for preparing the consoli-
dated financial statements. The application in this chapter is to a very simple group structure involving two
entities, one of which owns all the issued shares in the other. Further issues associated with the preparation
of consolidated financial statements are discussed in the chapters that follow (see chapters 21–23).
The accounting standards governing the preparation of consolidated financial statements are IFRS 3
Business Combinations issued in 2008 and IFRS 10 Consolidated Financial Statements issued in 2011.
The objective of IFRS 3, as stated in paragraph 1:
is to establish principles and requirements for how the acquirer:
(a) recognises and measures in its financial statements the identifiable assets acquired, the liabilities assumed
and any non-controlling interest in the acquiree;
(b) recognises and measures the goodwill acquired in the business combination or a gain from a bargain pur-
chase; and
(c) determines what information to disclose to enable users of the financial statements to evaluate the nature
and financial effects of the business combination.
The objective of IFRS 10 is stated in paragraph 1:
to establish principles for the presentation and preparation of consolidated financial statements when an entity
controls one or more other entities.
To achieve this, IFRS 10 then:
• requires a parent to present consolidated financial statements
• establishes control as the criterion for consolidation
• defines the criterion of control
• provides guidance on identifying when one entity controls another
• sets out the accounting requirements for the preparation of consolidated financial statements.
LO1 20.1 CONSOLIDATED FINANCIAL STATEMENTS

Consolidated financial statements are defined in Appendix A of IFRS 10 as follows:
The financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the
parent and its subsidiaries are presented as those of a single economic entity.
Consider figure 20.1. P Ltd has investments in a number of other companies. A shareholder’s wealth in
P Ltd is dependent not only on how well P Ltd performs, but also on the performance of the other enti-
ties in which P Ltd has an investment. Rather than require a shareholder in P Ltd to analyse each of the
companies in the economic group, if P Ltd prepared a set of financial statements by adding together the
financial statements of all entities in the group, this would assist investors in P Ltd to analyse their invest-
ment. Assuming that one share equals one voting right, P Ltd owns 70% of S1 Ltd and effectively owns
42% (70% × 60%) of S2 Ltd. However, P Ltd controls both S1 Ltd and S2 Ltd (through S1 Ltd’s control of
S2 Ltd). P Ltd also owns and controls 100% of S3 Ltd.
Consolidated financial statements perform this function as they are a consolidation, or an adding
together, of the financial statements of all entities within an economic entity. As stated in paragraph B86
of IFRS 10, consolidated financial statements ‘combine like items of assets, liabilities, equity, income,
expenses and cash flows’ of the entities in the group.
This process of adding the financial statements together can be seen in its simplest form in figure 20.2.
In this example there are two entities in the group, P Ltd and S Ltd. The consolidated financial statements
are prepared by adding together the assets and liabilities of both entities. In chapter 21 a consolidation
worksheet is used to perform this addition process.
This aggregation process is subject to a number of adjustments, and these are covered in detail in later
chapters. However, in this chapter, the process of consolidation should be seen simply as a process of
aggregation of the financial statements of all entities within the group. Note that the consolidation process
does not involve making adjustments to the individual financial statements or the accounts of the entities
in the group. This is because the individual companies within the group remain separate legal entities. The
consolidated financial statements are an additional set of financial statements and are prepared using a
worksheet to facilitate the addition and adjustment process.
562 PART 4 Economic entities

P Ltd
70% 100%
S1 Ltd S3 Ltd
60%
S2 Ltd
FIGURE 20.1 A group of entities
Consolidation of
P Ltd S Ltd P Ltd and S Ltd
Non-current assets* 150 000 + 120 000 = 270 000

Current assets 50 000 + 20 000 = 70 000
Total assets 200 000 140 000 340 000
Total liabilities (80 000) + (30 000) = (110 000)
Net assets $120 000 $110 000 $ 230 000
* Excluding P Ltd’s investment in S Ltd (explained in chapter 21)
FIGURE 20.2 The consolidation process
The consolidated financial statements consist of a consolidated statement of financial position, consoli-
dated statement of profit or loss and other comprehensive income, a consolidated statement of changes in
equity, and a consolidated statement of cash flows.
The following definitions are contained in Appendix A of IFRS 10:
Group A parent and its subsidiaries.
Parent An entity that controls one or more entities.
Subsidiary An entity that is controlled by another entity.
The consolidated financial statements combine the financial statements of all the entities within a group.
The entities in the group consist of two types; namely, parent and subsidiary. There is only one parent in
a group, which is the controlling entity; that is, the entity that controls all other entities in the group. Sec-
tion 20.2 discusses the meaning of control. All other entities in the group — the controlled entities — are
called subsidiaries. Hence, in figure 20.1, assuming that P Ltd controls all other companies in the figure, P
Ltd is the parent entity, and all other entities in the group are subsidiaries.
Note that for a number of entities that are interconnected there may be a number of groups. Consider
figure 20.3. If B Ltd controls C Ltd, then B Ltd is a parent and C Ltd is its subsidiary, and together they
form a group. If A Ltd controls both B Ltd and C Ltd, then A Ltd is a parent and both B Ltd and C Ltd are
its subsidiaries, and all together they form a group.
20.1.1 Reasons for consolidation

There are several reasons why consolidated financial statements are prepared:
1. Supply of relevant information. The information obtained from the consolidated financial statements is
relevant to investors in the parent entity. These investors have an interest in the group as a whole, not
just in the parent entity. To require these investors to source their information from the financial state-
ments of each of the entities comprising the group would place a large cost burden on the investors.
2. Comparable information. Some entities are organised into a group structure such that different activi-
ties are undertaken by separate members of the group. Other entities are organised differently, with
some having all activities conducted within the one entity. For an investor to make useful compar-
isons between entities, access to consolidated financial statements makes the comparative analysis
an easier task.

A Ltd
100%
B Ltd
100%
C Ltd
FIGURE 20.3 Multiple groups
3. Accountability. A key purpose for all financial reporting is the discharge of accountability by manage-
ment. Entities that are responsible or accountable for managing a pool of resources, being the recipients
of economic benefits and responsible for payment of obligations, are generally required to report on
their activities, and are held accountable for the management of those activities. The management of
the parent entity is not just responsible for the management of the assets and liabilities of the parent
itself. As the parent controls the assets of all subsidiaries, the assets under the control of the parent en-
tity’s management are the assets of the group. The consolidated financial statements report the assets
under the control of the group management as well as the claims on those assets.
4. Reporting of risks and benefits. There are risks associated with managing an entity, and an entity rarely
obtains control of another without obtaining significant opportunities to benefit from that control. The
consolidated financial statements allow an assessment of these risks and benefits at a group level.
Notwithstanding these advantages, it should be noted that the aggregation process of the consolidation
results in little information being available for the individual subsidiaries. Hence, users of consolidated
financial statements would not normally be able to identify individual subsidiaries that exhibit better or
worse financial position and performance.
LO2 20.2 CONTROL AS THE CRITERION FOR CONSOLIDATION

In Appendix A of IFRS 10, a parent is defined as an entity that controls one or more entities while a subsid-
iary is a controlled entity. The entity that is responsible for preparing the consolidated financial statements
is the parent. An entity must then determine when it is a parent and which entities it controls. The deter-
mination of whether one entity controls another is crucial to the determination of which entities need to
prepare consolidated financial statements. Paragraph 5 of IFRS 10 notes that ‘an investor’ must determine
whether it is a parent by assessing whether it controls an ‘investee’.
Under IFRS 10, the criterion for consolidation is control. It should first be noted that determination of
whether control exists is a matter of judgement. In many situations it will not be clear cut that one entity con-
trols another, and determination will have to be made by considering all available facts and circumstances
(paragraph 8 of IFRS 10). As noted later in this section, IFRS 10 provides numerous factors to be considered in
making the decision concerning the existence of control. Hence, it is important to understand the meaning of
the term ‘control’ and what evidence may be accumulated to determine its existence or non-existence in specific
circumstances. Further, if those circumstances change, there may be a need to assess whether control still exists.
Second, note that control is an exclusionary power. In a group there can be only one parent. If two or
more investors join together to direct the activities of the investees, neither investor controls the investee —
decision-making ability cannot be shared.
Control of an investee is defined in Appendix A of IFRS 10 as follows:
An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involve-
ment with the investee and has the ability to affect those returns through its power over the investee.
Paragraph 7 of IFRS 10 identifies three elements, all of which must be held by an investor in order for it
to have control, namely:
1. power over the investee
2. exposure, or rights, to variable returns from its involvement with the investee
3. the ability to use its power over the investee to affect the amount of the investor’s returns.
These three elements are discussed in detail in the following sections.

20.2.1 Power
Power is defined in Appendix A of IFRS 10 as follows:
Existing rights that give the current ability to direct the relevant activities.
Note the key features of this definition.
Power arises from rights
These rights generally arise from some form of legal contract. For example, the rights that are held by
the owner of an ordinary share in a company may include voting rights, rights to dividends or rights on
liquidation of the company. Rights could also exist because of a contract between one entity and another
entity. For example, an entity might engage another entity to manage its activities — the latter entity then
has management rights but potentially no rights to dividends. The rights that are of importance in deter-
mining whether power exists are those relating to the ability to direct the relevant activities of an investee.
Rights in relation to purely administration tasks are not rights that affect power. Examples of rights that
affect who has power are listed in paragraph B15 of IFRS 10, namely:
• voting rights
• rights to appoint, reassign or remove members of an investee’s key management personnel
• rights to appoint or remove another entity that participates in management decisions
• rights to direct the investee to enter into, or veto any changes to, transactions that affect the investee’s
returns.
Some questions that could be asked to assist in determining whether certain rights give rise to power are
as follows (based on paragraph B18 of IFRS 10):
• Can the investor appoint or approve the investee’s key management personnel who direct the relevant
activities?
• Can the investor direct the investee to enter into or veto any changes to significant transactions that
affect the investor’s returns?
• Can the investor dominate either the nominations process of electing members of the investee’s
governing body or the obtaining of proxies from other holders of voting rights?
The rights must also be substantive rights. According to paragraph B22 of IFRS 10, for rights to be sub-
stantive the holders must have the practical ability to exercise the rights; that is, there are no barriers to
the holders exercising the rights. The rights need to give the holder the current ability to direct the relevant
activities when decisions about those activities need to be made.
As judgement is required in assessing whether rights are substantive, paragraph B23 of IFRS 10 provides
some factors to consider in making that determination:
• whether the party or parties that hold the rights would benefit from the exercise of those rights, for
example, potential voting rights.
• whether there are any barriers — economic or otherwise — that prevent a holder from the exercising
of rights. Examples of such barriers are financial penalties, terms and conditions that make it unlikely
that rights will be exercised, and the absence of specialised services necessary for exercising the rights.
Paragraph B23(a) of IFRS 10 provides a detailed list of possible barriers.
• where more than one party is involved, whether there is a mechanism in place to enable those parties
to practically exercise the rights.
If the rights are purely protective rights, the holder does not have power (paragraph 14). Protective
rights are defined in Appendix A of IFRS 10 as follows:
Rights designed to protect the interest of the party holding those rights without giving that party power over the
entity to which those rights relate.
Paragraph B28 of IFRS 10 provides examples of protective rights, which include:
(a) a lender’s right to restrict a borrower from undertaking activities that could significantly change the credit
risk of the borrower to the detriment of the lender.
(b) the right of a party holding a non-controlling interest in an investee to approve capital expenditure greater
than that required in the ordinary course of business, or to approve the issue of equity or debt instruments.
(c) the right of a lender to seize the assets of a borrower if the borrower fails to meet specified loan repayment
conditions.
A non-controlling interest is equity in a subsidiary not attributable to a parent. For example, if a parent
owns 80% of the shares of a subsidiary, then the non-controlling interest in the subsidiary is 20%.
Power is the ability to direct
There is a distinction between ability to direct and actually directing. An entity that has the ability to direct
may decide not to exercise that ability and so allow another entity to actually direct. For example, Entity
C may have two owners — Entity A that owns 55% of the shares in Entity C and Entity B that holds the
remaining 45% of issued shares. Entity A may have the ability to direct the activities of Entity C but, as it
is an investment company and holds shares purely for cash flow via dividends, may have no interest in
management of other entities. Entity B may then actually undertake the management of Entity C. In such
a circumstance, Entity B is the parent as it has the ability to direct the activities of Entity C.

The ability to direct must be current
The investor must be able to exercise its rights to direct at the time decisions are made concerning the
activities of an investee. However, there are circumstances where power is still held by an investor even
though there may be a time period to pass, or an activity that needs to be undertaken, before the right to
direct can be currently exercisable. Paragraph B24 of IFRS 10 provides examples of these circumstances.
One example is:
An investor holds an option to acquire the majority of shares in an investee that is exercisable in 25 days and
that would generate a profit for the investor upon exercising the option; that is, the value of the share exceeds the
exercise price. A special meeting to change existing policies requires 30 days’ notice. The existing shareholders
cannot change existing policies before the exercise of the option. The investor has a substantive right that gives
them the current ability to direct the relevant activities even before the option is exercised.
In contrast, assume the investor held a forward contract to acquire the majority of shares at a settlement
date in 6 months’ time. The existing shareholders would have the current ability to direct the activities of
the investee as they can change the existing policies before the forward contract is settled.
It is relevant activities that are directed

Relevant activities are defined in Appendix A of IFRS 10 as:
activities of the investee that significantly affect the investee’s returns.
The determination of relevant activities may change over time and differ between entities; hence it may
be necessary to analyse the purpose and design of an investee. For many investees, the relevant decisions
are those that govern the financial and operating policies of the investee. Paragraph B11 of IFRS 10 pro-
vides examples of some possible relevant activities, including:
• selling and purchasing goods and services
• managing financial assets
• selecting, acquiring and disposing of assets
• researching and developing new products
• determining a funding structure or obtaining funding.
To have power, an investor need not be able to make any decision it likes in relation to an investee, as
the investor is constrained by corporate and contract laws under which the interests of non-controlling
investors, creditors and others are protected.
Level of share ownership

Ownership of ordinary shares in a company normally provides voting rights that enable the holder of
the majority of shares to dominate the appointment of directors or an entity’s governing board. As para-
graph B35 of IFRS 10 states, where an investor holds more than half of the voting rights of an investee, the
investor has power providing:
(a) the relevant activities are directed by a vote of the holder of the majority of voting rights, or
(b) a majority of the members of the governing body that directs the relevant activities are appointed by a vote
of the holder of the majority of the voting rights.
Hence, in the absence of other evidence, where an investor holds a majority of voting shares that investor
would be considered to have power over the investee.
Where an investor holds less than 50% of the shares of an investee, the determination of whether the
investor has power over the investee is more difficult. In determining the existence of power, it is necessary
to examine the potential actions of the holders of the other shares in the investee. Some factors to assist
in this process are:
• Size of the voting interest. The more voting shares an investor has, the more likely it is that it will have
power. A further consideration is the number of shareholders who hold the remaining voting shares
and the extent of their holdings. Where the remaining voting shares are held by a large number of
shareholders, each holding a small number of shares, the probability of these other shareholders
getting together to outvote the shareholder who holds a substantial proportion, but not a majority, of
the shares must be considered. Note that, where the remaining shares are held by a small number of
shareholders, the probability that they could get together and outvote the holder of the large parcel of
shares is higher. Paragraphs B44–B45 of IFRS 10 provide examples of these circumstances.
In the first example, investor A holds 45% of the voting rights of an investee. Two other investors
each hold 26% of the voting rights of the investee. The remaining voting rights are held by investors
who hold less than 1% each. There are no other arrangements that affect decision making. In this case,
consideration of the size of investor A’s voting interest and its relative size to the other shareholdings
is sufficient to conclude that investor A does not have power. The two investors who hold 26% each
would need to cooperate to be able to prevent investor A from controlling the investee.
In the second example, an investor holds 40% of the voting rights of an investee, with the next
two largest holdings of voting rights being 10% and 4%. The remaining voting rights are held by
thousands of shareholders, none holding more than 1% of the voting rights. None of the shareholders
has any arrangements to consult each other or make collective decisions. In this case, on the basis

of the absolute size of its holding and the relative size of the other shareholdings, the investor has
a sufficiently dominant voting interest to meet the power criterion without the need to consider any
other evidence of power.
• Attendance at annual general meetings. Although all shareholders may attend general meetings and vote
in matters relating to governance of the entity, it is rare for this to occur. If, therefore, only 60% of the
eligible votes are cast at a general meeting and an entity has more than a 30% interest in that entity, it
can cast the majority of votes at that meeting. It then has power over that entity.
• The existence of contracts. As noted in paragraph B39 of IFRS 10, the contractual arrangement between
an investor and other holders of shares may give the investor sufficient voting rights to give the investor
power. An example of such a contract is provided in application example 5 of paragraph B43 of IFRS 10:
Investor A holds 40% of voting rights of an investee and twelve other investors each hold 5% of voting rights of
the investee. A shareholder agreement grants investor A the right to appoint, remove and set the remuneration of
management responsible for directing the relevant activities.
In this case, consideration of the absolute size of the investor’s holding and the relative size of the
other shareholdings alone is not conclusive to determine the investor has rights sufficient to give
it power. However, the fact that investor A has the contractual right to appoint, remove and set the
compensation of key management is sufficient to conclude that investor A has power over the investee.
The fact that investor A might not have exercised this right yet or the likelihood of investor A exercising
their right to select, appoint or remove key management should not be considered when assessing
whether investor A has power.
• Level of disorganisation or apathy of the remaining shareholders. This factor is affected by the dispersion
of the shareholders, and reflected in their attendance at general meetings. Holders of small parcels of
shares are often not organised into forming voting blocks. Shareholders with environmental or ethical
concerns may be less apathetic about the actions of an entity and its management policies, and may
form voting blocks.
The assessment of the existence of power where the investor holds less than a majority of voting
shares is difficult and requires judgement. In many cases that assessment relies on an analysis of the
non-action of other shareholders. Do the non-voting shareholders at an annual general meeting not
vote because they are happy with the management ability of the investor, as opposed to being apa-
thetic? Would they be willing to combine to outvote the investor if the latter’s decisions were considered
untenable? The success of the investee under the control of the investor is a further measure of the
potential for generally passive shareholders to be sufficiently concerned to cast a vote at the next annual
general meeting. When an investee is performing poorly, the interest of shareholders as well as their
willingness to become involved generally increases. Poor performance with resultant lowering of share
prices may also result in a current or new shareholder acquiring a large block of shares and changing the
voting mix at general meetings.
Numerous problems arise in applying the concept of power under IFRS 10. First, there is the question
of temporary control. Where the investor holds more than 50% of the voting shares of the investee, there
is no danger of a change in the identity of the parent. However, if the identification of the parent is based
on factors that may change over time, the process becomes more difficult. For example, the percentage of
votes cast at general meetings may historically be 70%, but in a particular year it may be 50%. A share-
holder with 30% of the voting shares has control in the latter circumstance but not in the former. Simi-
larly, consider the situation where there are two substantial block holdings of voting shares, meaning that
neither has power over the investee. One of the holders of a substantial block of shares may then sell its
shares to a large number of buyers. The other holder of a substantial block may suddenly find that it has
the power to control, regardless of whether this investor wants to exercise control or not.
Second, the ability of an entity to control another may be affected by relationships with other entities.
For example, a holder of 40% of the voting shares may be ‘friendly’ with the holder of another 11% of
shares. The 11% shareholder might be a financial institution that has invested in the holder of the 40% of
votes and plans to vote with that entity to increase its potential for repayment of loans. However, business
relationships and loyalties are not always permanent.
These two examples illustrate some of the practical issues in applying the concept of power in IFRS 10.
Potential voting rights

Paragraphs B47–B50 of IFRS 10 discuss the issue of whether potential voting rights should be considered
in assessing the existence of power. Potential voting rights are rights to obtain voting rights of an investee,
such as those within an option or convertible instrument (paragraph B47).
As noted earlier in this section:
• the rights must be substantive
• the investor must have a current ability to exercise those rights.
Where this occurs, potential voting rights must be taken into consideration when assessing the existence
of power. Illustrative examples 20.1 and 20.2 provide some examples of potential voting rights adapted
from paragraph B50 of IFRS 10.

ILLUSTRATIVE EXAMPLE 20.1 Potential voting rights — exercisable options
Arctic holds 70% of the voting rights of an investee. Baltic holds the other 30% but also holds an option
to acquire half of Arctic’s voting rights, with the option being exercisable at a fixed price over the next
2 years.
If the option is deeply ‘out of the money’ (that is, the fixed price is too high relative to the current
share price of the investee) then Arctic would be considered to hold power as the current economic con-
ditions are such that the rights associated with the option are not substantive, in that it is not practicable
for Baltic to exercise the option.
If the option was ‘in the money’ (that is, where the underlying share price is well above the exercise
price) then Baltic would be considered to have power as it could exercise the option and direct the
activities of the investee.
Source: Adapted from IASB 2011, IFRS 10 Consolidated Financial Statements, Example 9, p. 33.
ILLUSTRATIVE EXAMPLE 20.2 Potential voting rights — convertible debt instruments
An investee has three shareholders — Ant and two other investors. Each investor holds one-third of the
voting rights. Ant also holds debt instruments that are convertible into voting shares of the investee at a
fixed price that is ‘out of the money’, but not by a large amount. If the debt was converted, Ant would
hold 60% of the shares of the investee. Because of the advantages of controlling the investee, it may be
considered that Ant has power over the investee given Ant’s ability to convert the debt instrument into
shares. Additional information would need to be considered, including the current influence that Ant
has on directing the activities of the investee.
Source: Adapted from IASB 2011, IFRS 10 Consolidated Financial Statements, Example 10, p. 33.
20.2.2 Exposure or rights to variable returns

Besides having power to direct the activities of an investee, an investor must also have the rights to variable
returns from that investee. IFRS 10 does refer to this explicitly, but it appears that the standard equates
control with exposure to risk.
Where an investor holds ordinary shares in an investee, it expects returns in relation to dividends,
changes in the value of the investment, and residual interests on liquidation. These returns can be positive
or negative; hence, the use of the term ‘returns’ rather than ‘benefits’. The returns are not exclusive to the
parent, but may also be received by other non-controlling shareholders. Other returns include (see para-
graph B57 of IFRS 10 for examples of returns):
• returns from structuring activities with the investee; for example, obtaining a secure supply or raw
material, access to a port facility, or a distribution network
• returns from denying or regulating access to a subsidiary’s assets; for example, obtaining control of a
patent for a competing product and stopping production
• returns from economies of scale
• remuneration from provision of services such as servicing of assets, and management.
The returns must have the potential to vary based on the performance of the investee. Examples of such
variability are:
• dividends from ordinary shares that will change based on the profit performance of the investee
• fixed interest payments from a bond, as they expose the investor to the credit risk of the issuer of the
bond, namely the investee
• fixed performance fees for management of the investee’s assets, as they expose the investor to the
performance risk of the investee.
20.2.3 Ability to use power to affect returns

Besides having power to direct the activities of the investee and rights to variable returns from the
investee, a parent must have the ability to use its power over the investee to affect the returns received
from the investee. This requires that the parent be able to use its power to increase its benefits and limit
its losses from the subsidiary’s activities. There is then a link between the holding of the power and
the returns receivable. However, there is no specification of the level of returns to be received. IFRS 10
only requires that some variable returns be receivable and that the investor by its actions can affect the
amount of those returns.

20.2.4 Agents
In determining whether control exists over an investee, an investor with decision-making rights needs to
assess whether it is a principal or an agent.
Paragraph B58 of IFRS 10 explains that an agent is a party primarily engaged to act on behalf and for
the benefit of another party or parties, being the the principal and therefore does not control the investee
when it exercises its decision-making authority. The agent has a fiduciary relationship to the principal.
Paragraph B60 of IFRS 10 provides a number of factors to consider in determining whether a decision
maker is a principal or an agent:
• the scope of its decision-making authority over the investee — this relates to the range of activities that
the decision maker is permitted to direct
• the rights held by other parties; for example, whether another entity has substantive removal rights
over the decision maker
• the remuneration to which it is entitled in accordance with the remuneration agreement — the
remuneration of an agent would be expected to be commensurate with the level of skills needed
to provide the management service while the remuneration agreement would contain terms and
conditions normally included in arrangements for similar services
• the decision maker’s exposure to variability of returns from other interest that it holds in the investee —
the greater the decision maker’s exposure to variable returns from its involvement in the investee, the
more likely it is that the decision maker is not an agent.
An agent cannot be a parent. Where a controlling decision maker is determined to be an agent, it is the
principal that would be considered to be the parent.
LO3 20.3 PREPARATION OF CONSOLIDATED

FINANCIAL STATEMENTS
Paragraph 4(a) of IFRS 10 requires all parents to prepare consolidated financial statements, except in those
circumstances where it meets all the following conditions:
(i) it is a wholly owned subsidiary or is a partially owned subsidiary of another entity and all 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;
(ii) its debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an
over-the-counter market, including local and regional markets);
(iii) it did not file, nor is it in the process of filing, its financial statements with a securities commission or other
regulatory organisation for the purpose of issuing any class of instruments in a public market; and
(iv) its ultimate or any intermediate parent produces consolidated financial statements that are available for
public use and comply with IFRSs.
The essence of these conditions is to ensure that only companies with no public accountability are
exempted from the requirement to prepare consolidated financial statements.
Consider the group structure in figure 20.4. A Ltd is a parent entity with two subsidiaries. According to
paragraph 4 of IFRS 10, A Ltd is required to prepare consolidated financial statements, combining the finan-
cial statements of A Ltd, B Ltd and C Ltd. B Ltd is also a parent with C Ltd being its subsidiary. Is B Ltd also
required to prepare consolidated financial statements?
A Ltd
100%
B Ltd
100%
C Ltd
FIGURE 20.4 A parent and its subsidiaries

If B Ltd meets all the conditions in paragraph 4(a), it does not have to prepare consolidated financial
statements. To determine this the following questions are asked:
• Is B Ltd itself a wholly owned subsidiary? In figure 20.4, B Ltd is itself a wholly owned subsidiary of A
Ltd, hence this meets the first condition in paragraph 4(a)(i). Note also in paragraph 4(a)(i), that even
if A Ltd owned only, say, 80% of B Ltd, making B Ltd a partially owned subsidiary, B Ltd may still be
exempted from preparing consolidated financial statements if the 20% non-controlling interest in B
Ltd has been informed about and do not object to the parent not presenting consolidated financial
statements.
• Has B Ltd filed its financial statements with a regulatory agency for the purpose of issuing any debt or equity
instruments in a public market or are the debt and equity instruments of B Ltd traded in a public market? If B
Ltd intends to issue such instruments of if they are traded in a public market, then there are potential
users for a set of consolidated financial statements from B Ltd. Where B Ltd is a wholly owned
subsidiary, it is unlikely that its equity instruments would be traded in a public market.
• Has A Ltd produced consolidated financial statements complying with IFRS® Standards?
LO4 20.4 BUSINESS COMBINATIONS AND CONSOLIDATION

As noted in chapter 14, accounting for a business combination under the acquisition method requires the
identification of an acquirer. The acquirer is the combining entity that obtains control of the other com-
bining entities or businesses. Hence, as the criterion for identification of a parent–subsidiary relationship
is control, it is expected that when a business combination is formed by the creation of a parent–
subsidiary relationship, the parent will be identified as the acquirer. As noted in paragraph 3 of IFRS 10,
the accounting requirements for business combinations and their effect on consolidation, including good-
will arising on a business combination, are set out in IFRS 3 Business Combinations.
However, there are situations where the parent entity is not the acquiring entity. In paragraph B19
of Appendix B to IFRS 3, a distinction is made between the legal acquirer/acquiree and the accounting
acquirer/acquiree. The parent entity is usually the legal acquirer as it issues its equity interests as consider-
ation in the combination transaction, with the subsidiary being the legal acquiree. This parent has control
of the group subsequent to the business combination occurring. However, the accounting acquirer in a
business combination is determined based on which entity participating in the business combination is
the entity that obtains control of the other entities.
20.4.1 Formation of a new entity

Consider the situation in figure 20.5 in which A Ltd and B Ltd combine by the formation of a new entity,
C Ltd, which acquires all the shares of both of these entities with the issue of shares in C Ltd. C Ltd con-
trols both A Ltd and B Ltd.
C Ltd
C Ltd acquires C Ltd acquires
all the shares all the shares
of A Ltd of B Ltd
A Ltd B Ltd
FIGURE 20.5 Identification of an acquirer where a new entity is formed
Paragraph B18 of IFRS 3 states: ‘[I]f a new entity is formed to issue equity interests to effect a business
combination, one of the combining entities that existed before the business combination shall be identi-
fied as the acquirer by applying the guidance in paragraphs B13–B17.’ In other words, even though C Ltd
is acquiring the shares of both A Ltd and B Ltd, it is not to be considered the accounting acquirer; either
A Ltd or B Ltd must be considered to be the accounting acquirer.
Deciding which entity is the acquirer involves a consideration of factors such as which of the combining
entities initiated the combination, and whether the assets and revenues of one of the combining entities
significantly exceed those of the others. The reasons for this decision by the International Accounting
Standards Board (IASB®) are given in paragraphs BC98–BC101 of the Basis for Conclusions on IFRS 3

Business Combinations. The key reason for the standard setter’s decision is in paragraph BC100. The argu-
ment is that the new entity, C Ltd, may have no economic substance, and the accounting result for the
combination of the three entities should be the same if A Ltd simply combined with B Ltd without the
formation of C Ltd. It is argued in paragraph BC100 that to account otherwise would ‘impair both the
comparability and the reliability of the information’.
However, the problem that then arises in the scenario in figure 20.5 is that a choice has to be made: is A
Ltd or B Ltd the acquirer? In deciding on which entity is the acquirer, paragraphs B14–B18 of Appendix B
to IFRS 3 provide some indicators to consider in situations where it may be difficult to identify an acquirer.
The entity likely to be the acquirer is the one:
• that has a significantly greater fair value
• that gives up the cash or other assets, in the case where equity instruments are exchanged for cash or
other assets
• whose management is able to dominate the business combination.
In this circumstance, although C Ltd is the legal parent of the subsidiaries A Ltd and B Ltd, it is not the
acquirer in the business combination.
20.4.2 Reverse acquisitions

A further situation considered in paragraphs B19–B27 of IFRS 3 is the ‘reverse acquisition’ form of busi-
ness combination. Consider the situation in figure 20.6.
100%
A Ltd B Ltd
Before business combination Share capital — 60 shares

Share capital — 100 shares Fair value per share — $40
Fair value per share — $12
Terms of combination
A Ltd issues 2.5 shares in exchange for each B Ltd share.
Hence, A Ltd issues 150 shares to the former shareholders of B Ltd.
Subsequent to combination
A Ltd holds all the shares in B Ltd.
The holders of shares in A Ltd consist of the holders of the 100 shares existing before the business
combination and the former shareholders of B Ltd who now hold 150 shares in A Ltd.
FIGURE 20.6 Reverse acquisition
A Ltd acquired all the shares in B Ltd, and A Ltd can therefore legally control the financial and operating
policies of B Ltd. However, an analysis of the shareholding in A Ltd shows that the former shareholders of
B Ltd hold 60% (i.e. 150/250) of the shares of A Ltd. Some people argue that the substance of the busi-
ness combination is that B Ltd has really taken over A Ltd because the former shareholders of B Ltd are in
control. Paragraph BC96 of the Basis for Conclusions on IFRS 3 provides a further example of a reverse
acquisition:
The IASB also observed that in some reverse acquisitions, the acquirer may be the entity whose equity inter-
ests have been acquired and the acquiree is the issuing entity. For example, a private entity might arrange
to have itself ‘acquired’ by a smaller public entity through an exchange of equity interests as a means of
obtaining a stock exchange listing. As part of the agreement, the directors of the public entity resign and
are replaced by directors appointed by the private entity and its former owners. The IASB observed that in
such circumstances, the private entity, which is the legal subsidiary, has the power to govern the financial
and operating policies of the combined entity so as to obtain benefits from its activities. Treating the legal
subsidiary as the acquirer in such circumstances is thus consistent with applying the control concept for
identifying the acquirer.
The problem with the reverse acquisitions argument is that it relies on an analysis of which share-
holders control the decision making — that is, the acquiring entity is the one whose owners control

the combined entity and who have the power to govern the financial and operating policies of the
entity so as to obtain benefits from its activities.
LO5 20.5 DISCLOSURE

There are no disclosures specified in IFRS 10. IFRS 12 Disclosure of Interests in Other Entities, issued in 2011
at the same time as IFRS 10, outlines the disclosures required in the consolidated financial statements for
subsidiaries. IAS 27 Separate Financial Statements, also issued in 2011, sets out disclosures required in the
separate financial statements of the parent.
20.5.1 Disclosures required by IFRS 12

The key objective of IFRS 12 is stated in paragraph 1:
The objective of this IFRS is to require an entity to disclose information that enables users of its financial state-
ments to evaluate:
(a) the nature of, and risks associated with, its interests in other entities, and
(b) the effects of those interests on its financial position, financial performance and cash flows.
Notice the emphasis on the ability of users of financial statements to be able to evaluate risks. In
the introduction to IFRS 12 Disclosure of Interests in Other Entities, in paragraph IN5, the IASB noted
that ‘the global financial crisis that started in 2007 highlighted a lack of transparency about the risks
to which a reporting entity was exposed from its involvement with structured entities’. As a result,
IFRS 12 requires an entity to disclose the significant judgements and assumptions it has made in
determining the nature of its interest in another entity (paragraph 2(a)), and in particular judge-
ments, assumptions and changes in these in relation to subsidiaries (paragraph 7). Paragraph 9 of
IFRS 12 provides the following examples of situations where it is necessary to disclose significant
judgements and assumptions:
• where an entity does not control another entity but it holds more than half of the voting rights in the
other entity
• where an entity controls another entity but it holds less than half of the voting rights of the other
entity
• where an entity is an agent or a principal.
To assist users in understanding the nature of the group, paragraph 10 of IFRS 12 states:
An entity shall disclose information that enables users of its consolidated financial statements
(a) to understand:
(i) the composition of the group; and
(ii) the interest that non-controlling interests have in the group’s activities and cash flows (paragraph 12);
and
(b) to evaluate:
(i) the nature and extent of significant restrictions on its ability to access or use assets, and settle liabilities,
of the group (paragraph 13);
(ii) the nature of, and changes in, the risks associated with its interests in consolidated structured entities
(paragraphs 14–17);
(iii) the consequences of changes in its ownership interest in a subsidiary that do not result in a loss of con-
trol (paragraph 18); and
(iv) the consequences of losing control of a subsidiary during the reporting period (paragraph 19).
Where the financial statements of a subsidiary are as of a date that differs from that of the parent, the
entity must disclose both the date used by the subsidiary as well as the reason for using a different date
(paragraph 11). As the parent controls the subsidiary, the choice of a different date must be one made by
the parent and not the subsidiary.
Where a non-controlling interest exists in a subsidiary, paragraph 12 of IFRS 12 requires that an entity
disclose for each such subsidiary:
(a) the name of the subsidiary.
(b) the principal place of business (and country of incorporation if different from the principal place of busi-
ness) of the subsidiary.
(c) the proportion of ownership interests held by non-controlling interests.
(d) the proportion of voting rights held by non-controlling interests, if different from the proportion of owner-
ship interests held.
(e) the profit or loss allocated to non-controlling interests of the subsidiary during the reporting period.
(f) accumulated non-controlling interests of the subsidiary at the end of the reporting period.
(g) summarised financial information about the subsidiary (see paragraph B10).

Paragraph B10 of IFRS 12 states:
For each subsidiary that has non-controlling interests that are material to the reporting entity, an entity shall
disclose:
(a) dividends paid to non-controlling interests.
(b) summarised financial information about the assets, liabilities, profit or loss and cash flows of the sub-
sidiary that enables users to understand the interest that non-controlling interests have in the group’s
activities and cash flows. That information might include but is not limited to, for example, current
assets, non-current assets, current liabilities, non-current liabilities, revenue, profit or loss and total
Paragraph B11 notes that the summarised financial information is required before adjusting for
intragroup transactions. Paragraph 13 of IFRS 12 provides disclosures required where an entity has
significant restrictions on its ability to access or use the assets or settle the liabilities of the group.
Paragraph 14 of IFRS 12 deals with consolidated structured entities. In Appendix A, a structured entity
is defined as:
An entity that has been designed so that voting or similar rights are not the 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.
Paragraphs B22–B24 provide further information about structured entities.
According to paragraph B22, a structured entity may have the following features:
(a) restricted activities.
(b) a narrow and well-defined objective, such as to effect a tax-efficient lease, carry out research and develop-
ment activities, provide a source of capital or funding to an entity or provide investment opportunities for
investors by passing on risks and rewards associated with the assets of the structured entity to investors.
(c) insufficient equity to permit the structured entity to finance its activities without subordinated financial
support.
(d) financing in the form of multiple contractually linked instruments to investors that create concentrations of
credit or other risks (tranches).
The following examples of entities that are regarded as structured entities are noted in paragraph B23:
(a) securitisation vehicles.
(b) asset-backed financings.
(c) some investment funds.
Disclosures in relation to consolidated structured entities required by IFRS 12 include:
• the terms of any contractual arrangement that could require a parent or its subsidiaries to supply
financial support to a consolidated structured entity
• information about the provision of financial support supplied without the parent or its subsidiaries
having a contractual obligation to do so
• current intentions to provide financial or other support to a consolidated structured entity.
Where the structured entity is not consolidated, paragraphs 24–31 of IFRS 12 provide information on
the disclosures required. As these structured entities are not consolidated, it is important that users are
aware of any risks associated with involvement with these entities. In particular paragraph 26 requires
disclosure about:
its interests in unconsolidated structured entities, including, but not limited to, the nature, purpose, size and
activities of the structured entity and how the structured entity is financed.
To assist in the evaluation of risks associated with unconsolidated structured entities, paragraph 29
requires an entity to disclose in tabular format, unless another format is more appropriate, a summary of:
(a) the carrying amounts of the assets and liabilities recognised in its financial statements relating to its interests
in unconsolidated structured entities.
(b) the line items in the statement of financial position in which those assets and liabilities are recognised.
(c) the amount that best represents the entity’s maximum exposure to loss from its interests in unconsolidated
structured entities, including how the maximum exposure to loss is determined. If an entity cannot quantify
its maximum exposure to loss from its interests in unconsolidated structured entities it shall disclose that
fact and the reasons.
(d) a comparison of the carrying amounts of the assets and liabilities of the entity that relate to its interests in
unconsolidated structured entities and the entity’s maximum exposure to loss from those entities.
Paragraphs 18 and 19 set out disclosures required where there are changes in the parent’s ownership
interest in a subsidiary as well as when a parent loses control of a subsidiary.
20.5.2 Disclosures required by IAS 27

Paragraph 4 of IAS 27 contains the following definition of separate financial statements:
Separate financial statements are those presented by a parent (ie an investor with control of a subsidiary) or an
investor with joint control of, or significant influence over, an investee, in which the investments are accounted
for at cost or in accordance with IFRS 9 Financial Instruments.

There are two situations where separate financial statements are prepared:
1. Where a parent is exempted from preparing consolidated financial statements in accordance with paragraph 4(a)
of IFRS 10.
In this case, paragraph 16 of IAS 27 requires the parent to supply the following information in the
separate financial statements prepared by the parent:
(a) the fact that the financial statements are separate financial statements; that the exemption from consolida-
tion has been used; the name and principal place of business (and country of incorporation, if different) of
the entity whose consolidated financial statements that comply with International Financial Reporting Stand-
ards have been produced for public use; and the address where those consolidated financial statements are
obtainable;
(b) a list of significant investments in subsidiaries, jointly controlled entities and associates, including the name,
country of incorporation or residence, proportion of ownership interest and, if different, proportion of
voting power held; and
(c) a description of the method used to account for the investments listed under (b).
2. Where a parent prepares separate financial statements in addition to consolidated financial statements.
Paragraph 17 of IAS 27 requires the following information to be disclosed in the separate financial
statements:
(a) the fact that the statements are separate financial statements and the reasons why those statements are pre-
pared if not required by law;
(b) a list of significant investments in subsidiaries, joint ventures and associates, including:
(i) the name of those investees.
(ii) the principal place of business (and country of incorporation, if different) of those investees.
(iii) its proportion of the ownership interest (and its proportion of the voting rights, if different) held in
those investees.
(c) a description of the method used to account for the investments listed under (b).
The parent or investor shall also identify the financial statements prepared in accordance with IFRS 10,
IFRS 11 or IAS 28 (as amended in 2011) to which they relate.
SUMMARY
Where entities form relationships with other entities, accounting standards often require additional disclo-
sure so that users of financial statements can understand the economic substance of the entities involved.
Where an entity is classified as a subsidiary of another, the parent, IFRS Standards establish principles for
the preparation of consolidated financial statements. These statements are in addition to those prepared for
either the parent or a subsidiary as separate legal entities. The consolidated financial statements are prepared
by adding the financial statements of a parent and each of its subsidiaries, with adjustments being made
during this process.
An important decision is the determination of whether the relationship between two entities is such
as to be classified as a parent–subsidiary relationship. The existence of this relationship is determined by
whether one entity has control over another. The existence of control requires the assessment of the power
an entity has over another entity, whether the investor is exposed or has rights to variable returns from
its involvement in the investee, and the ability of the investor to use its power over the investee to affect
the amount of those returns. This analysis requires the accountant to exercise judgement in analysing the
specific relationships between entities, since the existence of control is not simply a matter of determining
whether an entity owns a majority of shares in another.
In general, parent entities are responsible for the preparation of the consolidated financial statements.
However, IFRS 10 exempts parent entities that meet specified criteria from the preparation of these state-
ments. For those parents preparing consolidated financial statements, IFRS 3 will need to be applied as the
formation of a parent–subsidiary relationship is normally also a business combination.
IFRS 10 does not contain disclosure requirements for consolidated financial statements. The disclosure
requirements are found in IFRS 12 and IAS 27.
1. What is a subsidiary?
2. What is meant by the term ‘control’?
3. When are potential voting rights considered when deciding if one entity controls another?
4. Are only those entities in which another entity owns more than 50% of the issued shares classified as
subsidiaries?
5. What benefits could be sought by an entity that obtains control over another entity?

Exercise 20.1 CONVERTIBLE DEBENTURES

★ Pea Ltd establishes Soup Ltd for the sole purpose of developing a new product to be manufactured and
marketed by Pea Ltd. Pea Ltd engages Mr Smith to lead the team to develop the new product. Mr Smith
is named Managing Director of Soup Ltd at an annual salary of £100 000, £10 000 of which is advanced
to Mr Smith by Soup Ltd at the time Soup Ltd is established. Mr Smith invests £10 000 in the project and
receives all of Soup Ltd’s initial issue of 10 voting ordinary shares.
Pea Ltd transfers £500 000 to Soup Ltd in exchange for 7%, 10-year debentures convertible at any time
into 500 voting ordinary shares of Soup Ltd. Soup Ltd has enough shares authorised to fulfil its obligation
if Pea Ltd converts its debentures into voting ordinary shares.
The constitution of Soup Ltd provides certain powers for the holders of voting common shares and the
holders of securities convertible into voting ordinary shares that require a majority of each class voting
separately. These include:
(a) the power to amend the corporate purpose of Soup Ltd
(b) the power to authorise and issue voting shares of securities convertible into voting shares.
At the time Soup Ltd is established, there are no known economic legal impediments to Pea Ltd con-
verting the debt.
Required
Discuss whether Soup Ltd is a subsidiary of Pea Ltd.
Exercise 20.2 OPTIONS

★ Palau Ltd and India Ltd own 80% and 20% respectively of the ordinary shares that carry voting rights at
a general meeting of shareholders of Cook Islands Ltd. Palau Ltd sells half of its interest in Cook Islands
Ltd to Kobe Ltd and buys call options from Kobe Ltd that are exercisable at any time at a premium to the
market price when issued and, if exercised, would give Palau Ltd its original 80% ownership interest and
voting rights. At 30 June 2014, the options are out of the money.
Required
Discuss whether Palau Ltd is the parent of Cook Islands Ltd.
Exercise 20.3 CONTROL

★★ Pluto Ltd has acquired, during the current year, the following investments:
Sun Ltd €120 000 (40% of issued capital)

Saturn Ltd €117 000 (35% of issued capital)
Pluto Ltd is unsure how to account for these investments and has asked you, as the auditor, for some
professional advice.
Specifically, Pluto Ltd is concerned that it may need to prepare consolidated financial statements under IFRS
10. To help you, the company has provided the following information about the two investee companies:
Sun Ltd
• The remaining shares in Sun Ltd are owned by a diverse group of investors who each hold a small
parcel of shares.
• Historically, only a small number of the shareholders attend the general meetings or question the
actions of the directors.
• Pluto Ltd has nominated three new directors and expects that they will be appointed at the next
annual general meeting. The current board of directors has five members.
Saturn Ltd
• The remaining shares in Saturn Ltd are owned by a small group of investors who each own
approximately 15% of the issued shares. One of these shareholders is Sun Ltd, which owns 17%.
• The shareholders take a keen interest in the running of the company and attend all meetings.
• Two of the shareholders, including Sun Ltd, already have representatives on the board of directors who
have indicated their intention of nominating for re-election.
Required
1. Advise Pluto Ltd as to whether, under IFRS 10, it controls Sun Ltd and/or Saturn Ltd. Support your
conclusion.
2. Would your conclusion be different if the remaining shares in Sun Ltd were owned by three institutional
investors each holding 20%? If so, why?

Exercise 20.4 SUBSIDIARY STATUS
★★ Pumpkin Ltd owns 40% of the shares of Soup Ltd, and holds the only substantial block of shares in that
entity; no other party owns more than 3% of the shares. The annual general meeting of Soup Ltd is to be
held in 1 month’s time. Two situations that may arise are:
• Pumpkin Ltd will be able to elect a majority of Soup Ltd’s board of directors as a result of exercising its
votes as the largest holder of shares. As only 75% of shareholders voted in the previous year’s annual
meeting, Pumpkin Ltd may have the majority of the votes that are cast at the meeting.
• By obtaining the proxies of other shareholders and, after meeting with other shareholders who
normally attend general meetings of Soup Ltd and convincing these shareholders to vote with it,
Pumpkin Ltd may obtain the necessary votes to have its nominees elected as directors of the board of
Soup Ltd, regardless of the attendance at the general meeting.
Required
Discuss the potential for Soup Ltd being classified as a subsidiary of Pumpkin Ltd.
Exercise 20.5 DETERMINING SUBSIDIARY STATUS

★★ Required
In the following independent situations, determine whether a parent–subsidiary relationship exists, and
which entity, if any, is a parent required to prepare consolidated financial statements under IFRS 10.
1. Perth Ltd is a company that was hurt by a recent global financial crisis. As a result, it experienced
major trading difficulties. It previously obtained a significant loan from Fremantle Bank, and when Perth
Ltd was unable to make its loan repayments, the bank made an agreement with Perth Ltd to become
involved in the management of that company. Under the agreement between the two entities, the bank
had authority for spending within Perth Ltd. Perth Ltd’s managers had to obtain authority from the
bank for acquisitions over $10 000, and was required to have bank approval for its budgets.
2. Broome Ltd owns 80% of the equity shares of Shark Bay Ltd, which owns 100% of the shares of Gerald-
ton Ltd. All companies prepare reports under IFRS Standards. Although the shares of Shark Bay Ltd are
not traded on any stock exchange, its debt instruments are publicly traded.
3. Denmark Ltd is a major financing company whose interest in investing is return on the investment.
Denmark Ltd does not get involved in the management of its investments. If the investees are not
managed properly, Denmark Ltd sells its shares in that investee and selects a more profitable investee
to invest in. It previously held a 35% interest in Esperance Ltd as well as providing substantial conver-
tible debt finance to that entity. Recently, Esperance Ltd was having cash flow difficulties and persuaded
Denmark Ltd to convert some of the convertible debt into equity so as to ease the effects of interest
payments on cash flow. As a result, Denmark Ltd’s equity interest in Esperance Ltd increased to 52%.
Denmark Ltd still wanted to remain as a passive investor, with no changes in the directors on the
board of Esperance Ltd. These directors were appointed by the holders of the 48% of shares not held
by Denmark Ltd.
Exercise 20.6 LESS THAN MAJORITY OWNERSHIP

★★ On 1 March 2015, Pink Ltd acquired 40% of the voting shares of Scarlet Ltd. Under the company’s consti-
tution, each share is entitled to one vote. On the basis of past experience, only 65% of the eligible votes
are typically cast at the annual general meetings of Scarlet Ltd. No other shareholder holds a major block
of shares in Scarlet Ltd.
The financial year of Scarlet Ltd ends on 31 December each year. The directors of Pink Ltd argue that
they are not required under IFRS 10 to include Scarlet Ltd as a subsidiary in Pink Ltd’s consolidated finan-
cial statements at 31 December 2015 as there is no conclusive evidence that Pink Ltd can control the finan-
cial and operating policies of Scarlet Ltd. The auditors of Pink Ltd disagree, referring specifically to past
years’ voting figures.
Required
Provide a report to Pink Ltd on whether it should regard Scarlet Ltd as a subsidiary in its preparation of
consolidated financial statements at 31 December 2015.

21 Consolidation: wholly
owned subsidiaries
ACCOUNTING IFRS 3 Business Combinations

STANDARDS IFRS 10 Consolidated Financial Statements
IN FOCUS
IFRS 12 Disclosure of Interests in Other Entities

OBJECTIVES
1 understand the nature of the group covered in this chapter, and the initial adjustments required
in the consolidation worksheet
2 explain how a consolidation worksheet is used
3 prepare an acquisition analysis for the parent’s acquisition in a subsidiary
4 prepare the worksheet entries at the acquisition date, being the business combination valuation
entries and the pre-acquisition entries
5 prepare the worksheet entries in periods subsequent to the acquisition date, adjusting for
movements in assets and liabilities since acquisition date and dividends from pre-acquisition equity
6 prepare the worksheet entries where the subsidiary revalues its assets at acquisition date
7 prepare the disclosures required by IFRS 3 and IFRS 12.
CHAPTER 21 Consolidation: wholly owned subsidiaries 577

LO1 21.1 THE CONSOLIDATION PROCESS
This chapter discusses the preparation of consolidated financial statements. As discussed in chapter 20,
under IFRS 10 Consolidated Financial Statements consolidated financial statements are the result of com-
bining the financial statements of a parent and all its subsidiaries. (The determination of whether an entity is
a parent or a subsidiary is discussed in chapter 20.) The two accounting standards mainly used in this chapter
are IFRS 10 and IFRS 3 Business Combinations. The accounting principles relevant for business combina-
tions have been discussed earlier (see chapter 14) and an in-depth understanding of that chapter is essential
to the preparation of consolidated financial statements because the parent’s acquisition of shares in a sub-
sidiary is simply one form of a business combination.
In IFRS 3 Appendix A, ‘acquisition date’ is defined as the date on which the acquirer obtains control of
the acquiree. As discussed in chapter 14, both the fair values of the identifiable assets and liabilities of the
subsidiary and the consideration transferred are measured at the acquisition date. In this chapter, the only
combinations considered are those where the parent acquires its controlling interest in a subsidiary and, as
a result, owns all the issued shares of the subsidiary — the subsidiary is then a wholly owned subsidiary.
This may occur by the parent buying all the shares in a subsidiary in one transaction, or by the parent
acquiring the controlling interest after having previously acquired shares in the subsidiary.
Note, however, as discussed in chapter 20, control of a subsidiary does not necessarily involve the parent
acquiring shares in a subsidiary. The consolidated financial statements of a parent and its subsidiaries
include information about a subsidiary from the date the parent obtains control of the subsidiary; that
is, from the acquisition date. A subsidiary continues to be included in the parent’s consolidated finan-
cial statements until the parent no longer controls that entity; that is, until the date of disposal of the
subsidiary.
Before undertaking the consolidation process, it may be necessary to make adjustments in relation to
the content of the financial statements of the subsidiary:
• If the end of a subsidiary’s reporting period does not coincide with the end of the parent’s reporting
period, adjustments must be made for the effects of significant transactions and events that occur
between those dates, with additional financial statements being prepared where it is practicable to do
so (IFRS 10 paragraphs B92–B93). In most cases where there are different dates, the subsidiary will
prepare adjusted financial statements as at the end of the parent’s reporting period, so that adjustments
are not necessary on consolidation. Where the preparation of adjusted financial statements is unduly
costly, the financial statements of the subsidiary, prepared at a different date from the parent, may be
used subject to adjustments for significant transactions. However, as paragraph B93 states, for this to be
a viable option, the difference between the ends of the reporting periods can be no longer than
3 months. Further, the length of the reporting periods, as well as any difference between the ends of
the reporting periods, must be the same from period to period.
• The consolidated financial statements are to be prepared using uniform accounting policies for like
transactions and other events in similar circumstances (IFRS 10 paragraph 19). Where different policies
are used, adjustments are made so that like transactions are accounted for under a uniform policy in
the consolidated financial statements.
The preparation of the consolidated financial statements involves adding together the financial state-
ments of the parent and its subsidiaries as well as processing a number of adjustments, these being
expressed in the form of consolidating journal entries:
• As required by IFRS 3, at the acquisition date the acquirer must recognise the identifiable assets
acquired and liabilities assumed of the subsidiary at fair value. Adjusting the carrying amounts of the
subsidiary’s assets and liabilities to fair value and recognising any identifiable assets acquired and
liabilities assumed as a part of the business combination but not recorded by the subsidiary is a part
of the consolidation process. The entries used to make these adjustments are referred to in this chapter
as the business combination valuation entries. As noted later (see section 21.2) these adjusting entries are
generally not made in the records of the parent or of the subsidiary, but in a consolidation worksheet.
• Where the parent has an ownership interest (i.e. owns shares) in a subsidiary, adjusting entries are
made, referred to in this chapter as the pre-acquisition entries. As noted in paragraph B86(b) of IFRS
10, this involves eliminating the carrying amount of the parent’s investment in each subsidiary and
the parent’s portion of pre-acquisition equity in each subsidiary. The name of these entries is derived
from the fact that the equity of the subsidiary at the acquisition date is referred to as pre-acquisition
equity, and it is this equity that is being eliminated. These entries are also made in the consolidation
worksheet and not in the records of the parent or subsidiary.
• The third set of adjustments to be made is for transactions between the entities within the group
subsequent to the acquisition date, including events such as sales of inventory or non-current
assets. These intragroup transactions are referred to in IFRS 10 paragraph B86(c) (adjustments for these
transactions are discussed in detail in chapter 22).
In this chapter, the group under discussion is one where:
• there are only two entities within the group: one parent and one subsidiary (see figure 21.1)
• both entities have share capital

100%
Parent Subsidiary
FIGURE 21.1 A wholly owned group
• the parent owns all the issued shares of the subsidiary; that is, the subsidiary is wholly owned
(partially owned subsidiaries, where it is necessary to account for the non-controlling interest, are
covered later (see chapter 23))
• there are no intragroup transactions between the parent and its subsidiary after the acquisition date.
LO2 21.2 CONSOLIDATION WORKSHEETS

The consolidated financial statements are prepared by adding together the financial statements of the
parent and the subsidiary. It is the financial statements of the parent and the subsidiary, rather than the
underlying accounts, which are added together. There are no consolidated ledger accounts. The financial
statements that are added together are the statements of financial position, statements of profit or loss
and other comprehensive income and statements of changes in equity prepared by the management of
the parent and the subsidiary. Consolidated statements of cash flows must also be prepared, but these are
beyond the scope of this book.
To facilitate the addition process, particularly where there are several subsidiaries, as well as to make
the necessary valuation and pre-acquisition entry adjustments, a worksheet or computer spreadsheet is
often used. From the worksheet, the external statements are prepared — the consolidated statement of
financial position, statement of profit or loss and other comprehensive income and statement of changes
in equity.
The format for the worksheet is presented in figure 21.2, which contains the information used for the
consolidation of the parent, P Ltd, and the subsidiary, S Ltd. Assume that P has paid £20 000 for all of
the shares of S. At the time of acquisition S reported £15 000 in share capital and £5000 in retained
earnings. Note that this simple example does not deal with goodwill or fair value adjustments, which
are discussed later.
Adjustments
Parent Subsidiary
Financial statements P Ltd S Ltd Dr Cr Consolidation
Investment in S Ltd 20 000 — 20 000 1 —

Other assets 35 000 27 000 62 000
55 000 27 000 20 000 £62 000
Share capital 30 000 15 000 1 15 000 30 000
Retained earnings 25 000 12 000 1 5 000 32 000
55 000 27 000 20 000 £62 000
FIGURE 21.2 Consolidation worksheet — basic format
Note the following points about the worksheet:

• The first column contains the names of the accounts, as the financial statements are combined on a
line-by-line basis.
• The second and third columns contain the internal financial statements of the parent, P Ltd, and
its subsidiary, S Ltd. These statements are obtained from the separate legal entities. The number of
columns is expanded if there are more subsidiaries within the group.
• The next set of columns, headed ‘Adjustments’, are used to make the adjustments required in
the consolidation process. These include adjustments for valuations at acquisition date, pre-
acquisition equity, and intragroup transactions such as sales of inventory between the parent and
subsidiary. The adjustments, written in the form of journal entries, are recorded on the worksheet.
Where there are many adjustments, each journal entry should be numbered so that it is clear
which items are being affected by a particular adjustment entry. In figure 21.2 there is only one

worksheet entry, hence the number ‘1’ is entered against each adjustment item. The worksheet
adjustment entry is:
(1) Share Capital of S Dr 15 000

(1) Retained Earnings of S (balance at acquisition) Dr 5 000
Investment in S Ltd Cr 20 000
• As noted earlier, the process of consolidation is one of adding together the financial statements of
the members of the group and making various adjustments. Hence, figures for each line item in the
right-hand column, headed ‘Consolidation’, arise through addition and subtraction as you proceed
horizontally across the worksheet.
• The share capital and the retained earnings at acquisition date (on S Ltd’s financial statements) are
eliminated against the Investment in S Ltd (on P Ltd’s financial statements).
• For example, for share capital, retained earnings and the shares in S Ltd, the effect of the adjustments are:
Share capital: £30 000 + £15 000 − £15 000 = £30 000
Retained earnings: £25 000 + £12 000 − £5 000 = £32 000
Investment in S Ltd: £20 000 − £20 000 = £0
The figures in the right-hand column provide the information for the preparation of the consolidated
financial statements of the group, P Ltd and S Ltd. Note that the retained earnings reported by the group
include only £7 000 of the £15 000 reported by S. This is because S Ltd generated this amount in undistrib-
uted profit since acquisition. The subsidiary’s retained earnings at acquisition amounted to £5 000 whereas
at the date of consolidation this amount had increased to £12 000. Only the earnings of the subsidiary
post acquisition are attributable to the group’s performance and hence only £7 000 is absorbed into the
consolidated retained earnings.
In preparing the consolidated financial statements, no adjustments are made in the accounting records
of the individual entities that constitute the group. The adjusting entries recorded in the columns of the
worksheet do not affect the accounts of the individual entities. They are recorded in a separate consoli-
dation journal, not in the journals of any of the entities within the group, and are then recorded on the
consolidation worksheet. Hence, where consolidated financial statements are prepared over a number of
years, a particular entry (such as a pre-acquisition entry) needs to be made every time a consolidation work-
sheet is prepared, because the entry never affects the actual financial statements of the individual entities.
LO3 21.3 THE ACQUISITION ANALYSIS: DETERMINING

GOODWILL OR BARGAIN PURCHASE
On acquisition involving 100% of the shares in the acquired entity, there are three main measurement
tasks that should be performed at acquisition date. First, the value of consideration paid to the previous
shareholders of the acquired entity must be determined. In a simple case, this is the cash amount paid.
Often, however, the acquirer uses other payment methods. Under one popular method, the acquirer issues
its own shares in return for the shares in the target company (or a combination of cash and shares). In this
case, the fair value of the shares issued should be determined. Occasionally, the fair value of the target’s
shares, rather than the acquirer’s, may be measured more reliably and hence used instead (paragraph 33
of IFRS 10). The fair value of the consideration given should also take into account contingent payments
(payments that are made in the future to the previous shareholders of the target company if certain con-
ditions are met). These should also be fair-valued (paragraph 37). A slight complication arises when the
acquisition is done in steps (step acquisition). For example, in the first step 30% of the target’s shares are
acquired and in the second step an additional 70% stake is purchased. In such a case the acquirer has to
combine the value of consideration transferred in the last stage with the acquisition-date fair value of the
initial 30% (paragraphs 41–42). The total of these two components is then regarded as the overall value of
the 100% stake assumed (see section 21.3.2).
The second measurement task requires the determination of the fair value of net assets (assets less liabili-
ties) in the target’s acquisition-date balance sheet. This typically involves fair-valuing of all on-balance-sheet
assets and liabilities, as well as some off-balance-sheet items (e.g. intangible assets and contingent liabili-
ties) (see chapter 14).
The third measurement task is to assess the value of goodwill to show in the consolidated balance
sheet. As discussed in chapter 14, this is done by comparing the value of considerations transferred (plus,
possibly, the value of a previously held stake) to the fair value of net assets acquired. If the fair value of

consideration transferred (plus, possibly, the value of a previously held stake) exceeds that of fair value of
net assets acquired, then goodwill arises. If there is no excess whereby the fair value of net assets is higher,
then negative goodwill arises. This is regarded as a bargain purchase. In such a case IFRS 10 (paragraph 36)
requires the acquirer to conduct a review of its calculations. If the calculations hold, the negative goodwill
is recorded in income (paragraph 35).
It should be noted that any acquisition-related costs, such as finders’ fees; advisory, legal, accounting,
valuation and other professional or consulting fees do not enter the above calculations and they need to
be expensed (paragraph 53).
We discuss next several scenarios that may arise on acquisition date.
21.3.1 Parent has no previously held equity interest in

the subsidiary
In this case, the parent acquires all the shares of the subsidiary at acquisition date in one transaction. In
terms of paragraph 32 of IFRS 3 and as mentioned above, goodwill arises when the consideration trans-
ferred (32(a)(i)) is greater than the net fair value of the identifiable assets and liabilities acquired (32(b)).
Where the reverse occurs, a gain on bargain purchase is recognised.
An acquisition analysis is conducted at acquisition date because it is necessary to recognise the iden-
tifiable assets and liabilities of the subsidiary at fair value, and to determine whether there has been an
acquisition of goodwill or a bargain purchase gain.
The first step in the consolidation process is to undertake the above acquisition analysis in order to
obtain the information necessary for making both the business combination valuation and pre-acquisition
entry adjustments for the consolidation worksheet. Consider the example in figure 21.3.
On 1 July 2013, Parent Ltd acquired all the issued share capital of Sub Ltd (300 000 shares), giving in
exchange 100 000 shares in Parent Ltd, these having a fair value of £5 per share. At acquisition date,
the statements of financial position of Parent Ltd and Sub Ltd, and the fair values of Sub Ltd’s assets and
liabilities, were as follows:
Parent Ltd Sub Ltd
Carrying Carrying Fair

amount amount value
ASSETS
Land £ 120 000 £ 150 000 £170 000
Equipment 620 000 480 000 330 000
Accumulated depreciation ( 380 000) ( 170 000)
Investment in Sub Ltd 500 000
Inventory 92 000 75 000 80 000
Cash 15 000 5 000 5 000
Total assets £967 000 £540 000 £585 000
LIABILITIES AND EQUITY
Liabilities
Provisions 30 000 60 000 60 000
Trade and other payables 27 000 34 000 34 000
Tax payable 10 000 6 000 6 000
Total liabilities £ 67 000 £100 000 £100 000
Equity
Total equity 900 000 440 000
Total liabilities and equity £967 000 £540 000
At acquisition date, Sub Ltd has an unrecorded patent with a fair value of £20 000, and a contingent liability
with a fair value of £15 000. This contingent liability relates to a loan guarantee made by Sub Ltd which did
not recognise a liability in its records because it did not consider it could reliably measure the liability. The
tax rate is 30%.
FIGURE 21.3 Information at acquisition date

The analysis at acquisition date consists of comparing the fair value of the consideration trans-
ferred and the net fair value of the identifiable assets and liabilities of the subsidiary at acquisition
date. The net fair value of the subsidiary could be calculated by revaluing the assets and liabilities of
the subsidiary from the carrying amounts to fair values, remembering that under IAS 12 Income Taxes
where there is a difference between the carrying amount and the tax base caused by the revaluation,
the tax effect of such a difference has to be recognised. However, in calculating the net fair value of
the subsidiary, because particular information is required to prepare the valuation and pre-acquisition
entries, the calculation is done by adding the recorded equity of the subsidiary (which represents the
recorded net assets of the subsidiary) and the differences between the carrying amounts of the assets
and liabilities and their fair values, adjusted for tax. The book equity of the subsidiary in figure 21.3
consists of:
£300 000 capital + £140 000 retained earnings
These fair value adjustments, are recorded initially against the business combination valuation reserve
(BCVR). This reserve is not an account recognised in the subsidiary’s records, but it is recognised in the
consolidation process as part of the business combination. For example, for land there is a difference of
£20 000 in the fair value carrying amount and, on revaluation of the land to fair value, a business com-
bination valuation reserve of £14 000 (i.e. £20 000 (1 − 30%)) is raised. The total of pre-tax fair value
adjustments is £50 000, giving rise to deferred tax liability of £15 000.
The acquisition analysis, including the determination of the goodwill of the subsidiary, is as shown in
figure 21.4.
Sub Ltd
Carrying Fair value Fair

amount adjustment value
ASSETS
Land £150 000 £ 20 000 £170 000
Equipment 310 000 20 000 330 000
Patent 20 000 20 000
Inventory 75 000 5 000 80 000
Cash 5 000 5 000
Total assets £540 000 £ 65 000 £605 000
LIABILITIES
Trade and other payables 34 000 34 000
Contingent liability — loan guarantee 15 000 15 000
Tax payable 6 000 6 000
Net Assets £440 000 £ 35 000 £475 000
Determination of goodwill:
1 July 2013
Consideration paid 500 000
Less: Fair value of net assets acquired 475 000
Goodwill £ 25 000
FIGURE 21.4 Acquisition analysis — no previously held equity interests
The information from the completed acquisition analysis is used to prepare the adjustment entries for
the consolidation worksheet. These entries are illustrated below (see section 21.4).
In this book, it is assumed that the tax base of the subsidiary’s assets and liabilities is unchanged as a
result of the parent’s acquisition of the subsidiary. In some jurisdictions, where the group becomes the
taxable entity, there is a change in the tax base to the fair value amounts. In this case, no tax effect would
be recognised in relation to the assets and liabilities acquired.

21.3.2 Parent has previously held equity interest in the subsidiary
The situation used in figure 21.3 will be used here with the only difference being that on 1 July 2013
Parent Ltd acquires 80% of the shares in Sub Ltd, giving in exchange 80 000 shares in Parent Ltd, these
having a fair value of £5 per share. Parent Ltd had previously acquired the other 20% stake in Sub Ltd for
£75 000. At 30 June 2013, this investment in Sub Ltd was recorded at £92 000. The appreciation in value
was recorded in income since the investment was classified as an equity instrument and measured at fair
value through income. At 1 July 2013, these shares had been reassessed to have a fair value of £100 000.
In accordance with IFRS 3 paragraph 42, Parent Ltd revalues the previously held investment to fair value,
recognising the increase in profit or loss. If previously changes in fair value are recognized in other com-
prehensive income, then these amounts are then taken into profit or loss as a reclassification adjustment.
The journal entries in Parent Ltd at acquisition date, both for the previously held investment as well as the
acquisition of the remaining shares in Sub Ltd, are as follows:
Investment in Sub Ltd Dr 8 000

Profit or Loss Cr 8 000
(Revaluation to fair value)

(Acquisition of shares in Sub Ltd: 80 000 at £5 per share)
The determination of goodwill is shown in figure 21.5.
Determination of goodwill:
1 July 2013
Value of previously acquired 20% stake £100 000
Consideration paid 400 000
500 000
Goodwill £ 25 000
FIGURE 21.5 Determination of goodwill — previously held equity

interests
As a result of the numbers used in this example, the goodwill number is the same as that shown in
figure 21.4. There are no subsequent effects on the consolidation process because the parent had previ-
ously held an investment in the subsidiary.
LO4 21.4 WORKSHEET ENTRIES AT THE ACQUISITION DATE

As noted earlier, the consolidation process does not result in any entries being made in the actual records
of either the parent or the subsidiary. The adjustment entries are made in the consolidation worksheet.
Hence, adjustment entries need to be passed each time a worksheet is prepared, and these entries change
over time. In this section, the adjustment entries that would be passed in a consolidation worksheet pre-
pared immediately after the acquisition date are analysed.
21.4.1 Business combination valuation entries

In figure 21.3, there are three identifiable assets recognised by the subsidiary whose fair values differ from
their carrying amounts at acquisition date, as well as an intangible asset and a contingent liability recog-
nised as part of the business combination. The entries for the business combination valuations are done in
the consolidation worksheet rather than in the records of the subsidiary (see section 21.6 for a discussion on
making these adjustments in the records of the subsidiary itself).
The identifiable assets and liabilities that require adjustment to fair value can be easily identified by ref-
erence to the acquisition analyses in figures 21.4 and 21.5, namely land, equipment, inventory, patent and
the unrecorded guarantee. Goodwill also has to be recognised on consolidation. These differences are all
recognised using business combination valuation entries. Consolidation worksheet adjustment entries for
each of these assets and the unrecorded liability are given in figure 21.6.

Business combination valuation entries
(1) Land Dr 20 000
Business Combination Valuation Reserve Cr 14 000
(2) Accumulated Depreciation – Equipment Dr 170 000

Equipment Cr 150 000
(3) Inventory Dr 5 000

(4) Patent Dr 20 000

(5) Business Combination Valuation Reserve Dr 10 500

Deferred Tax Asset Dr 4 500
Provision for Loan Guarantee Cr 15 000
(6) Goodwill Dr 25 000

FIGURE 21.6 Business combination valuation entries at acquisition date
The total balance of the business combination valuation reserve at this stage is £60 000. It will be can-
celled to zero when the pre-acquisition entries are processed. The adjustments to assets and liabilities
at acquisition date could be achieved by one adjusting entry, giving a net balance to the business com-
bination valuation reserve. However, in order to keep track of movements in that reserve as assets are
depreciated or sold, liabilities paid or goodwill impaired, it is practical to prepare a valuation entry for
each component of the valuation process. The valuation entries are passed in the adjustment columns of
the worksheet, which is illustrated in section 21.4.3. Note that, in relation to entry (6) for goodwill, there is
no deferred tax liability. This is because paragraph 21 of IAS 12 states that no such deferred tax liability
is recognised, as goodwill is measured as a residual, and the recognition of a deferred tax liability would
increase its carrying amount. Further, note that the goodwill is recognised on the consolidated balance
sheet and not on the balance sheet of the acquiring company.
21.4.2 Pre-acquisition entries

As noted in paragraph B86(b) of IFRS 10, an entry is required to eliminate the carrying amount of the
parent’s investment in the subsidiary against the parent’s stake in the subsidiary’s equity.
The investment in subsidiary on the parent’s balance sheet represents the underlying assets and liabil-
ities. As the consolidation process adds the net assets of the parent and subsidiary together to form the
consolidated balance sheet, the investment in the subsidiary on the parent’s balance sheet is eliminated to
avoid double counting.
When the parent holds 100% of outstanding shares, this implies a full elimination of the subsidiary’s
equity as at the acquisition date. However, when the parent holds less than 100%, then the investment
account is eliminated against the relevant portion of the subsidiary’s equity on acquisition date (see chapter
23). The pre-acquisition entries, then, involve two areas:
• the Investment in Subsidiary, as shown in the financial statements of the parent
• the equity of the subsidiary at the acquisition date (i.e. the pre-acquisition equity). The pre-acquisition
equity is not just the equity recorded by the subsidiary but includes the business combination
valuation reserve recognised on consolidation via the valuation entries.
Using the example in figure 21.3, and reading the information from the acquisition analysis in
figure 21.4 (including the business combination valuation reserve for the revalued assets including
goodwill and the contingent liability), the pre-acquisition entry at acquisition date is as shown in
figure 21.7. The pre-acquisition entry in this figure is numbered (7) because there were six previous
valuation entries.

Pre-acquisition entry
(7) Retained Earnings (1 July 2013) Dr 140 000
Business Combination Valuation Reserve Dr 60 000
Investment in Sub Ltd Cr 500 000
FIGURE 21.7 Pre-acquisition entry at acquisition date
The pre-acquisition entry is necessary to avoid overstating the equity and net assets of the group. To illustrate,
consider the information in figure 21.3 relating to Parent Ltd’s acquisition of the shares of Sub Ltd. Having
acquired the shares in Sub Ltd, Parent Ltd records the asset ‘Investment in Sub Ltd’ at £500 000. This asset
represents the actual net assets of Sub Ltd; that is, the ownership of the shares gives Parent Ltd the right to the
net assets of Sub Ltd. To include both the asset ‘Investment in Sub Ltd’ and the net assets of Sub Ltd in the con-
solidated statement of financial position would double count the assets of the group, because the investment
account is simply the right to the other assets. On consolidation, the investment account is therefore eliminated
and, in its place, the net assets of the subsidiary are included in the consolidated statement of financial position.
Similarly, to include both the equity of the parent and the equity of the subsidiary in the consolidated
statement of financial position would double-count the equity of the group. In the example, Parent Ltd
has equity of £900 000, which is represented by its net assets including the investment in the subsidiary.
Because the investment in the subsidiary is the same as the net assets of the subsidiary, the equity of the
parent effectively relates to the net assets of the subsidiary. To include in the consolidated statement of
financial position the equity of the subsidiary at acquisition date as well as the equity of the parent would
double-count equity in relation to the net assets of the subsidiary.
The credit balance on the business combination valuation reserve is also eliminated as it represents a
valuation adjustment to the net assets of Sub Ltd and is also included in the £500 000 acquisition price.
21.4.3 Consolidation worksheet

Figure 21.8 contains the consolidation worksheet prepared at acquisition date, with adjustments being
made for business combination valuation and pre-acquisition entries. The right-hand column reflects the
consolidated statement of financial position, showing the position of the group. In relation to the figures
in this column, note the following:
• In relation to the two equity accounts — share capital and retained earnings — only the parent’s
balances are carried into the consolidated statement of financial position. At acquisition date, all the
equity of the subsidiary is pre-acquisition and eliminated as well as the business combination reserve.
With the business combination valuation reserve, the valuation entry establishes the reserve, and the
pre-acquisition entry eliminates it because it is by nature pre-acquisition equity.
• The assets of the subsidiary are carried forward into the consolidated statement of financial position at
fair value.
• The adjusting journal entries have equal debits and credits (as shown in the line ‘Total adjustments’),
which is essential if the statement of financial position is to balance.
FIGURE 21.8 Consolidation worksheet at acquisition date
Adjustments
Parent Sub
Financial statements Ltd Ltd Dr Cr Consolidation
ASSETS
Land £ 120 000 £ 150 000 1 £ 20 000 £ 290 000
Equipment 620 000 480 000 150 000 2 950 000
Accumulated
depreciation (380 000 ) (170 000 ) 2 170 000 (380 000)
Investment in Sub Ltd 500 000 — 500 000 7 —
Inventory 92 000 75 000 3 5 000 172 000
Cash 15 000 5 000 20 000
Patent — — 4 20 000 20 000
Goodwill — — 6 25 000 25 000
Total assets £ 967 000 £ 540 000 £ 1 097 000
(continued)

Provisions £ 30 000 £ 60 000 £ 15 000 5 £ 105 000

Tax payables 10 000 6 000 16 000
6 000 2
1 500 3
— — 6 000 4 15 000
Total Liabilities £ 67 000 £ 100 000 £ 197 000
EQUITY
Share capital 550 000 300 000 7 300 000 550 000
Retained earnings
(1 July 2013) 350 000 140 000 7 140 000 350 000
900 000 440 000 900 000
Total liabilities and equity £ 967 000 £ 540 000 £ 1 097 000
Business combination
valuation reserve 5 10 500 14 000 1
7 60 000 14 000 2
3 500 3
14 000 4
25 000 6
Total adjustment £ 75 500 £ 75 500
21.4.4 Subsidiary has recorded dividends at acquisition date

Using the information in figure 21.3, assume that one of the trade and other payables at acquisition date
is a dividend payable of £10 000. The parent can acquire the shares in the subsidiary on a cum div. or an
ex div. basis.
If the shares are acquired on a cum div. basis, then the parent acquires the right to the dividend declared
at acquisition date. In this case, if Parent Ltd pays £500 000 for the shares in Sub Ltd, then the right to
receive dividend effectively reduces the consideration given by £10 000 to £490 000. The entry it passes to
record the business combination is:

Dividend Receivable Dr 10 000
In other words, the parent acquires two assets — the investment in the subsidiary and the dividend
receivable. In calculating the goodwill in the subsidiary therefore, the consideration given is £490 000.
Deducting the fair value of net assets received of £475 000 then results in goodwill of £15 000. The pre-
acquisition entry is:

Investment in Shares in Sub Ltd Cr 490 000
A further consolidation worksheet entry is also required:
Dividend Payable Dr 10 000

Dividend Receivable Cr 10 000

This entry is necessary so that the consolidated statement of financial position shows only the assets
and liabilities of the group; that is, only those benefits receivable from and obligations payable to entities
external to the group. In relation to the dividend receivable recorded by Parent Ltd, this is not an asset of
the group, because that entity does not expect to receive dividends from a party external to it. Similarly,
the dividend payable recorded by the subsidiary is not a liability of the group. That dividend will be paid
within the group, not to entities outside the group.
If the shares are acquired on an ex div. basis, then the parent only acquires the shares, as the dividend
will be paid to previous shareholders and not the parent company. The dividend has no effect on the
acquisition analysis. If Parent Ltd had paid £500 000 for the shares in Sub Ltd on an ex div. basis, then the
acquisition analysis is:
Net fair value of identifiable assets and liabilities

of Sub Ltd = £475 000 (see the cum div. basis)
Consideration transferred = 100 000 shares × £5 = £500 000
Goodwill = 500 000 − 475 000
= 25 000
The pre-acquisition entry is:
Retained Earnings (1/7/13) Dr 140 000

Investment in in Sub Ltd Cr 500 000
21.4.5 Gain on bargain purchase

In figure 21.3, Parent Ltd paid £500 000 for the shares in Sub Ltd. Consider the situation where Parent Ltd
paid £470 000 for these shares. The gain on bargain purchase analysis is as shown in figure 21.9.
Determination of gain on bargain purchase:

1 July 2013
Consideration paid £470 000
Gain on bargain purchase 5 000
FIGURE 21.9 Gain on bargain purchase
As the net fair value of the identifiable assets and liabilities of the subsidiary is greater than the consid-
eration transferred, in accordance with paragraph 36 of IFRS 3 the acquirer must firstly reassess the identi-
fication and measurement of the subsidiary’s identifiable assets and liabilities as well as the measurement
of the consideration transferred. The expectation under IFRS 3 is that the excess of the net fair value over
the consideration transferred is usually the result of measurement errors rather than being a real gain to the
acquirer. However, having confirmed the identification and measurement of both amounts paid and net assets
acquired, if an excess still exists, under paragraph 34 it is recognised immediately in the consolidated (rather
than the acquirer’s) profit as a gain on bargain purchase. This may happen, for example, when the subsidiary
is in poor financial health and the subsidiary’s shareholders are forced to offer a discount to a potential buyer.
Existence of a gain on bargain purchase implies that the entry (6) in Figure 21.6 cannot be passed. How-
ever, if the subsidiary has previously recorded goodwill a business combination revaluation a business
combination revaluation entry crediting goodwill and debiting business combination valuation reserve
for the amount of goodwill recorded by the subsidiary would be required. The reason for this is that if the
acquisition price paid by the parent is less than the subsidiary’s identifiable net assets, this implies that no
goodwill can exist in the subsidiary.
With a bargain purchase we replace entry (6) in Figure 21.6, as follows:


The pre-acquisition entry for the situation in figure 21.9 is as shown in figure 21.10.
Pre-acquisition entry
FIGURE 21.10 Pre-acquisition entry at acquisition date — gain on bargain purchase
LO5 21.5 WORKSHEET ENTRIES SUBSEQUENT TO THE

ACQUISITION DATE
At acquisition date, the business combination valuation entries result in the economic entity recognising
assets and liabilities not recorded by the subsidiary. Subsequently, changes in these assets and liabilities
occur as assets are depreciated or sold, liabilities paid and goodwill impaired. Movements in the subsid-
iary’s equity also occur as dividends are paid or declared and transfers are made within equity.

In the example used in figure 21.3, there were five items for which valuation entries were made — land,
equipment, inventory, patent and the guarantee (a contingent liability). In this section, a 3-year time
period subsequent to the acquisition date, 1 July 2013, is analysed (giving an end of reporting period of 30
June 2016) with the following events occurring:
• the land is sold in the 2015/16 period, for net proceeds of £199 000
• the equipment is depreciated on a straight-line basis over a 5-year period
• the inventory on hand at 1 July 2013 is all sold by 30 June 2014, the end of the first year
• the patent has an indefinite life, and is tested for impairment annually, with an impairment loss of
£5000 recognised in the 2014/15 period
• the liability for the guarantee results in a payment of £10 000 in June 2014, with no further liability existing
• goodwill is written down by £5000 in the 2014/15 period as a result of an impairment test (see chapter
15 for impairment of goodwill).
The statements of financial position of Parent Ltd and Sub Ltd, and the fair values of Sub Ltd’s assets
and liabilities, as of 30 June 2016 are shown in figure 21.11.
Parent Ltd Sub Ltd

Carrying amount Carrying amount Fair value of net assets
acquired on 1 July 2013 that
are still included in Sub Ltd’s
balance sheet
Assets
Land £170 000 £50 000
Equipment 750 000 680 000 £530 000
Patent 15 000
Investment in shares in Sub Ltd 500 000
Inventory 52 000 75 000
Cash 65 000 95 000
Total assets £1 089 000 £444 000
Equity and Liabilities
Trade and other payables 32 000 24 000
Tax payable 12 000 16 000
Total liabilities £84 000 £80 000
Equity
Total equity £1 005 000 £364 000
Total liabilities and equity £1 089 000 £444 000
FIGURE 21.11 Statements of financial position at 30 June 2016

The income statements for Parent Ltd and Sub Ltd for the year ended 30 June 2016 are shown in
figure 21.12.
Income statements Parent Ltd Sub Ltd

Revenue 120 000 95 000
Expenses 85 000 72 000
35 000 23 000
Gain on sale of non-current assets 15 000 31 000
Income tax expense 15 000 21 000
Profit for the period 35 000 33 000
Retained earnings (1 July 2015) 420 000 220 000
Retained earnings (30 June 2016) 455 000 253 000
FIGURE 21.12 Income statements at 30 June 2016
We next analyse the effect of each of these items on the consolidation process.
Equipment
Of net assets acquired on 1 July 2013, the subsidiary’s statement of financial position features only the
equipment and the patent. The equipment had a remaining useful life of 5 years on acquisition date. Hence,
Sub Ltd recorded an annual depreciation expense of ((£480 000 − £170 000)/5 = £62 000) bringing total
accumulated depreciation for acquisition date’s equipment to £356 000 and net book value of £124 000.
However, from the group’s perspective the initial fair value adjustment was £20 000. Hence the equip-
ment was restated to £330 000 with zero accumulated depreciation. For the purpose of consolidated state-
ments, therefore, subsequent annual depreciation expense is £66 000, or £4000 higher than what was
booked by Sub Ltd. After 3 years the net book value of this equipment is £132 000 (£330 000 − £198 000).
Note that the carrying value of the equipment at Sub Ltd’s stand-alone balance sheet (£124 000) is lower
than the carrying value in the consolidated balance sheet (£132 000). The difference of £8 000 reflects
40% of the fair value adjustment recorded on acquisition date, because the remaining useful life of this
adjustment is 2 (out of 5) years.
Note also the effect on the group’s earning. The consolidation process effectively absorbs 100% of the
profit reported by the subsidiary since acquisition. However, the calculation of this profit, which is reflected
in Sub Ltd’s equity, is not based on acquisition date’s fair values. Hence, relative to the group, over the
3-year period, Sub Ltd’s pre-tax profits are higher by £12 000 owing to lower annual depreciation expense
(£32 000 vs. £36 000). After tax, Sub Ltd’s retained earnings are higher by £8 400. The £8 400 reduction in
retained earnings is split between a reduction of £5 600 to opening retained earnings, and a reduction to
the 2014/15 after-tax profit of £2 800 (£4000 depreciation less £1200 tax saving).
Valuation entry for 2015/16 is shown in figure 21.13.
(1) Accumulated Depreciation — Equipment Dr 158 000

Retained Earnings — 30 June 2015 Dr 5 600
Equipment — Cost Cr 150 000
Tax Expense Cr 1 200
FIGURE 21.13 Business combination valuation entries at 30 June 2016
Note that the total effect on consolidated retained earnings as at 30 June 2016 is a reduction of £8400
(£5600 + £4000 − £1200).
Patent
The patent was impaired in 2014/15 to £15 000. Since the patent is not recorded in Sub Ltd’s stand-
alone balance sheet, the impairment was recorded only in consolidated income in the previous year.
Hence, Sub Ltd’s retained earnings as of 30 June should be reduced by £3 500 (£5000 × 70%). Deferred
tax liability should also be reduced by £1 500 and stand at £400 in the 30 June 2016 consolidated state-
ment of financial position.

Valuation entry for 2015/16:
(2) Patent Dr 15 000

Retained Earnings — 30 June 2015 Dr 3 500
Land
The land was sold in 2015/16. Because Sub Ltd recorded a gain that is based on lower carrying value than
what was recorded in the 30 June 2015 consolidated balance sheet, its 2015/16 profit is higher by £14 000
(£20 000 × 70%). Therefore, this should be deducted from Sub Ltd’s income for the year.
(3) Gain on Sale of Land Dr 20 000

Tax Expense Cr 6 000
Inventory
The inventory was sold in 2013/14. Because Sub Ltd recorded gross profit that is based on lower carrying
value than what was recorded in the 1 July 2013 consolidated balance sheet, its 2013/14 profit is higher by
£3500 (£5000 × 70%).
(4) Retained Earnings — 30 June 2015 Dr 3 500

Contingent liability
The guarantee liability was originally stated at £15 000 on the acquisition date consolidated balance sheet.
Since in 2013/14 the settlement involved a payment of only £10 000, the group needs to record a pre-tax
gain of £5 000. Sub Ltd’s income statement in 2013/14 recorded a pre-tax loss of £10 000, because in its
stand-alone balance sheet on 1 July 2013 no liability was recognised for the guarantee. Hence there is a
difference of £15 000 between Sub Ltd’s income and the group’s income. Sub Ltd’s retained earnings need
to be increased by £10 500 (£15 000 × 70%) in the consolidation process.

Retained Earnings — 30 June 2015 Cr 10 500
The above analysis is summarised in the tables below:
Analysis of effect of acquisition-date adjustments

on subsequent balance sheet
Effect on
(1) (2) (3) (4) (5)
Deferred tax Deferred tax Retained
Balance sheet Balance sheet liability liability earnings
30 June 2016 1 July 2013 30 June 2016 1 July 2013 30 June 2016
Equipment −150 000 −150 000
Accumulated
Depreciation 158 000 170 000
8 000 20 000 2 400 6 000 (8 400)
Land 0 20 000 0 6 000 (14 000)
Patent 15 000 20 000 4 500 6 000 (3 500)
Inventory 0 5 000 1 500 (3 500)
Contingent
Liability —
Guarantee 0 (15 000) 0 (4 500) 10 500
Total £23 000 £50 000 £6 900 £15 000 £(18 900)

Analysis of effect of acquisition-date adjustments
on 2015/16 profit
Effect on
(1) (2) (3) (4) (5)
Deferred Deferred tax After-tax
Balance sheet Balance sheet tax liability liability profit
30 June 2016 30 June 2015 30 June 2016 1 July 2013 2015/16
Equipment −150 000 −150 000
Accumulated 158 000 162 000
Depreciation
8 000 12 000 2 400 3 600 (2 800)
Land 0 20 000 0 6 000 (14 000)
Patent 15 000 15 000 4 500 4 500 0
Inventory 0 0 0 0 0
Contingent 0 0 0 0 0
Liability —
Guarantee
Total £23 000 £47 000 £6 900 £14 100 £(16 800)
Note:
Column (3) = 30% of column (1)
Column (4) = 30% of column (2)
Column (5) = [column (1) − column (2)] − [column (3) − column (4)]
Goodwill
Impairment tests for goodwill are undertaken annually. Goodwill is written down by £5000 in the 2014/15
period as a result of an impairment test. In the consolidation worksheet prepared at 30 June 2015, the business
combination valuation entry will recognise the loss and reduction in goodwill. Because goodwill impairment
is not tax deductible (i.e. it is a permanent difference) there is no effect on deferred tax liability or tax expense.
(6) Retained Earnings — 30 June 2015 Dr 5 000

Goodwill Dr 20 000
21.5.2 Pre-acquisition entry

With the above entries (1)–(6) recorded, the final entry is to eliminate the investment in Sub Ltd account
against the equity of the subsidiary as it was on acquisition date:
(7) Retained Earnings Dr 140 000

We are now ready to prepare the consolidated statement of financial position and income statement
(see figure 21.14).
21.5.3 Dividends paid/payable from subsidiary equity

Prior to July 2008, IAS 27 Consolidated and Separate Financial Statements described a cost method in relation
to accounting for a parent’s investment in a subsidiary. The equity of the subsidiary was then classified into
pre-acquisition and post-acquisition components based upon whether the equity existed before or after
the acquisition date. Dividends from pre-acquisition equity were accounted for as a recovery of a parent’s
investment in a subsidiary and recognised as a reduction in the cost of the investment. Dividends from
post-acquisition equity were accounted for by a parent as revenue.
In 2008, the IASB made amendments to IAS 27. These amendments deleted the definition of the cost
method from IAS 27 and required that all dividends paid or payable by a subsidiary were to be accounted
for as revenue by the parent.

Adjustments
Parent Sub
Ltd Ltd Dr Cr Consolidation
Assets
Land £ 170 000 £ 50 000 £ 220 000
Equipment 750 000 680 000 150 000 1 1 280 000
Accumulated depreciation (448 000) (456 000) 1 158 000 (746 000)
Patent 2 15 000 15 000
Investment in Sub Ltd 500 000 500 000 7
Inventory 52 000 75 000 127 000
Cash 65 000 95 000 160 000
Goodwill 6 20 000 20 000
Total assets £1 089 000 £ 444 000 £1 076 000
Liabilities
Provisions 40 000 40 000 80 000
Tax payable 12 000 16 000 28 000
Deferred tax liability 2 400 1 6 900
4 500 2
Total liabilities £ 84 000 £ 80 000 £ 170 900
Equity
Share capital 550 000 300 000 7 300 000 550 000
Retained earnings:
Revenues 120 000 95 000 215 000
Expenses 85 000 72 000 1 4 000 161 000
35 000 23 000 54 000
Gain on sale of non-
current assets 15 000 31 000 3 20 000 26 000
Profit before tax 50 000 54 000 1 200 1 80 000
Income tax expense 15 000 21 000 6 000 3 28 800
Profit for the period 35 000 33 000 24 000 7 200 51 200
(30 June 2015) 2 3 500
4 3 500
6 5 000
420 000 31 000 7 140 000 303 900
Retained earnings
(30 June 2016) 455 000 64 000 355 100
Total equity £1 005 000 £ 364 000 £481 600 £ 17 700 £ 905 100
Total liabilities and equity £1 089 000 £ 444 000 £481 600 £ 24 600 £1 076 000
Business combination 5 10 500 14 000 1
valuation reserve 7 60 000 14 000 2
14 000 3
3 500 4
25 000 6
Total adjustments £ 745 100 £ 745 100
FIGURE 21.14 Consolidation worksheet at 30 June 2016
In 2011, the International Accounting Standards Board (IASB®) issued a new IAS 27 Separate Financial
Statements. Paragraph 12 of this standard states:
An entity shall recognise a dividend from a subsidiary, a joint venture or an associate in profit or loss in its sep-
arate financial statements when its right to receive the dividend is established.
Under IAS 27, all dividends paid or payable by the subsidiary to a parent are recognised as revenue in
the profit or loss of the parent. In relation to dividends, there is no need to classify the equity of the sub-
sidiary into pre-acquisition and post-acquisition equity. Effectively, all dividends are accounted for as if
they are paid from post-acquisition equity.
Paragraphs BC14 to BC20 of IAS 27, as issued in 2011, discuss the reasons for the accounting for div-
idends received from a subsidiary, a joint venture or an associate. BC14 notes that one of the driving

forces for the current accounting for dividends was the problem of classifying equity into pre- and post-
acquisition components on first-time adoption of IFRS® Standards by entities. To reduce any risk from
removing the cost method and any possible overstatement of income by a parent, the IASB looked at the
impairment testing of the investment account recorded by the parent. As a result, as part of the internal
sources of information used to determine whether there is any indication of impairment of an asset, para-
graph 12(h) of IAS 36 Impairment of Assets states:
for an investment in a subsidiary, joint venture or associate, the investor recognises a dividend from the invest-
ment and evidence is available that:
(i) the carrying amount of the investment in the separate financial statements exceeds the carrying amounts in
the consolidated financial statements of the investee’s net assets, including associated goodwill; or
(ii) the dividend exceeds the total comprehensive income of the subsidiary, joint venture or associate in the
period the dividend is declared.
Bonus share dividends

Bonus share dividends involve a subsidiary issuing shares instead of a cash dividend to shareholders. There
are no entries in the records of the parent as a result of this transaction. Hence, the IASB’s amendments
to IAS 27 do not apply to this transaction. The effect to be adjusted for in the pre-acquisition entry is that
this transaction results in moving pre-acquisition equity from one account to another, with no change in
total pre-acquisition equity.
Assume that in the 2013/14 period the subsidiary pays a dividend of £3000 by the issue of bonus shares.
The entries passed in the parent and the subsidiary as a result of the dividend are:
Parent Subsidiary
No entry required Bonus Dividend Paid Dr 3 000
No entry is required by the parent because its share of wealth in the subsidiary is unchanged by the
bonus share issue. The pre-acquisition entries for the 2013/14 period are shown in figure 21.15.
Retained Earnings (1 July 2013) Dr 140 000

Investment in Subsidiary Cr 500 000

Bonus Dividend Paid Cr 3 000
FIGURE 21.15 Dividend provided for in the current period.
The effect of the bonus dividend is to increase the share capital of the subsidiary by £3000 and to reduce
the retained earnings by the same amount. There is no overall change in the pre-acquisition equity of the
subsidiary, just a transfer from one equity account to another. Accordingly, there is no change in the bal-
ance of the investment account in the records of the parent.
The pre-acquisition entry in subsequent periods is:
Retained Earnings (opening balance) [£140 000 − £3000] Dr 137 000

21.5.4 Pre-acquisition reserve transfers

From time to time the subsidiary may transfer retained earnings to reserves, or make transfers from reserves
to retained earnings. These do not cause any change in the total pre-acquisition equity but simply change
the composition of that equity. Therefore, there is no change in the investment account recorded by the
parent entity. In fact, the parent is unaffected by these transfers. However, the parent needs to decide if
for consolidation purposes such transfers should be reflected in consolidated equity. With such approval,
there is not anything to account for in the consolidation purpose. For example, if the subsidiary makes a
transfer out from retained earnings to a restricted reserve, and this is approved, or even instructed, by the

parent, the restricted reserve should appear in the consolidated balance sheet. In what follows, however,
we would assume this is not the case.
Assume for the cases illustrated below that the pre-acquisition entry for the year ending 30 June 2014,
apart from the effect of reserve transfers, is as follows:

Case 1: Transfers from retained earnings to other reserves

Assume that in the 2013/14 period the subsidiary transfers £4 000 to general reserve from retained earn-
ings. The entry passed in the subsidiary as a result of the transfer is:

The pre-acquisition entries for the 2013/14 period are shown in figure 21.16.

General Reserve Dr 4 000

FIGURE 21.16 Transfer to general reserve in the current period
As both the transfer to general reserve and the general reserve accounts are pre-acquisition in nature,
they are eliminated as part of the pre-acquisition entry. The pre-acquisition entry in subsequent periods is:
Retained Earnings (opening balance) [£140 000 – £4000] Dr 136 000

In this case and in the following cases, the only equity account in which movements (transfers to and
from) are specifically identified is retained earnings. Movements within the general reserve account are not
specifically noted. This is because, as illustrated in figure 21.13, the retained earnings account and changes
therein are used to connect the statement of profit or loss and other comprehensive income accounts and
the statement of financial position accounts. In preparing the consolidated statement of changes in equity,
where movements in all equity accounts are disclosed, adjustments for pre-acquisition transfers must be
taken into account. Whether such adjustments are necessary can be seen from viewing the consolidation
worksheet and the adjustments made to individual equity accounts. A similar issue arises in preparing
other notes to the consolidated financial statements, such as for property, plant and equipment, where
movements such as additions and disposals must be disclosed.
Case 2: Transfers to retained earnings from other reserves

This case uses the information in case 1, in which a £4 000 general reserve was created. Assume that in the
2014/15 period the subsidiary transfers £1 000 to retained earnings from general reserve. The entry passed
in the subsidiary as a result of the transfer is:


The pre-acquisition entries for the 2014/15 period are shown in figure 21.17.


FIGURE 21.17 Transfer from general reserve in the current period
Since both the transfer from general reserve and general reserve accounts are pre-acquisition in
nature, they are eliminated as part of the pre-acquisition entry. The pre-acquisition entry in subse-
quent periods is:
Retained Earnings (opening balance) [£140 000 – £4000 + £1000] Dr 137 000
LO6 21.6 REVALUATIONS IN THE RECORDS OF THE

SUBSIDIARY AT ACQUISITION DATE
IFRS 3 does not discuss whether the valuation of the assets of the subsidiary at acquisition date should be
done in the consolidation worksheet or in the records of the subsidiary. It is expected that most entities
will make their adjustments in the consolidation worksheet, for two reasons:
• Adjustments for assets such as goodwill and inventory are not allowed in the actual records of the
subsidiary. Goodwill is not allowed to be revalued because it would amount to the recognition of
internally generated goodwill, and inventory cannot be written to an amount greater than cost.
• The revaluation of non-current assets in the records of the subsidiary means that the subsidiary has
effectively adopted the revaluation model of accounting for those assets. As discussed in chapter 11,
IAS 16 Property, Plant and Equipment requires the assets to be recorded at amounts not materially
different from fair value. For entities wanting to measure assets using the cost model, the revaluation of
subsidiary assets would be undertaken in the consolidation worksheet.
Note that the business combination valuation entries applied in the consolidation worksheet for
property, plant and equipment assets in this chapter are of the same form as those applied for prop-
erty, plant and equipment in chapter 11. The revaluation surplus created in the financial statements of
the subsidiary will be eliminated as part of the pre-acquisition entries and the underlying asset will
be shown on the consolidated statement of financial position at fair value. Hence, the consolidated
financial statements at acquisition date are the same regardless of whether revaluation occurs on con-
solidation or in the records of the subsidiary. In future periods, differences will arise because there is no
requirement for valuations done in the consolidation worksheet to be updated for subsequent changes
in the fair values of the assets.
LO7 21.7 DISCLOSURE

Paragraphs B64–B67 of Appendix B to IFRS 3 cover the disclosure of information about business combi-
nations. These paragraphs require an acquirer to disclose information that enables users of its financial
statements to evaluate the nature and financial effect of business combinations that occurred during the
reporting period, as well as those that occur between the end of the reporting period and when the finan-
cial statements are authorised for issue. Examples of disclosures required by these paragraphs are given in
figure 21.18.

FIGURE 21.18 Disclosure of business combinations
IFRS 3
Note 4. Business combinations paragraph
On 20 October 2013, Libra Ltd acquired 100% of the voting shares of Pisces Ltd, B64(a), (b), (c)
a listed company specialising in the manufacture of electronic parts for sound
equipment. The primary reason for the acquisition was to gain access to specialist B64(d)
knowledge relating to electronic systems. Control was obtained by acquisition of all
the shares of Pisces Ltd.
To acquire this ownership interest, Libra Ltd issued 600 000 ordinary shares, valued B64(f)(iv)
at £2.50 per share, which rank equally for dividends after the acquisition date. The
fair value is based on the published market price at acquisition date.
The total consideration transferred was £1 800 000 and consisted of: B64(f)
£’000
Shares issued, at fair value 1 500
Cash paid 240
Cash payable in 2 years’ time 60
Total consideration transferred 1 800
The fair values and the carrying amounts of the assets acquired and liabilities B64(f)
assumed in Pisces Ltd as at 20 October 2013 were
Fair Carrying
value amount
£’000 £’000
Property, plant and equipment 1 240 1 020
Receivables 340 340
Inventory 160 130
Intangibles 302 22
Goodwill 54 0
2 096 1 512
Payables 152 152
Provisions 103 103
Tax liabilities 41 41
296 296
Fair value of net assets of Pisces Ltd 1 800
Goodwill in Pisces Ltd can be attributed to the synergies existing within the B64(e)
company, and relate to the high level of training given to the staff as well as the
professional expertise of the employees. Further, there exist in-process research
activities in Pisces Ltd for which it was impossible to determine reliable fair values
for the separate recognition of intangible assets.
Pisces Ltd earned a profit for the period from 20 October 2013 to 30 June 2014 of B64(q)(i)
£520 000. This has been included in the consolidated statement of profit or loss and
other comprehensive income for the year ended 30 June 2014.
None of the above information has been prepared on a provisional basis. B67
The consolidated profit is shown in the consolidated statement of profit or loss B64(q)(ii)
and other comprehensive income at £5 652 000, which includes the £520 000
contributed by Pisces Ltd from 20 October 2013 to the end of the period. If Pisces
Ltd had been acquired at 1 July 2013, it is estimated that the consolidated entity
would have reported:
£’000
Consolidated revenue 36 654
Consolidated profit 6 341
In relation to the business combination in the 2012/13 period when Libra Ltd B67(a)(iii)
acquired all the shares in Orion Ltd, an adjustment was made in the current period
relating to the provisional measurement of specialised equipment held by Orion
Ltd. A loss of £250 000 was recognised in the current reporting period because of
the write-down of this equipment.

Included in the current period profit are gains on the sale of land acquired as a part B67(e)
of the business combination with Pisces Ltd. The gain amounted to £100 000 and
arose due to an upsurge in demand for inner-city properties.
Goodwill B67(d)
£’000
Gross amount at 1 July 2013 120
Accumulated impairment losses (15)
Carrying amount at 1 July 2013 105
Goodwill recognised in current period 54
Carrying amount at 30 June 2014 159
Gross amount at 30 June 2014 174
Accumulated impairment losses (15)
Carrying amount at 30 June 2014 159
IFRS 12 Disclosure of Interests in Other Entities also requires disclosures in relation to a parent’s interest in
its subsidiaries. Figure 21.19 illustrates some of these disclosures.
IFRS 12
Note 5. Subsidiaries paragraph
Aries Ltd has a 40% interest in Virgo Ltd. Although it has less than half the voting 9(b)
power, Aries Ltd believes it has control of the financial and operating policies of Virgo
Ltd. Aries Ltd is able to exercise this control because the remaining ownership in Virgo
Ltd is diverse and widely spread, with the next single largest ownership block being
11%.
Aries Ltd has invested in a special purpose entity established by Pictor Ltd. Pictor Ltd 9(a)
established Cetus Ltd as a vehicle for distributing the sailing boats it makes. Aries Ltd
currently owns 60% of the shares issued by Cetus Ltd. However, because of the limited
decisions that the board of Cetus Ltd can make owing to the constitution of that entity,
Aries Ltd believes that it does not have any real control over the operations of Cetus Ltd,
so it sees its role in Cetus Ltd as that of an investor.
Aries Ltd has a wholly owned subsidiary, Gemini Ltd, which operates within the 11
electricity generating industry. The end of its reporting period is 31 May. Gemini Ltd
continues to use this date because the government regulating authority requires all
entities within the industry to provide financial information to it based on financial
position at that date.
Aries Ltd has a wholly owned subsidiary, Hercules Ltd, in the country of Mambo. 10(b)(i)
Because of constraints on assets leaving the country recently imposed by the new
military government, there are major restrictions on the subsidiary being able to transfer
funds to Aries Ltd.
FIGURE 21.19 Disclosures concerning subsidiaries
Disclosures in relation to subsidiaries are set out in IFRS 12 Disclosure of Interests in Other Entities, issued
in 2011. These are discussed in chapter 20. Note, however, the following extract from paragraph 10.
An entity shall disclose information that enables users of its consolidated financial statements
(a) to understand:
(i) the composition of the group; and
(ii) the interest that non-controlling interests have in the group’s activities and cash flows (paragraph 12);
and
(b) to evaluate:
(i) the nature and extent of significant restrictions on its ability to access or use assets, and settle liabilities,
of the group (paragraph 13);
(ii) the nature of, and changes in, the risks associated with its interests in consolidated structured entities
(paragraphs 14–17) . . .

SUMMARY
This chapter covers the preparation of the consolidated financial statements for a group consisting of a
parent and a wholly owned subsidiary. Because of the requirements of IFRS 3 to recognise the identifiable
assets acquired and liabilities assumed of an acquired entity at fair value, an initial adjustment to be made
on consolidation concerns any assets or liabilities for which there are differences between fair value and
carrying amount at the acquisition date. Further, although some intangible assets and liabilities of the
subsidiary may not have been recognised in the subsidiary’s records, they are recognised as part of the
business combination.
The preparation of the consolidated financial statements is done using a consolidation worksheet, the
left-hand columns of which contain the financial statements of the members of the group. The adjustment
columns contain the consolidation worksheet entries that adjust the right-hand columns to form the con-
solidated financial statements. The adjustment entries have no effect on the actual financial records of the
parent and its subsidiaries.
At acquisition date, an acquisition analysis is undertaken. The key purposes of this analysis are to deter-
mine the fair values of the identifiable assets and liabilities of the subsidiary, and to calculate any goodwill
or gain on bargain purchase arising from the business combination. From this analysis, the main consol-
idation worksheet adjustment entries at acquisition date are the business combination valuation entries
(to adjust carrying amounts of the subsidiaries’ assets and liabilities to fair value) and the pre-acquisition
entries.
In preparing consolidated financial statements in periods after acquisition date, the consolidation work-
sheet will contain valuation entries and pre-acquisition entries. However, these entries are not necessarily
the same as those used at acquisition date. If there are changes to the assets and liabilities of the subsid-
iaries since acquisition date, or there have been movements in pre-acquisition equity, changes must be
made to these entries.
1. Explain the purpose of the pre-acquisition entries in the preparation of consolidated financial
statements.
2. When there is a dividend payable by the subsidiary at acquisition date, under what conditions
should the existence of this dividend be taken into consideration in preparing the pre-acquisition
entries?
3. Is it necessary to distinguish pre-acquisition dividends from post-acquisition dividends? Why?
4. If the subsidiary has recorded goodwill in its records at acquisition date, how does this affect the
preparation of the pre-acquisition entries?
5. Explain how the existence of a bargain purchase affects the pre-acquisition entries, both in the year of
acquisition and in subsequent years.
Exercise 21.1 ACCOUNTING FOR ASSETS AND LIABILITIES

★ Mensa Ltd has acquired all the shares of Cancer Ltd. The accountant for Mensa Ltd, having studied the
requirements of IFRS 3 Business Combinations, realises that all the identifiable assets and liabilities of
Cancer Ltd must be recognised in the consolidated financial statements at fair value. Although he is happy
about the valuation of these items, he is unsure of a number of other matters associated with accounting
for these assets and liabilities. He has approached you and asked for your advice.
Required
Write a report for the accountant at Mensa Ltd advising on the following issues:
1. Should the adjustments to fair value be made in the consolidation worksheet or in the accounts of
Cancer Ltd?
2. What equity accounts should be used when revaluing the assets, and should different equity ac-
counts such as income (similar to recognition of an excess) be used in relation to recognition of
liabilities?
3. Do these equity accounts remain in existence indefinitely, since they do not seem to be related to the
equity accounts recognised by Cancer Ltd itself?

Exercise 21.2 CONSOLIDATION WORKSHEET ENTRIES 1 YEAR AFTER ACQUISITION DATE
★ At 1 July 2013, Pisces Ltd acquired all the shares of Ursa Ltd for £283 000. At this date the equity of Ursa
Ltd consisted of:
Share capital — 100 000 shares £200 000

All the identifiable assets and liabilities of Ursa Ltd were recorded at amounts equal to fair value except
for the following assets:

Inventory £ 60 000 £ 65 000
Plant (cost £280 000) 200 000 210 000
The inventory was all sold by 30 June 2014. The plant has a further 5-year life, and depreciation is cal-
culated on a straight-line basis. When revalued assets are sold or fully consumed, any related revaluation
surplus is transferred to retained earnings.
Required
Prepare the consolidation worksheet entries at 30 June 2014 for the preparation of the consolidated finan-
cial statements of Pisces Ltd.
Exercise 21.3 ACQUISITION ANALYSIS, PARENT HOLDS PREVIOUSLY ACQUIRED SHARES IN SUBSIDIARY,
★ WORKSHEET ENTRIES AT ACQUISITION DATE
At 1 July 2014, Pavo Ltd acquired 60% of the shares of Octans Ltd for £153 000 on a cum div. basis. Pavo
Ltd had acquired 40% of the shares of Octans Ltd 2 years earlier for £80 000. This investment, classified
as a financial asset, was recorded using the equity method on 1 July 2014 of £102 000. At 1 July 2014, the
equity of Octans Ltd consisted of:
Share capital £160 000

At this date, the identifiable assets and liabilities of Octans Ltd were recorded at fair value except for:

Inventory £ 40 000 £ 44 000
Plant (cost £120 000) 100 000 105 000
At 1 July 2014, Octans Ltd’s assets and liabilities included a dividend payable of £5 000. An analysis of
the unrecorded intangibles of Octans Ltd revealed that the company had unrecorded internally generated
brands, considered to have a fair value of £50 000. Further, Octans Ltd had expensed research outlays of
£80 000 that were considered to have a fair value of £20 000. In its financial statements at 30 June 2014,
Octans Ltd had reported a contingent liability relating to a potential claim by customers for unsatisfactory
products, the fair value of the claim being £10 000.
Required
Prepare the acquisition analysis at 1 July 2014, and the consolidation worksheet entries for preparation of
consolidated financial statements of Pavo Ltd at that date.

Exercise 21.4 BUSINESS COMBINATION VALUATION AND PRE-ACQUISITION ENTRIES
★ On 1 July 2013, Pyxis Ltd acquired all the share capital of Gemini Ltd for £218 500. At this date, Gemini
Ltd’s equity comprised:

All identifiable assets and liabilities of Gemini Ltd were recorded at fair value as at 1 July 2013 except
for the following:

Inventory £27 000 £35 000
Land 75 000 90 000
Equipment (cost
£100 000) 50 000 60 000
The equipment is expected to have a further 10-year life. All the inventory was sold by June 2014. The
tax rate is 30%.
On 30 June 2014, the directors of Gemini Ltd decided to transfer £25 000 from the general reserve to
retained earnings.
Required
Prepare the consolidation worksheet entries for the preparation of consolidated financial statements for
Pyxis Ltd and its subsidiary Gemini Ltd as at:
1. 1 July 2013
2. 30 June 2014.
Exercise 21.5 BARGAIN PURCHASE

★★ The accountant for Carina Ltd, Ms Finn, has sought your advice on an accounting issue that has been puz-
zling her. When preparing the acquisition analysis relating to Carina Ltd’s acquisition of Lyra Ltd, she cal-
culated that there was a gain on bargain purchase of £10 000. Being unsure of how to account for this, she
was informed by accounting acquaintances that this should be recognised as income. However, she reasoned
that this would have an effect on the consolidated profit in the first year after acquisition date. For example,
if Lyra Ltd reported a profit of £50 000, then consolidated profit would be £60 000. She is unsure of whether
this profit is all post-acquisition profit or a mixture of pre-acquisition profit and post-acquisition profit.
Required
Compile a detailed report on the nature of an excess, how it should be accounted for and the effects of its
recognition on subsequent consolidated financial statements.
Exercise 21.6 PARENT HOLDS PREVIOUSLY ACQUIRED INVESTMENT, CONSOLIDATION WORKSHEET

★★ On 1 December 2009, Reticulum Ltd acquired 20% of the shares of Dorado Ltd for £10 000. These were
classified as a financial investment by Reticulum Ltd with changes in fair value being recognised in other
comprehensive income. At 30 June 2013, these were recorded at a fair value of £20 400. Reticulum Ltd
acquired the remaining 80% of the share capital of Dorado Ltd for £81 600 on 1 July 2013 when the
equity of Dorado Ltd consisted of:

All identifiable assets and liabilities of Dorado Ltd were recorded at amounts equal to fair value, except
as follows:

Inventory £20 000 £25 000
Plant (cost £80 000) 60 000 70 000
The plant is expected to have a further useful life of 5 years. All the inventory on hand at 1 July 2013 was
sold by 31 December 2013.

The income tax rate is 30%.
At 30 June 2015, the information below was obtained from both entities.
Required
1. Prepare the consolidation worksheet entries for the preparation of consolidated financial statements for
Reticulum Ltd and its subsidiary, Dorado Ltd, as at 1 July 2013.
2. Prepare the consolidation worksheet entries and the consolidation worksheet for the preparation of
consolidated financial statements for Reticulum Ltd and its subsidiary, Dorado Ltd, as at 30 June 2015.
For the year ending 30 June 2015 Reticulum Ltd Dorado Ltd
Profit before tax £ 50 000 £ 40 000
Profit 30 000 25 000
Retained earnings (1/7/14) 50 000 35 000
80 000 60 000
Transfer to general reserve (approved by parent) (20 000) (5 000)
Retained earnings (30/6/15) £ 60 000 £ 55 000

30 June 2015
Cash £ 13 000 £ 14 000

Inventory 70 000 50 000
Investment in Dorado Ltd 102 000 —
Plant 200 000 80 000
Total assets £330 000 £125 000
Payables 20 000 5 000
Total liabilities £ 85 000 £ 15 000
Total equity 245 000 110 000
Exercise 21.7 CONSOLIDATION WORKSHEET

★★ Cepheus Ltd gained control of Aquarius Ltd by acquiring its share capital on 1 January 2013. The state-
ment of financial position of Aquarius Ltd at that date showed:
Land £ 20 000 Liabilities £ 15 000

Plant and machinery 120 000 Share capital 60 000
Accumulated depreciation (20 000) Retained earnings 40 000
Inventory 15 000 Asset revaluation surplus 20 000
£135 000 £135 000
At 1 January 2013, the recorded amounts of Aquarius Ltd’s assets and liabilities were equal to their fair
values except as follows:

Plant and machinery £100 000 £102 000
Inventory 15 000 18 000

Half of this inventory was sold by Aquarius Ltd in the following 12 months. The depreciable assets have
a further 5-year life, benefits being received evenly over this period. Any business combination valuation
adjustments are made on consolidation. The tax rate is 30%.
At 31 December 2013, the following information was obtained from both entities:
Cepheus Ltd Aquarius Ltd

Land — £ 20 000
Plant and machinery £ 575 000 120 000
Accumulated depreciation (20 000 ) (25 000 )
Inventory 15 000 23 000
Investment in Aquarius Ltd 130 000 —
Total assets £700 000 £138 000
Total liabilities £ 42 000 £ 4 000
Income tax expense (20 000 ) (5 000 )
183 000 50 000
Asset revaluation surplus* 30 000 24 000
£700 000 £138 000
*This reserve relates to certain items of plant. At 1/1/13, the balances of the account were £15 000 for Cepheus Ltd and
£20 000 for Aquarius Ltd.
Required
1. Prepare the consolidated financial statements for Cepheus Ltd at 31 December 2013.
2. Prepare the valuation and pre-acquisition entries at 31 December 2017, assuming that, on consolida-
tion, business combination valuation reserves are transferred to retained earnings when the related asset
is sold or fully consumed.
Exercise 21.8 REVALUATION IN SUBSIDIARY’S RECORDS

★★ On 1 July 2013, Cancer Ltd acquired all the shares of Grus Ltd (totalling £40 000) for a cash outlay of
£100 000. At that date the other reserves and retained earnings of Grus Ltd were as follows:
General reserve £30 000

All identifiable assets and liabilities of Grus Ltd were recorded at fair value at 1 July 2013 except as
follows:

Land £30 000 £34 000
Plant (cost £28 000) 20 000 22 000
Inventory 40 000 44 000
The plant has a further 5-year life. Of the inventory on hand at 1 July 2013, 90% was sold by 30 June
2014. The tax rate is 30%.
Required
1. Prepare the consolidation worksheet entries at 30 June 2014 assuming Grus Ltd revalued the land and
plant to their fair values in its records just before it was acquired at 1 July 2013.
2. Prepare the consolidation worksheet entries at 30 June 2014 assuming all business combination valua-
tions are made in the consolidation worksheet.
3. If the balance of inventory was sold, what would be the business combination valuation and the pre-
acquisition entries at 30 June 2015, assuming requirement 2 above?

Exercise 21.9 CONSOLIDATION WORKSHEET AND RESERVE TRANSFER
★★★
Adjustments
Triangulum Cygnus
Financial statements Ltd Ltd Dr Cr Consolidation
Profit £ 6 000 £ 4 000

28 000 22 000
Transfer from general reserve 5 000 3 000
Retained earnings (30/6/16) £33 000 £25 000
An extract from the consolidation worksheet of Triangulum Ltd and its subsidiary, Cygnus Ltd, as at 30
June 2016, is shown above. Triangulum Ltd acquired all the share capital (cum div.) of Cygnus Ltd on 1
July 2012 for £127 000 when the equity of Cygnus Ltd consisted of:
Share capital £85 000

All the identifiable assets and liabilities of Cygnus Ltd at 1 July 2012 were recorded at fair value except for:

Plant (cost £100 000) £80 000 £82 000
Inventory 6 000 7 000
The plant had a further 5-year life. All the inventory was sold by Cygnus Ltd by 22 September 2012.
The tax rate is 30%. The liabilities of Cygnus Ltd included a dividend payable of £6000. Cygnus Ltd had
not recorded any goodwill. At 1 July 2012, Cygnus Ltd had incurred research and development outlays of
£5000, which it had expensed. Triangulum Ltd placed a fair value of £2000 on this item. The project was
still in progress at 30 June 2016, with Cygnus Ltd capitalising £3000 in the 2015/16 period. Valuation
adjustments are made on consolidation.
The transfer from general reserve during the current period ending 30 June 2016 is from pre-acquisition
reserves, and is the only such transfer since the acquisition date.
Required
1. Prepare the consolidation worksheet entries at 30 June 2016.
2. Complete the worksheet extract above.
Exercise 21.10 BARGAIN PURCHASE, CONSOLIDATION WORKSHEET

★★★ The financial statements of Equuleus Ltd and its subsidiary, Fornax Ltd, at 30 June 2015 contained the
following information:
Equuleus Ltd Fornax Ltd

Land £ 8 600 £ 5 100
Plant 17 000 8 000
Financial assets 3 000 2 000
Cash 300 360
Investment in Fornax Ltd 15 000 —
Total assets £41 900 £18 460
Liabilities £ 5 000 £ 1 300

Equuleus Ltd Fornax Ltd
Profit before tax £ 3 200 £ 1 800
Income tax expense (1 300) (240)
3 400 3 660
Dividend paid (500) (0)
Other components of equity* 1 000 500
Total equity £36 900 £17 160
*This relates to the financial assets. The balances of the accounts at 1/7/14 were £1500 (Equuleus Ltd) and £300 (Fornax Ltd).
Equuleus Ltd had acquired all the share capital of Fornax Ltd on 1 July 2013 for £15 000 when the
equity of Fornax Ltd consisted of:

At the acquisition date by Equuleus Ltd, Fornax Ltd’s non-monetary assets consisted of:

Land £ 4 000 £6 000
Plant (cost £6000) 5 500 6 500
The plant had a further 5-year life. All the inventory was sold by 30 June 2014. All valuation adjustments
to non-current assets are made on consolidation. The land was sold in January 2015 for £6000. The rele-
vant business combination valuation reserves are transferred, on consolidation, to retained earnings.
In September 2013, Fornax Ltd transferred £500 from its general reserve, earned before 1 July 2013, to
retained earnings.
Required
Prepare the consolidated financial statements for the year ended 30 June 2015.

22 Consolidation:
transactions
intragroup

STANDARDS
IN FOCUS

OBJECTIVES
1 explain the need for making adjustments for intragroup transactions
2 prepare worksheet entries for intragroup transactions involving profits and losses in beginning
and ending inventory
3 prepare worksheet entries for intragroup services such as management fees
4 prepare worksheet entries for intragroup dividends
5 prepare worksheet entries for intragroup borrowings.
CHAPTER 22 Consolidation: intragroup transactions 605

INTRODUCTION
In this chapter, the group under discussion is restricted to one where:
• there are only two entities within the group (i.e. one parent and one subsidiary)
• the parent owns all the shares of the subsidiary.
Diagrammatically, then, the group is as shown in figure 22.1.
Group
100%
Parent Subsidiary
FIGURE 22.1 Group
In chapter 20, it is explained that the process of consolidation involves adding together the financial
statements of a parent and its subsidiaries to reflect an overall view of the financial affairs of the group
of entities as a single economic entity. It is also pointed out that two major adjustments are necessary to
effect the process of consolidation:
(a) adjustments involving equity at the acquisition date, namely the business combination valuation
entries (if any) and the elimination of investment in subsidiary, eliminating the investment account in
the parent’s financial statements against the pre-acquisition equity of the subsidiary (see chapter 21)
(b) elimination of intragroup balances and the effects of transactions whereby profits or losses are made
by different members of the group through trading with each other.
This chapter focuses on (b), adjustments for intragroup balances and transactions. The chapter analyses
transactions involving inventory, depreciable assets, services, dividends and borrowings.
LO1 22.1 RATIONALE FOR ADJUSTING FOR

INTRAGROUP TRANSACTIONS
Whenever related entities trade with each other, or borrow and lend money to each other, the separate
legal entities disclose the effects of these transactions in the assets and liabilities recorded and the profits
and losses reported. For example, if a subsidiary sells inventory to its parent, the subsidiary records a sale
of inventory, including the profit on sale and reduction in inventory assets, and the parent records the pur-
chase of inventory at the amount paid to the subsidiary. If, then, in preparing the consolidated financial
statements, the separate financial statements of the legal entities are simply added together without any
adjustments for the effects of the intragroup transactions, the consolidated financial statements include
not only the results of the group transacting with external entities (i.e. entities outside the group) but also
the results of transactions within the group. This conflicts with the purpose of the consolidated financial
statements to provide information about the financial performance and financial position of the group as
a result of its dealings with external entities. Hence, the effects of transactions within the group must be
adjusted for in the preparation of the consolidated financial statements.
The requirement for the full adjustment for the effects of intragroup transactions is stated in paragraph
B86(c) of IFRS 10 Consolidated Financial Statements:
eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions
between entities of the group (profits or losses resulting from intragroup transactions that are recognised in
assets, such as inventory and fixed assets, are eliminated in full). Intragroup losses may indicate an impairment
that requires recognition in the consolidated financial statements. IAS 12 Income Taxes applies to temporary dif-
ferences that arise from the elimination of profits and losses resulting from intragroup transactions.
Besides adjusting for the effects of transactions occurring in the current period, it is also necessary to
adjust the current period’s consolidated financial statements for the ongoing effects of transactions in pre-
vious periods. Because the consolidation adjustment entries are applied in a worksheet only, and not in
the accounts of either the parent or the subsidiary, any continuing effects of previous periods’ transactions
must be considered. This affects transactions such as loans between, say, a parent and a subsidiary where a
balance owing at the end of a number of periods is reduced over time as repayments are made. Similarly,
where assets such as inventory are transferred at the end of one period and then are still on hand at the
beginning of the next period, consolidation adjustments are required to be made in both periods.
Some intragroup transactions do not affect the carrying amounts of assets and liabilities (e.g. where
there is a management fee paid by one entity to another within the group). In that case, the items affected

are fee revenue and fee expense. However, in other circumstances, there are assets and liabilities recog-
nised by the group at amounts different from the amounts recognised by the individual legal entities. For
example, consider the situation where a subsidiary sold an item of inventory to the parent for $1000 and
the inventory had cost the subsidiary $800. The parent recognises the inventory at cost of $1000, whereas
the cost of the inventory to the group is only $800. As is explained in more detail later in this chapter,
consolidation adjustment entries are necessary to adjust for both the profit on the intragroup transaction
and the carrying amount of the inventory.
Under IAS 12 Income Taxes, deferred tax accounts must be raised where there are temporary differences
between the carrying amount of an asset or liability and its tax base. Any difference between the carrying
amount of an asset or a liability and its tax base in a legal entity within the group is accounted for by the
legal entity. However, on consolidation, in relation to intragroup transactions, adjustments may be made
to the carrying amounts of assets and liabilities. Hence, in adjusting for intragroup transactions wherever
there are changes to the carrying amounts of assets and liabilities, any associated tax effect must be consid-
ered. Paragraph B86(c) of IFRS 10 recognises the need to apply tax-effect accounting for temporary differ-
ences arising from the elimination of profits and losses from intragroup transactions.
For example, assume an asset is recorded by a subsidiary at a carrying amount of $1000, and that the
tax base is $800. In the records of the subsidiary, the application of tax-effect accounting will account for
the temporary difference of $200, raising a deferred tax liability of $60, assuming a tax rate of 30%. If, on
consolidation, an adjustment is made to reduce the carrying amount of the asset, say to $950, the con-
solidation adjustment entries must include an adjustment for the tax effect of the change in the carrying
amount of the asset, namely a reduction in the deferred tax liability of $15 (i.e. 30% × $50). The consol-
idated financial statements then show a deferred tax liability of $45 (i.e. $60 − $15). The combination
of the tax-effect entries in the subsidiaries and the tax-effect adjustments on consolidation will account
for the temporary difference caused by the group showing the asset at $950 and the tax base being $800,
namely a deferred tax liability of $45 (i.e. 30% × ($950 − $800)).
As can be seen in this example, in preparing the consolidation adjustments it is unnecessary to consider
the tax-effect entries made in the individual entities in the group. If the appropriate tax-effect adjustments
are made for changes in the carrying amounts of the assets, then the combination of those adjustments
and the tax-effect entries made in the entities themselves will produce the correct answer.
In this book, it is assumed that each subsidiary is a tax-paying entity. Under the tax consolidation system
in some countries, groups comprising a parent and its wholly owned subsidiaries can elect to consolidate
and be treated as a single entity for tax purposes. Such entities prepare a consolidated tax return, and the
effects of intragroup transactions are eliminated. Under such a scheme, the tax-effect adjustments demon-
strated in this chapter would not apply.
Just as the elimination of investment in subsidiary is used in a consolidation worksheet to eliminate the
investment and to adjust for pre-acquisition equity, adjustment journal entries are prepared for intragroup
transactions and are recorded in the consolidation worksheet. The same two adjustment columns are used
to effect these adjustments. For example, if it were necessary to adjust downwards by $10 000 the sales rev-
enue recorded by the legal entities, the consolidation worksheet would show the following line:
Adjustments
Parent Subsidiary Dr Cr Group
Sales revenue 100 000 80 000 10 000 170 000
In the following sections of this chapter, two types of intragroup transactions are discussed — transfers
of inventory and intragroup services. In each of the specific sections covering these transactions, the pro-
cess of determining when profits are realised for the different types of transactions is discussed.
LO2 22.2 TRANSFERS OF INVENTORY

In the following examples, assume that Jessica Ltd owns all the share capital of Amelie Ltd, and that the
consolidation process is being carried out on 30 June 2016, for the year ending on that date. Assume also a
tax rate of 30%. All entries shown as being for the individual entities assume the use of a perpetual inven-
tory system, and adjustments will be made, where necessary, to cost of sales.
22.2.1 Sales of inventory

Example: Intragroup sales of inventory
On 1 January 2016, Jessica Ltd acquired $10 000 worth of inventory for cash from Amelie Ltd. The inven-
tory had previously cost Amelie Ltd $8000.

In the accounting records of Amelie Ltd, the following journal entries are made on 1 January 2016:
Cash Dr 10 000

Inventory Cr 8 000
In Jessica Ltd, the journal entry is:
Inventory Dr 10 000
Cash Cr 10 000
From the viewpoint of the group in relation to this transaction, no sales of inventory were made to any
party outside the group, nor has the group acquired any inventory from external entities. Hence, if the
financial statements of Jessica Ltd and Amelie Ltd are simply added together for consolidation purposes,
‘sales’, ‘cost of sales’ and ‘inventory’ will need to be adjusted on consolidation as the consolidated finan-
cial statements must show only the results of transactions with entities external to the group.
22.2.2 Realisation of profits or losses

Paragraph B86(c) of IFRS 10 states that the profits and losses resulting from intragroup transactions
that require consolidation adjustments to be made are those ‘recognised in assets’. These profits can be
described as ‘unrealised profits’. The test for realisation is the involvement of an external party in relation
to the item involved in the intragroup transaction. If an item of inventory is transferred from a subsidiary
to the parent entity (or vice versa), no external party is involved in that transaction. The profit made by the
subsidiary is unrealised to the group. If the parent then sells that inventory item to a party external to the
group, the intragroup profit becomes realised to the group. For example, assume a subsidiary, Amelie Ltd,
sells inventory to its parent, Jessica Ltd, for $100, and that inventory cost Amelie Ltd $90. The profit on
this transaction is unrealised. If Jessica Ltd sells the inventory to an external party for $100, the intragroup
profit is realised. The group sold inventory that cost the group $90 to an external party for $100. The group
has made $10 profit. Hence, the consolidation adjustments for profits on intragroup transfers of inventory
depend on whether the acquiring entity has sold the inventory to entities outside the group. In other
words, the adjustments depend on whether the acquiring entity still carries some or all of the transferred
inventory as ending inventory at the end of the financial period.
22.2.3 Profits in ending inventory

The following example uses the information in the example in section 22.2.1 and provides information
about whether the inventory transferred is still on hand at the end of the financial period.
Example: Transferred inventory still on hand
On 30 June 2016, all the inventory sold by Amelie Ltd to Jessica Ltd is still on hand. The adjustment
entries in the consolidation worksheet at 30 June 2016 are:

Inventory Cr 2 000
The sales adjustment is necessary to eliminate the effects of the original sale in the current period.
Amelie Ltd recorded sales of $10 000. From the group’s viewpoint, as no external party was involved in
the transaction, no sales should be shown in the consolidated financial statements. To adjust sales revenue
downwards, a debit adjustment is necessary. The effect of this adjustment on the consolidation process is
seen in figure 22.2. Hence, an adjustment is necessary to eliminate the sales recorded by Amelie Ltd.
Using similar reasoning as with the adjustment for sales revenue, the subsidiary has recorded cost of
sales of $8000, but the group has made no sales to entities external to the group. Hence, the consolida-
tion worksheet needs to have a reduction in cost of sales of $8000 in order to show a zero amount in the
consolidation column. Note also that adjusting sales by $10 000 and cost of sales by $8000 effectively
reduces consolidated profit by $2000. In other words, the $2000 profit recorded by Amelie Ltd on selling
inventory to Jessica Ltd is eliminated and a zero profit is shown on consolidation. As no external party was
involved in the transfer of inventory, the whole of the profit on the intragroup transaction is unrealised.
This is illustrated in figure 22.2.

Adjustments
Parent Subsidiary Dr Cr Group
Sales revenue 0 10 000 1 10 000 —
Cost of sales 0 8 000 8 000 1 —
2 000
Tax expense 0 600 600 2 —
Profit 1 400 —
Inventory 10 000 — 2 000 1 8 000
Deferred tax asset — — 2 600 600
FIGURE 22.2 Extract from consolidation worksheet — profit in closing inventory
The previous explanation dealing with the effect on profit covers only the statement of profit or loss and
other comprehensive income part of the adjustment. Under the historical cost system, assets in the consol-
idated statement of financial position must be shown at cost to the group. Inventory is recorded in Jessica
Ltd at $10 000, the cost to Jessica Ltd. The cost to the group is, however, $8000, the amount that was paid
for the inventory by Amelie Ltd to entities external to the group. Hence, if inventory is to be reported at
$8000 in the consolidated financial statements, and it is recorded in Jessica Ltd’s records at $10 000, a
credit adjustment of $2000 is needed to reduce the inventory to $8000, the cost to the group. This effect
is seen in figure 22.2.
Jessica Ltd has recorded the inventory in its records at $10 000. This amount is probably also its tax
base. However, as explained in section 22.1, any difference between the tax base and the carrying amount
in Jessica Ltd is accounted for in the tax-effect entries in Jessica Ltd. On consolidation, a tax-effect entry
is necessary where an adjustment entry causes a difference between the carrying amount of an asset or
a liability in the records of the legal entity and the carrying amount shown in the consolidated finan-
cial statements. In the adjustment entry relating to profit in ending inventory in the above example, the
carrying amount of inventory is reduced downwards by $2000. The carrying amount and tax base of the
inventory in Jessica Ltd is $10 000, but the carrying amount in the group is $8000. This $2000 difference
is a deductible temporary difference giving rise to a deferred tax asset of $600 (i.e. 30% × $2000), as well
as a corresponding decrease in income tax expense. The appropriate consolidation worksheet adjustment
entry is:
Deferred Tax Asset Dr 600

The effects of this entry are shown in figure 22.2.

The deferred tax asset recognises that the group is expected to earn profits in the future that will not
require the payment of tax to the Taxation Office. When the inventory is sold by Jessica Ltd in a future
period, this temporary difference is reversed. To illustrate this effect, assume that in the following period
Jessica Ltd sells this inventory to an external entity for $11 000. Jessica Ltd will record a before-tax profit of
$1000 (i.e. $11 000 − $10 000) and an associated tax expense of $300. From the consolidated group posi-
tion, the profit on sale is $3000 (i.e. $11 000 − $8000). The group will show current tax payable of $300,
reverse the $600 deferred tax asset, and recognise an income tax expense of $900. These effects are further
illustrated below.
Example: Transferred inventories partly sold
On 1 January 2016, Jessica Ltd acquired $10 000 worth of inventory for cash from Amelie Ltd. The inventory
had previously cost Amelie Ltd $8000. By the end of the year, 30 June 2016, Jessica Ltd had sold $7500
of the transferred inventory for $14 000 to external entities. Thus, $2500 of the inventory is on hand in
Jessica Ltd at 30 June 2016.
The adjustment entry for the preparation of consolidated financial statements at 30 June 2016 is:
Sales Dr 10 000
Inventory Cr 500
The total sales recorded by the legal entities are $24 000; that is, $10 000 by Amelie Ltd and $14 000 by
Jessica Ltd. The sales by the group, being those sold to entities external to the group, are $14 000. The con-
solidation adjustment to sales revenue is then $10 000, being the amount necessary to eliminate the sales
within the group.

The total cost of sales recorded by the legal entities is $15 500; that is, $8000 by Amelie Ltd and $7500
by Jessica Ltd (i.e. 75% × $10 000). The cost of sales to the group, being those to entities external to the
group, is $6000 (i.e. 75% × $8000). Hence, the consolidation adjustment is $9500; that is, $15 500 (sum
of recorded sales) less $6000 (group). The adjustment is that necessary to adjust the sum of the amounts
recorded by the legal entities to that to be recognised by the group.
Note that the combined adjustments to sales and cost of sales result in a $500 reduction in before-tax
profit. Of the $2000 intragroup profit on the transfer of inventory from Amelie Ltd to Jessica Ltd, since
three-quarters of the inventory has been sold by Jessica Ltd to an external party, $1500 of the profit is
realised to the group and only $500, the profit remaining in ending inventory, is unrealised. It is the unre-
alised profit that is adjusted for in the worksheet entry.
The group profit is then $500 less than that recorded by the legal entities. The sum of profits recorded by
the legal entities is $8500, consisting of $2000 recorded by Amelie Ltd and $6500 (being sales of $14 000
less cost of sales of $7500) recorded by Jessica Ltd. From the group’s viewpoint, profit on sale of inventory
to external entities is only $8000, consisting of sales of $14 000 less cost of sales of $6000 (being 75% of
original cost of $8000). Hence, an adjustment of $500 is necessary to reduce recorded profit of $8500 to
group profit of $8000.
The $500 adjustment to inventory reflects the proportion of the total profit on sale of the transferred
inventory that remains in the inventory on hand at the end of the period. Since 25% of the transferred
inventory is still on hand at the end of the period, then 25% of the total profit on transfer of inventory (i.e.
25% × $2000) needs to be adjusted at the end of the period. The adjustment entry reduces the inventory
on hand at 30 June 2016 from the recorded cost to Jessica Ltd of $2500 to the group cost of $2000 (being
25% of the original cost of $8000).
The adjustments above have been determined by comparing the combined amounts recorded by the
parent and the subsidiary with the amounts that the group wants to report in the consolidated financial
statements. This process could be shown in the form of a table, as follows:
Parent Subsidiary Total Recorded Group Adjustment
Sales 14 000 10 000 24 000 14 000 Dr 10 000

Cost of sales (7 500) (8 000) (15 500) (6 000) Cr 9 500
Profit 6 500 2 000 8 500 8 000
Inventory 2 500 0 2 500 2 000 Cr $500
Consider the tax effect of this adjustment. The carrying amount of the inventory is reduced by $500,
reflecting the fact that the carrying amount to the group is $500 less than the carrying amount in Jessica
Ltd. This gives rise to a deductible temporary difference of $500. Hence, a deferred tax asset of $150 (i.e.
30% × $500) must be raised on consolidation with a corresponding effect on income tax expense. The
expectation of the group is that, in some future period, it will recognise the remaining $500 profit in trans-
ferred inventory when it sells the inventory to an external party, but will not have to pay tax on the $500
as Amelie Ltd has already paid the relevant tax. This expected tax saving to the group will be shown in the
consolidated financial statements by a debit adjustment of $150 to the Deferred Tax Asset account.
The tax-effect adjustment entry is then:

Example: Transferred inventory completely sold

On 1 January 2016, Jessica Ltd acquired $10 000 worth of inventory for cash from Amelie Ltd. The inven-
tory had previously cost Amelie Ltd $8000. By the end of the year, 30 June 2016, Jessica Ltd had sold all
the transferred inventory to an external party for $18 000.
Amelie Ltd records a profit of $ 2 000 (i.e. $10 000 − $8000)

Jessica Ltd records a profit of $ 8 000 (i.e. $18 000 − $10 000)
Total recorded profit is $10 000
Profit to the group = Selling price to external entities less cost to the group
= $18 000 − $8000
= $10 000
Since the recorded profit equals the profit to the group, there is no need for a profit adjustment on con-
solidation. Further, as there is no transferred inventory still on hand, there is no need for an adjustment to

inventory. Because all the inventory has been sold to an external entity, the whole of the intragroup profit
is realised to the group. Note, however, that an adjustment for the sales and cost of sales is still necessary.
As noted previously, the sales within the group amount to $18 000 whereas the sales recorded by the
legal entities total $28 000 (i.e. $10 000 + $18 000). Hence, sales must be reduced by $10 000. The total
recorded cost of sales is $18 000, being $8000 by Amelie Ltd and $10 000 by Jessica Ltd. The group’s cost
of sales is the original cost of the transferred inventory, $8000. Hence, cost of sales is reduced by $10 000
on consolidation. The adjustment entry is then:
Sales Dr 10 000
Since there is no adjustment to the carrying amounts of assets or liabilities, there is no need for any
tax-effect adjustment.
Where inventory is transferred in the current period and some or all of that inventory is still on hand at
the end of the period, the general form of the worksheet entries is:
Sales Revenue Dr xxx

Cost of Sales Cr xxx
Inventory Cr xxx
(The adjustment to inventory is based on the profit remaining in
inventory on hand at the end of the period)
Deferred Tax Asset Dr xxx

Income Tax Expense Cr xxx
(The tax rate times the adjustment to ending inventory)
22.2.4 Profits in opening inventory

Any transferred inventory remaining unsold at the end of one period is still on hand at the beginning
of the next period. Because the consolidation adjustments are made only in a worksheet and not in the
records of any of the legal entities, any differences in balances between the legal entities and the consoli-
dated group at the end of one period must still exist at the beginning of the next period.
Example: Transferred inventory on hand at the beginning of the period
On 1 July 2015, the first day of the current period, Amelie Ltd has on hand inventory worth $7000,
transferred from Jessica Ltd in June 2015. The inventory had previously cost Jessica Ltd $4500. The tax rate
is 30%.
In this example, in the preparation of the consolidated financial statements at 30 June 2015 the fol-
lowing adjustment entries for the $2500 profit in ending inventory would have been made in the consol-
idation worksheet:
Sales Dr 7 000
Inventory Cr 2 500

(30% × $2500)
Since the ending inventory at 30 June 2015 becomes the beginning inventory for the next year, an
adjustment is necessary in the consolidated financial statements prepared at 30 June 2015. The required
adjustment is:

In making this consolidation worksheet adjustment, it is assumed that the inventory is sold to external
entities in the current period. If this is not the case, then the adjustment to inventory as made at 30 June
2015 will need to be made again in preparing the consolidated financial statements at 30 June 2016.
In making a credit adjustment of $2500, cost of sales is reduced. The cost of sales recorded by Amelie Ltd
in the 2015–16 period is $2500 greater than that which the group wants to show, because the cost of sales

recorded by Jessica Ltd is $7000, whereas the cost of sales to the group is only $4500. A reduction in cost
of sales means an increase in profit. Hence, in the 2015–16 period, the group’s profit is greater than the
sum of the legal entities’ profit.
The debit adjustment to the opening balance of retained earnings reduces that balance; that is, the group
made less profit in previous years than the sum of the retained earnings recorded by the legal entities. This
is because, in June 2015, Jessica Ltd recorded a $2500 profit on the sale of inventory to Amelie Ltd, this
profit not being recognised by the group until the 2015–16 period.
Consider the tax effect of these entries. If the previous period’s tax-effect adjustment were carried forward
into this year’s worksheet it would be:

Retained Earnings (1/7/15) Cr 750
On sale of the inventory in the 2015–16 period, the deferred tax asset is reversed, with a resultant effect
on income tax expense:
Income Tax Expense Dr 750

Deferred Tax Asset Cr 750
On combining these two entries, the worksheet entry required is:

In summary, the adjustment to cost of sales, retained earnings and income tax expense can be combined
into one entry as follows:

Note that this entry has no effect on the closing balance of retained earnings at 30 June 2016. As the
inventory has been sold outside the group, the whole of the profit on the intragroup transaction is realised
to the group. There is no unrealised profit to be adjusted for at the end of the period.
Where inventory was transferred in a previous period and some or all of that inventory is still on hand
at the beginning of the current period, the general form of the entries is:
Retained Earnings (opening balance) Dr xxx

Cost of Sales Cr xxx

Retained Earnings (opening balance) Cr xxx
It can be seen that the consolidation worksheet entries for inventory transferred within the current
period are different from those where the inventory was transferred in a previous period. Before preparing
the adjustment entries, it is essential to determine the timing of the transaction.
ILLUSTRATIVE EXAMPLE 22.1 Intragroup transactions involving transfers of inventory
Leah Ltd acquired all the issued shares of Sophia Ltd on 1 January 2015. The following transactions
occurred between the two entities:
1. On 1 June 2016, Leah Ltd sold inventory to Sophia Ltd for $12 000, this inventory previously costing
Leah Ltd $10 000. By 30 June 2016, Sophia Ltd had onsold 20% of this inventory to other entities for
$3000. The other 80% was all sold to external entities by 30 June 2017 for $13 000.
2. During the 2016–17 period, Sophia Ltd sold inventory to Leah Ltd for $6000, this being at cost plus
20% mark-up. Of this inventory, $1200 remained on hand in Leah Ltd at 30 June 2017.

Required
Prepare the consolidation worksheet entries for Leah Ltd at 30 June 2017 in relation to the intragroup
transfers of inventory.
Solution
(1) Sale of inventory in previous period

Working:
– this is a prior period transaction
– profit after tax remaining in inventory at 1/7/16 is $1120 (= 80% × $2000 (1 – 30%))
– cost of sales recorded by Sophia Ltd is $9600 (= 80% × $12 000); cost of sales to the group is
$8000 (= 80% × $10 000). The adjustment is then $1600.
(2) Sale of inventory in current period
Sales Dr 6 000
Inventory Cr 200
Working:
– this is a current period transaction
– sales within the group are $6000
– cost of sales recorded by the members of the group are $5000 for Sophia Ltd and $4800 (= 4/5 ×
$6000) for Leah Ltd; a total of $9800. Cost of sales for the group is $4000 (= 4/5 × $5000). The
adjustment is then $5800
– the inventory remaining at 30 June 2017 is recorded by Leah Ltd at $1200. The cost to the group
is $1000 (= 1/5 × $5000). The adjustment to inventory is then $200
– as the inventory is adjusted by $200, the tax effect is $60 (= 30% × $200).
LO3 22.3 INTRAGROUP SERVICES

Many different examples of services between related entities exist. For instance:
• Jessica Ltd may lend to Amelie Ltd some specialist personnel for a limited period of time for the
performance of a particular task by Amelie Ltd. For this service, Jessica Ltd may charge Amelie Ltd a
certain fee, or expect Amelie Ltd to perform other services in return.
• One entity may lease or rent an item of plant or a warehouse from the other.
• A subsidiary may exist solely for the purpose of carrying out some specific task, such as research
activities for the parent, and a fee for such research is charged. In this situation, all service revenue
earned by the subsidiary is paid for by the parent, and must be adjusted in the consolidation process.
Example: Intragroup services
During 2015–16, Jessica Ltd offered the services of a specialist employee to Amelie Ltd for 2 months in
return for which Amelie Ltd paid $30 000 to Jessica Ltd. The employee’s annual salary is $155 000, paid
for by Jessica Ltd.
The journal entries in the records of Jessica Ltd and Amelie Ltd in relation to this transaction are:
Jessica Ltd
Cash Dr 30 000
Service Revenue Cr 30 000
Amelie Ltd
Service Expense Dr 30 000
Cash Cr 30 000

From the group’s perspective there has been no service revenue received or service expense made to enti-
ties external to the group. Hence, to adjust from what has been recorded by the legal entities to the group’s
perspective, the consolidation adjustment entry is:
Service Revenue Dr 30 000

Service Expense Cr 30 000
No adjustment is made in relation to the employee’s salary since, from the group’s view, the salary paid
to the employee is a payment to an external party.
Since there is no effect on the carrying amounts of assets or liabilities, there is no temporary difference
and no need for any income tax adjustment.
Example: Intragroup rent
Jessica Ltd rents office space from Amelie Ltd for $150 000 p.a.
In accounting for this transaction, Jessica Ltd records rent expense of $150 000 and Amelie Ltd records
rent revenue of $150 000. From the group’s view, the intragroup rental scheme is purely an internal
arrangement, and no revenue or expense is incurred. The recorded revenue and expense therefore need to
be eliminated. The appropriate consolidation adjustment entry is:
Rent Revenue Dr 150 000

Rent Expense Cr 150 000
There is no tax-effect entry necessary as assets and liabilities are unaffected by the adjustment entry.
22.3.1 Realisation of profits or losses

With the transfer of services within the group, the consolidation adjustments do not affect the profit of the
group. In a transaction involving a payment by a parent to a subsidiary for services rendered, the parent
shows an expense and the subsidiary shows revenue. The net effect on the group’s profit is zero. Hence,
from the group’s view, with intragroup services there are no realisation difficulties.
LO4 22.4 INTRAGROUP DIVIDENDS

In this section, consideration is given to dividends declared and paid after Jessica Ltd’s acquisition of
Amelie Ltd. As explained earlier (see section 21.5.3), all dividends received by the parent from the subsidiary
are accounted for as revenue by the parent, regardless of whether the dividends are paid from pre- or post-
acquisition equity.
Two situations are considered in this section:
• dividends declared in the current period but not paid
• dividends declared and paid in the current period.
It is assumed that the company expecting to receive the dividend recognises revenue when the dividend
is declared.
22.4.1 Dividends declared in the current period but not paid

Assume that, on 25 June 2016, Amelie Ltd declares a dividend of $4000. At the end of the period, the div-
idend is unpaid. The entries passed by the legal entities are:
Amelie Ltd
Dividend Declared (In retained earnings) Dr 4 000
Dividend Payable Cr 4 000
Jessica Ltd
Dividend Receivable Dr 4 000
Dividend Revenue Cr 4 000
The entry made by Amelie Ltd both reduces retained earnings and raises a liability account. From the
group’s perspective, there is no reduction in equity and the group has no obligation to pay dividends out-
side the group. Similarly, the group expects no dividends to be received from entities outside the group.
Hence, the appropriate consolidation adjustment entries are:

Dividend Declared Cr 4 000
(To adjust for the effects of the entry made by Amelie Ltd)
Dividend Revenue Dr 4 000

(To adjust for the effects of the entry made by Jessica Ltd)
In the following period when the dividend is paid, no adjustments are required in the consolidation
worksheet. As there are no dividend revenue, dividend declared, or receivable items left open at the
end of the period, then the position of the group is the same as the sum of the legal entities’ financial
statements.
22.4.2 Dividends declared and paid in the current period

Assume Amelie Ltd declares and pays an interim dividend of $4000 in the current period. Entries by the
legal entities are:
Jessica Ltd
Cash Dr 4 000
Dividend Revenue Cr 4 000
Amelie Ltd
Interim Dividend Paid (In retained earnings) Dr 4 000
Cash Cr 4 000
From the outlook of the group, no dividends have been paid and no dividend revenue has been
received. Hence, the adjustment necessary for the consolidated financial statements to show the affairs of
the group is:

Interim Dividend Paid Cr 4 000
Tax effect of dividends

Generally, dividends are tax-free. There are, therefore, no tax-effect adjustment entries required in relation
to dividend-related consolidation adjustment entries.
ILLUSTRATIVE EXAMPLE 22.2 Intragroup dividends
Alice Ltd owns all the issued shares of Abigail Ltd, having acquired them for $250 000 on 1 January
2015. In preparing the consolidated financial statements at 30 June 2017, the accountant documented
the following transactions:
2016
Jan. 15 Abigail Ltd paid an interim dividend of $10 000.
June 25 Abigail Ltd declared a dividend of $15 000, this being recognised in the records of both entities.
Aug. 1 The $15 000 dividend declared on 25 June was paid by Abigail Ltd.
2017
Jan. 18 Abigail Ltd paid an interim dividend of $12 000.
June 23 Abigail Ltd declared a dividend of $18 000, this being recognised in the records of both
entities.

Required
Prepare the consolidation worksheet adjustment entries for the preparation of consolidated financial
statements at 30 June 2017.

Solution
The required entries are:
(1) Interim dividend paid

Dividend Paid Cr 12 000
(2) Final dividend declared


LO5 22.5 INTRAGROUP BORROWINGS

Members of a group often borrow and lend money among themselves, and charge interest on the money
borrowed. In some cases, an entity may be set up within the group solely for the purpose of handling
group finances and for borrowing money on international money markets. Consolidation adjustments are
necessary in relation to these intragroup borrowings and interest thereon because, from the stance of the
group, these transactions create assets and liabilities and revenues and expenses that do not exist in terms
of the group’s relationship with external entities.
Example: Advances
Jessica Ltd lends $100 000 to Amelie Ltd, the latter paying $15 000 interest to Jessica Ltd. The relevant
journal entries in each of the legal entities are:
Jessica Ltd
Advance to Amelie Ltd Dr 100 000
Cash Cr 100 000
Cash Dr 15 000
Amelie Ltd
Cash Dr 100 000
Advance from Jessica Ltd Cr 100 000

Cash Cr 15 000
The consolidation adjustments involve eliminating the monetary asset created by Jessica Ltd, the mon-
etary liability raised by Amelie Ltd, the interest revenue recorded by Jessica Ltd and the interest expense
paid by Amelie Ltd:
Advance from Jessica Ltd Dr 100 000

Advance to Amelie Ltd Cr 100 000
Interest Revenue Dr 15 000

Interest Expense Cr 15 000
The adjustment to the asset and liability is necessary as long as the intragroup loan exists. In relation to
any past period’s payments and receipt of interest, no ongoing adjustment to accumulated profits (opening
balance) is necessary as the net effect of the consolidation adjustment is zero on that item.
Because the effect on net assets of the consolidation adjustment is zero, no tax-effect entry is
necessary.

SUMMARY
Intragroup transactions can take many forms and may involve transfers of inventory or property, plant
and equipment, or they may relate to the provision of services by one member of the group to another
member. To prepare the relevant worksheet entries for a transaction, it is necessary to consider the accounts
affected in the entities involved in the transaction.
Intragroup transfers of inventory, services, dividends and debentures and their adjustment in the consol-
idation process are associated with a need to consider the implications of applying tax-effect accounting in
the consolidation process.
The basic approach to determining the consolidation adjustment entries for intragroup transfers is:
(a) Analyse the events within the records of the legal entities involved in the intragroup transfer. Deter-
mine whether the transaction is a prior period or current period event.
(b) Analyse the position from the group’s viewpoint.
(c) Create adjusting entries to change from the legal entities’ position to that of the group.
(d) Consider the tax effect of the adjusting entries.
Note again that there are no actual adjusting entries made in the records of the individual legal entities
which constitute the group. However, if required, a special journal could be set up by the parent entity to
keep a record of the adjustments made in the process of preparing the consolidated financial statements.
Alternatively, the consolidation process may be performed by the use of special consolidation worksheets.
Why a particular adjustment is the correct one involves an explanation of each line in the adjustment
entry including why an account was adjusted, why it was increased or decreased, and why a particular
adjustment amount is appropriate. This generally involves a comparison of what accounts were affected in
the records of the legal entities with the financial picture the group wants to present in the consolidated
financial statements.
DEMONSTRATION PROBLEM 22.1 Intragroup transfers of assets
The following example illustrates procedures for the preparation of a consolidated statement of profit
or loss and other comprehensive income, a consolidated statement of changes in equity and a consoli-
dated statement of financial position where the subsidiary is 100% owned. The consolidation worksheet
adjustments for intragroup transactions including inventory are also demonstrated.
Details
On 1 July 2014, Eliza Ltd acquired all the share capital of Ebony Ltd for $472 000. At that date, Ebony
Ltd’s equity consisted of the following.
Share capital $ 300 000

At 1 July 2014, all the identifiable assets and liabilities of Ebony Ltd were recorded at fair value.
Financial information for Eliza Ltd and Ebony Ltd for the year ended 30 June 2016 is presented in the
left-hand columns of the worksheet illustrated in figure 22.3 overleaf. It is assumed that both companies
use the perpetual inventory system.
(a) On 1 January 2016, Ebony Ltd sold merchandise costing $30 000 to Eliza Ltd for $50 000. Half this
merchandise was sold to external entities for $28 000 before 30 June 2016.
(b) At 1 July 2015, there was a profit in the inventory of Eliza Ltd of $6000 on goods acquired from
Ebony Ltd in the previous period.
(c) The tax rate is 30%.
Required
Prepare the consolidated financial statements for the year ended 30 June 2016.
Solution
The first step is to determine the pre-acquisition entries at 30 June 2016. These entries are prepared after
undertaking an acquisition analysis.
At 1 July 2014:
Net fair value of the identifiable assets

and liabilities of Ebony Ltd = $300 000 + $96 000 + $56 000
= $452 000
Goodwill = $20 000

Consolidation worksheet entries
(1) Business combination valuation entry
As all the identifiable assets and liabilities of Ebony Ltd are recorded at amounts equal to their fair
values, the only business combination valuation entry required is that for goodwill.
Goodwill Dr 20 000
(2) Elimination of investment in subsidiary

The entry at 30 June 2016 is the same as that at acquisition date as there have not been any events
affecting that entry since acquisition date:

Shares in Ebony Ltd Cr 472 000
The next step is to prepare the adjustment entries arising because of the existence of intragroup trans-
actions. It is important that students classify the intragroup transactions into ‘current period’ and
‘previous period’ transactions. The resultant adjustment entries should reflect those decisions since
previous period transactions would be expected to affect accounts such as retained earnings rather
than accounts such as sales and cost of sales.
(3) Profit in ending inventory
The transaction occurred in the current period. The adjustment entries are:
Sales Dr 50 000
Inventory Cr 10 000
($10 000 = ½ × [$50 000 − $30 000])

(30% × $10 000)
Sales: The members of the group have recorded total sales of $78 000, being $50 000 by Ebony Ltd
and $28 000 by Eliza Ltd. The group recognises only sales to entities outside the group, namely the
sales by Eliza Ltd of $28 000. Hence, in preparing the consolidated financial statements, sales must
be reduced by $50 000.
Cost of sales: Ebony Ltd recorded cost of sales of $30 000, and Eliza Ltd recorded cost of sales of $25 000
(being half of $50 000). Recorded cost of sales then totals $55 000. The cost of the sales to entities
external to the group is $15 000 (being half of $30 000). Cost of sales must then be reduced by $40 000.
Inventory: At 30 June 2016, Eliza Ltd has inventory on hand from intragroup transactions, and records
them at cost of $25 000 (being half of $50 000). The cost of this inventory to the group is $15 000
(being half of $30 000). Inventory is then reduced by $10 000.
Deferred tax asset/income tax expense: Under tax-effect accounting, temporary differences arise where the
carrying amount of an asset differs from its tax base. In the first adjustment entry above, inventory is
reduced by $10 000; that is, the carrying amount of inventory is reduced by $10 000. This then gives rise
to a temporary difference, and because the carrying amount has been reduced, tax benefits are expected
in the future when the asset is sold. Hence a deferred tax asset, equal to the tax rate times the change to
the carrying amount of inventory (30% × $10 000), of $3000 is raised. Given there is no Deferred Tax
Asset in the worksheet in figure 22.3, the adjustment is made against the Deferred Tax Liability line item.
(4) Profit in beginning inventory
This is a previous period transaction. The required consolidation worksheet entry is:


Retained Earnings (1/7/14) Cr 1 800
(30% × $6000)

Retained earnings: In the previous period, Ebony Ltd recorded a $6000 before-tax profit, or a $4200
after-tax profit on sale of inventory within the group. Because the sale did not involve external enti-
ties, the profit must be eliminated on consolidation.
Cost of sales: In the current period, the transferred inventory is onsold to external entities. Eliza Ltd
records cost of sales at $6000 greater than to the group. Hence, cost of sales is reduced by $6000.
Note that this increases group profit by $6000, reflecting the realisation of the profit to the group in
the current period, when it was recognised by the legal entity in the previous period.
Income tax expense: At the end of the previous period, in the consolidated statement of financial
position a deferred tax asset of $1800 was raised because of the difference in cost of the inventory
recorded by the legal entity and that recognised by the group. This deferred tax asset is reversed when
the asset is sold. The adjustment to income tax expense reflects the reversal of the deferred tax asset
raised at the end of the previous period.
Figure 22.3 shows the completed worksheet for preparation of the consolidated financial statements
of Eliza Ltd and its subsidiary Ebony Ltd at 30 June 2016. Once the effects of all adjustments are
added or subtracted horizontally in the worksheet to calculate figures in the right-hand ‘consolida-
tion’ column, the consolidated financial statements can be prepared, as shown in figure 22.4(a), (b)
and (c).
Adjustments
Financial Statements Eliza Ltd Ebony Ltd Dr Cr Consolidation
Sales revenue 1 196 000 928 000 3 50 000 2 074 000

Cost of sales (888 000) (670 000) 40 000 3 (1 512 000)
Wages and salaries (57 500) (32 000) (89 500)
Depreciation (5 200) (4 800) (10 000)
Other expenses (4 000) — (4 000)
Total expenses (954 700) (706 800) (1 615 500)
Profit before income tax 241 300 221 200 458 500
Income tax expense (96 120) (118 480) 4 1 800 3 000 3 (213 400)
Profit for the year 145 180 102 720 245 100
Retained earnings (1/7/15) 100 820 70 280 2 56 000 1 800 4 110 900
4 6 000
246 000 173 000 356 000
Dividend paid (80 000) — (80 000)
Share capital 500 000 300 000 2 300 000 500 000
Business combination valuation reserve 2 20 000 20 000 1 —
General reserve 135 000 96 000 2 96 000 135 000
801 000 569 000 911 000
Other components of equity (1/7/15) 4 000 10 000 14 000
Gains on financial assets 1 000 3 000 4 000
Other components of equity (30/6/16) 5 000 13 000 18 000
Total equity 806 000 582 000 929 000
Deferred tax liability 52 000 30 000 3 3 000 79 000
Total equity and liabilities 858 000 612 000 1 008 000
Shares in Ebony Ltd 472 000 — 472 000 2 —
Cash 80 000 73 000 153 000
Inventory 169 000 36 000 10 000 3 195 000
Other current assets 10 000 300 000 310 000
Financial assets 15 000 68 000 83 000
Land 70 000 120 000 190 000
Plant and equipment 52 000 28 000 80 000
Goodwill — — 1 20 000 20 000
857 000 612 000 588 928 588 928 1 008 000
FIGURE 22.3 Consolidation worksheet — intragroup transfers of assets

ELIZA LTD
Consolidated Statement of Profit or Loss and Other Comprehensive Income
Revenues $ 2 074 000

Expenses 1 615 425
Profit before income tax 458 500
Profit for the year $ 245 100
Gains on financial assets 4 000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR $ 249 100
FIGURE 22.4(a) Consolidated statement of profit or loss and other comprehensive income
ELIZA LTD
Consolidated Statement of Changes in Equity
TOTAL COMPREHENSIVE INCOME FOR THE YEAR $249 100

Retained earnings at 1 July 2015 $ 110 900
Dividend paid $ (80 000)
Retained earnings at 30 June 2016 $276 000
General reserve at 1 July 2015 $ 140 000
General reserve at 30 June 2016 $ 140 000
Other components of equity at 1 July 2015 $ 14 000
Gains on financial assets $ 4 000
Other components of equity at 30 June 2016 $ 18 000
Share capital at 1 July 2015 $ 500 000
Share capital at 30 June 2016 $ 500 000
FIGURE 22.4(b) Consolidated statement of changes in equity
FIGURE 22.4(c) Consolidated statement of financial position
ELIZA LTD
Consolidated Statement of Financial Position
as at 30 June 2016
Current assets
Cash assets $ 153 000
Inventories 195 000
Financial assets 83 000
Other 310 000
Total current assets 741 000
Non-current assets
Property, plant and equipment:
Accumulated depreciation $ (23 000) $ 57 000
Land 190 000 247 000
Goodwill 20 000
Total assets 1 008 000
Deferred tax liabilities (79 000)
Net assets $ 929 000

FIGURE 22.4(c) (continued)
Equity
Other components of equity 18 000
Total equity $ 929 000
DEMONSTRATION PROBLEM 22.2 Dividends and borrowings
On 1 July 2015, Lilly Ltd acquired all the share capital of Tahlia Ltd and Eva Ltd for $187 500 and
$150 000 respectively. At that date, equity of the three companies was:
Lilly Ltd Tahlia Ltd Eva Ltd

Share capital $150 000 $100 000 $100 000
General reserve 90 000 60 000 40 000
At 1 July 2015, the identifiable net assets of all companies were recorded at fair values.
For the year ended 30 June 2016, the summarised financial information for the three companies show
the following details:
Lilly Ltd Tahlia Ltd Eva Ltd

Sales revenue $ 388 500 $ 200 000 $ 150 000
Dividend revenue 9 000 — —
Other revenue 10 000 — —
Total revenues 407 500 200 000 150 000
Total expenses (360 000) (176 000) (138 000)
Profit before income tax 47 500 24 000 12 000
Income tax expense (15 000) (10 000) (5 000)
Profit 32 500 14 000 7 000
Total available for appropriation 52 500 31 500 17 000
Interim dividend paid (7 500) (2 500) —
Final dividend declared (15 000) (5 000) (5 500)
Transfer to general reserve (2 000) (5 000) —
(24 500) (12 500) (5 500)
Retained earnings (30/6/16) $ 28 000 $ 19 000 $ 11 500
Shares in Tahlia Ltd $ 187 500 — —
Shares in Eva Ltd 150 000 — —
Dividend receivable 6 500 — —
Loan receivable 5 000 — —
Property, plant and equipment 18 500 $ 205 000 $ 167 000
Total assets 367 500 205 000 167 000
Final dividend payable 15 000 5 000 1 500
Loan payable — 5 000 —
Other non-current liabilities 82 500 11 000 10 000
Net assets $ 270 000 $ 184 000 $ 155 500
Share capital $ 150 000 $ 100 000 $ 104 000
General reserve 92 000 65 000 40 000
Total equity $ 270 000 $ 184 000 $ 155 500

(a) Lilly Ltd has lent $5000 to Tahlia Ltd, the loan having 10% interest rate attached.
(b) Lilly Ltd has recognised both the interim and final dividends from Tahlia Ltd and Eva Ltd as revenue.
Required
Prepare the consolidated financial statements as at 30 June 2016 for Lilly Ltd and its two subsidiaries,
Tahlia Ltd and Eva Ltd. Assume all reserve transfers are from post-acquisition profits.
Solution
The relationship between the parent and subsidiaries may be expressed as shown in figure 22.5.
Lilly Ltd
100% 100%
Tahlia Ltd Eva Ltd
FIGURE 22.5 Relationship between parent and subsidiaries
Figure 22.6 overleaf illustrates the consolidation worksheet necessary to consolidate the financial
statements of Lilly Ltd and its two subsidiaries. Detailed discussion of each adjustment is provided
below. Note that:
• no adjustment entries are made for transfers to and from reserves if post-acquisition equity only is
affected
• the dividends paid and declared by the parent to its shareholders are not adjusted for in the
consolidated financial statements, because these dividends are paid by the group to external entities.
Acquisition analysis: Lilly Ltd and Tahlia Ltd
At 1 July 2015:
Net fair value of identifiable assets and liabilities of Tahlia Ltd = $100 000 + $60 000 + $17 500
= $177 500
Goodwill = $10 000
Consolidation worksheet adjustment entries

(1) Business combination valuation entry: Lilly Ltd and Tahlia Ltd
Goodwill Dr 10 000
(2) Elimination of investment in subsidiary: Lilly Ltd and Tahlia Ltd

The elimination of investment in subsidiary at 30 June 2016 is then:

Shares in Tahlia Ltd Cr 187 500
Acquisition analysis: Lilly Ltd and Eva Ltd

At 1 July 2015:
Net fair value of identifiable assets and liabilities of Eva Ltd = $100 000 + $40 000 + $10 000
= $150 000
Goodwill = zero
No business combination valuation entry is required.

(3) Elimination of investment in subsidiary: Lilly Ltd and Eva Ltd
The elimination of investment in subsidiary at 30 June 2016 is then:

Shares in Eva Ltd Cr 150 000
(4) Interim dividend: Tahlia Ltd

This is a current period transaction. The consolidation worksheet entry is:

Tahlia Ltd paid a dividend in cash to Lilly Ltd. Lilly Ltd recognised dividend revenue and Tahlia Ltd
recognised dividends paid. From the group’s perspective, there were no dividends paid to entities
external to the group. Hence, on consolidation it is necessary to eliminate both the Dividend Paid
and Dividend Revenue accounts raised by the parent and the subsidiary.
(5) Final dividend declared: Tahlia Ltd
Final Dividend Payable Dr 5 000

Final Dividend Declared Cr 5 000

The subsidiary declares a dividend, recognising a liability to pay the dividend and reducing retained earn-
ings. The parent, which expects to receive the dividend, raises a receivable asset and recognises dividend
revenue. From the group’s point of view, because the dividend is not receivable or payable to entities
external to the group, it does not want to recognise any of these accounts. Hence, on consolidation, all
the accounts affected by this transaction in the records of the parent and the subsidiary are eliminated.
(6) Final dividend declared: Eva Ltd
Final Dividend Payable Dr 5 500

Final Dividend Declared Cr 5 500

The explanation for this entry is the same as that for the dividend declared by Tahlia Ltd.
(7) Loan: Lilly Ltd to Tahlia Ltd
The loan may have been made in a previous period or the current period. The consolidation work-
sheet entry is the same:
Loan Payable Dr 5 000

Loan Receivable Cr 5 000
This entry eliminates the receivable raised by the parent and the payable raised by the subsidiary. From
the group’s point of view, there are no loans payable or receivable to entities external to the group.
(8) Interest on loan
The interest paid/received is a current period transaction. In some situations where interest is accrued,
interest may relate to previous or future periods. The consolidation worksheet entry is:
Interest Revenue Dr 500

Interest Expense Cr 500
(10% × $5000)
The parent records interest revenue of $500 and the subsidiary records interest expense of $500. No
interest was paid or received by the group from entities external to the group, so these accounts must
be eliminated on consolidation.

Lilly Tahlia Eva Adjustments
Financial statements Ltd Ltd Ltd Dr Cr Group
Sales revenue 388 500 200 000 150 000 738 500
Dividend revenue 9 000 — — 4 2 500 —
6 5 000
7 1 500
Other revenue 10 000 — — 9 500 9 500
407 500 200 000 150 000 748 000
Expenses (360 000) (176 000) (138 000) 500 9 (673 500)
Profit before income tax 47 500 24 000 12 000 74 500
Income tax expense (15 000) (10 000) (5 000) (30 000)
Profit 32 500 14 000 7 000 44 500
Retained earnings (1/7/15) 20 000 17 500 10 000 2 17 500 20 000
3 10 000
52 500 31 500 17 000 64 500
Interim dividend paid (7 500) (2 500) — 2 500 4 (7 500)
Final dividend declared (15 000) (5 000) (1 500) 5 000 5 (15 000)
1 500 6
Transfer to general reserve (2 000) (5 000) 0 (7 000)
24 500 12 500 5 500 29 500
Retained earnings (30/6/16) 28 000 19 000 11 500 35 000
Share capital 150 000 100 000 100 000 2 100 000 150 000
3 100 000
General reserve 92 000 65 000 40 000 2 60 000 97 000
3 40 000
valuation reserve 2 10 000 10 000 1 —
Final dividend payable 15 000 5 000 1 500 5 5 000 15 000
6 1 500
Loan payable — 5 000 — 7 5 000 —
Other non-current liabilities 82 500 11 000 10 000 103 500
Total equity and liabilities 367 500 205 000 167 000 400 500
Shares in Tahlia Ltd 187 500 — — 187 500 2 —
Shares in Eva Ltd 150 000 — — 150 000 3 —
Dividend receivable 6 500 — — 5 000 5 —
1 500 6
Loan receivable 5 000 — — 5 000 7 —
Property, plant and equipment 18 500 205 000 167 000 390 500
Goodwill — — — 1 10 000 10 000
367 500 205 000 167 000 372 500 372 500 400 500
FIGURE 22.6 Consolidation worksheet — dividends

From figure 22.6, after all adjustments have been entered in the worksheet and amounts totalled
across to the consolidation column, the consolidated financial statements can be prepared in suitable
format as shown in figure 22.7(a), (b) and (c).
LILLY LTD
Revenues $748 000
Expenses 673 500

LILLY LTD

Retained earnings at 1 July 2015 $ 20 000
Interim dividend paid (7 500)
Final dividend declared (15 000)
Transfer of general reserve (7 000)
Retained earnings at 30 June 2016 $ 31 000
General reserve at 1 July 2015 $ 90 000
Transfer from retained earnings 7 000
General reserve at 30 June 2016 $ 97 000
Share capital as at 1 July 2015 $ 150 000
Share capital at 30 June 2016 $ 150 000
LILLY LTD
as at 30 June 2016
Non-current assets
Property, plant and equipment $390 500
Goodwill 10 000
Current liabilities
Final dividend payable 15 000
Non-current liabilities 103 500
Total liabilities 118 500
Net assets $282 000
Equity
Other reserves:
General reserve $ 97 000
Total equity $282 000
1. Why is it necessary to make adjustments for intragroup transactions?
2. In making consolidation worksheet adjustments, sometimes tax-effect entries are made. Why?
3. Why is it important to identify transactions as current or previous period transactions?
4. Where an intragroup transaction involves a depreciable asset, why is depreciation expense adjusted?
5. Are adjustments for post-acquisition dividends different from those for pre-acquisition dividends?
Explain.
6. What is meant by ‘realisation of profits’?
7. When are profits realised in relation to inventory transfers within the group?

Exercise 22.1 CONSOLIDATION ADJUSTMENTS

★ Jessica Ltd sold inventory during the current period to its wholly owned subsidiary, Amelie Ltd, for
$15 000. These items previously cost Jessica Ltd $12 000. Amelie Ltd subsequently sold half the items to
Ningbo Ltd for $8000. The tax rate is 30%.
The group accountant for Jessica Ltd, Li Chen, maintains that the appropriate consolidation adjustment
entries are as follows:
Sales Dr 15 000
Inventory Cr 2 000
Required
1. Discuss whether the entries suggested by Li Chen are correct, explaining on a line-by-line basis the cor-
rect adjustment entries.
2. Determine the consolidation worksheet entries in the following year, assuming the inventory is onsold,
and explain the adjustments on a line-by-line basis.
Exercise 22.2 ELIMINATION OF INVESTMENT IN SUBSIDIARY AND INTRAGROUP TRANSACTIONS, NO FAIR VALUE —
★★ CARRYING AMOUNT DIFFERENCES AT ACQUISITION DATE
On 1 January 2013, Molly Ltd acquired all the share capital of Mia Ltd for $300 000. The equity of Mia Ltd
at 1 January 2013 was:

$ 270 000
At this date, all identifiable assets and liabilities of Mia Ltd were recorded at fair value. Goodwill is tested
annually for impairment. By 31 December 2016, no impairment has occurred. At 1 January 2013, no good-
will had been recorded by Mia Ltd.
On 1 May 2016, Mia Ltd transferred $15 000 from the general reserve (pre-acquisition) to retained earn-
ings. The current tax rate is 30%. Assuming consolidated financial statements are required for the period
1 January 2015 to 31 December 2016, provide journal entries (including the elimination of investment in
subsidiary) to show the adjustments that would be made in the consolidation worksheets. Use the fol-
lowing information:
(a) At 31 December 2016, Mia Ltd holds $100 000 of 7% debentures issued by Molly Ltd on 1 January
2015. All necessary interest payments have been made.
(b) At the end of the reporting period, Mia Ltd owes Molly Ltd $1000 for items sold on credit.
(c) Mia Ltd undertook an advertising campaign for Molly Ltd during the year. Molly Ltd paid $8000 to
Mia Ltd for this service.
(d) The beginning and ending inventories of Molly Ltd and Mia Ltd in relation to the current period
included the following unsold intragroup inventory:
Molly Ltd Mia Ltd

Beginning inventory:
Transfer price $2 000 $1 200
Original cost 1 400 800
Ending inventory:
Transfer price 500 900
Original cost 300 700
Molly Ltd sold inventory to Mia Ltd during the current period for $3000. This was $500 above the cost
of the inventory to Molly Ltd. Mia Ltd sold inventory to Molly Ltd in the current period for $2500,
recording a pre-tax profit of $800.
(e) Molly Ltd received dividends totalling $63 000 during the current period from Mia Ltd. All of this
related to dividends paid in the current period.

Exercise 22.3 INTRAGROUP TRANSACTIONS, EXPLANATION OF RATIONALE
★★ Alexis Ltd owns 100% of the shares of Ruby Ltd. During the 2015–16 period, Alexis Ltd sold inventory for
$10 000 which had been sold to it by Ruby Ltd in June 2016. The inventory originally cost Ruby Ltd $6000
and was sold to Alexis Ltd for $9000.
Required
1. Prepare the adjustments required in the consolidation worksheet at 30 June 2016, assuming an income
tax rate of 30%.
2. Explain the rationale behind the entries you have prepared.
Exercise 22.4 CONSOLIDATION WORKSHEET, CONSOLIDATED FINANCIAL STATEMENTS

★★ On 1 July 2015, Sienna Ltd acquired all the shares of Amber Ltd for $160 000. The financial statements of
the two entities at 30 June 2016 contained the following information:
Sienna Ltd Amber Ltd
Sales revenue $ 234 800 $ 200 000
Dividend revenue 17 000 —
Other income 6 600 —
258 400 200 000
Cost of sales (123 000) (120 000)
(157 600) (140 000)
Profit before income tax 100 800 60 000
Total available for appropriation 92 800 52 000
Dividend paid from 2014–15 profit (18 000) (5 000)
Interim dividend paid from 2015–16 profit (16 000) (4 800)
Dividend declared from 2015–16 profit (16 000) (7 200)
Transfer to general reserve (8 000) —
(58 000) (17 000)
Retained earnings (30/6/16) $ 34 800 $ 35 000
Current assets
Cash $ 1 000 $ 40
Allowance for doubtful debts (500) (300)
Inventory 48 000 47 000
Non-current assets
Plant and machinery 100 000 70 000
Land 102 300 190 000
Debentures in Amber Ltd 57 000 —
Shares in Amber Ltd 160 000
Total non-current assets 379 300 234 000
Total assets 474 800 302 840
Current liabilities
Dividend payable 16 000 7 200
Bank overdraft — 14 840
Current tax liabilities 11 000 10 000
12% mortgage debentures — 80 000
Deferred tax liabilities 13 000 5 000
Total non-current liabilities 13 000 85 000
Net assets $ 422 800 $ 177 000
(continued)

Sienna Ltd Amber Ltd
Equity
Share capital $ 320 000 $ 120 000
Other components of equity 8 000 2 000
Total equity $ 422 800 $ 177 000
(a) At 1 July 2015, all identifiable assets and liabilities of Amber Ltd were recorded at fair values except for
inventory, for which the fair value was $1000 greater than the carrying amount. This inventory was all sold
by 30 June 2016. At 1 July 2015, Amber Ltd had research and development outlays that it had expensed as
incurred. Sienna Ltd measured the fair value of the in-process research and development at $8000. By 30
June 2016, it was assessed that $2000 of this was not recoverable. At 1 July 2015, Amber Ltd had reported
a contingent liability relating to a guarantee that was considered to have a fair value of $7000. This liability
still existed at 30 June 2016. At 1 July 2015, Amber Ltd had not recorded any goodwill.
(b) The debentures were issued by Amber Ltd at nominal value on 1 July 2014, and are redeemable on 30
June 2020. Sienna Ltd acquired its holding ($60 000) of these debentures on the open market on 1
January 2016, immediately after the half-yearly interest payment had been made. All interest has been
paid and brought to account in the records of both entities.
(c) During the 2015–16 period, Sienna Ltd sold inventory to Amber Ltd for $40 000, at a mark-up of cost
plus 25%. At 30 June 2016, $10 000 worth of inventory was still held by Amber Ltd.
(d) The Other Components of Equity account relates to the financial assets. For the 2015–16 period,
Sienna Ltd recorded an increase in these assets of $3000, and Amber Ltd recorded a decrease of $2000.
(e) The income tax rate is 30%.
Required
Prepare the consolidated financial statements for Sienna Ltd and its subsidiary for the year ended
30 June 2016.
Exercise 22.5 CONSOLIDATION WORKSHEET, IMPAIRMENT OF GOODWILL

★★ Financial information for Amy Ltd and its 100% owned subsidiary, Zara Ltd, for the year ended 31
December 2016 is provided below:
Amy Ltd Zara Ltd

Sales revenue $25 000 $23 600
Proceeds from sale of property, plant and equipment 5 000 22 000
Total 32 000 47 600
Cost of sales 21 000 18 000
Carrying amount of property, plant and equipment sold 4 000 20 000
Total expenses 28 000 39 000
8 650 9 650
Interim dividend paid (2 500) (1 000)
Amy Ltd acquired its shares in Zara Ltd at 1 January 2016, buying the 10 000 shares in Zara Ltd for
$20 000 — Zara Ltd recorded share capital of $10 000. The shares were bought on a cum div. basis as Zara
Ltd had declared a dividend of $3000 that was not paid until March 2016.
At 1 January 2016, all identifiable assets and liabilities of Zara Ltd were recorded at fair value except for
inventory, for which the carrying amount of $2000 was $400 less than fair value. Some of this inventory
has been a little slow to sell, and 10% of it is still on hand at 31 December 2016. Inventory on hand in
Zara Ltd at 31 December 2016 also includes some items acquired from Amy Ltd during the year. These
were sold by Amy Ltd for $5000, at a profit before tax of $1000. Half the goodwill was written off as the
result of an impairment test on 31 December 2016.

During March 2016, Amy Ltd provided some management services to Zara Ltd at a fee of $500.
By 31 December 2016, the financial assets acquired by Amy Ltd and Zara Ltd increased by $1000 and
$650 respectively, with gains being recognised in other comprehensive income.
Required
1. Prepare the consolidated statement of profit or loss and other comprehensive income for Amy Ltd and
its subsidiary, Zara Ltd, at 31 December 2016.
2. Discuss the concept of ‘realisation’ using the intragroup transactions in this question to illustrate the
concept.
Exercise 22.6 CONSOLIDATION WORKSHEET, CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER
★★ COMPREHENSIVE INCOME
Financial information for Jasmine Ltd and Poppy Ltd for the year ended 30 June 2016 is shown below:
Jasmine Ltd Poppy Ltd

Sales revenue $78 000 $40 000
Proceeds from sale of office furniture — 3 000
Dividend revenue 4 400 1 600
Total income 82 400 44 600
Total expenses 70 800 37 500
23 100 7 700
Interim dividend paid 4 000 2 000
Final dividend declared 8 000 2 400
12 000 4 400
Retained earnings (30/6/16) $11 100 $ 3 300
(a) On 1 July 2014, Jasmine Ltd purchased 100% of the shares of Poppy Ltd for $50 000. At that date the
equity of the two entities was as follows:

Asset revaluation surplus $25 000 $ 4 000
At 1 July 2014, all the identifiable assets and liabilities of Poppy Ltd were recorded at fair value except
for the following:

Plant and equipment (cost $80 000) $60 000 $61 000
All of this inventory was sold by December 2014. The plant and equipment had a further 5-year life.
Any valuation adjustments are made on consolidation.
(b) Jasmine Ltd records dividend receivable as revenue when dividends are declared.
(c) The opening inventory of Poppy Ltd included goods which cost Poppy Ltd $2000. Poppy Ltd pur-
chased this inventory from Jasmine Ltd at cost plus 33¹/³%.
(d) Intragroup sales totalled $10 000 for the year. Sales from Jasmine Ltd to Poppy Ltd, at cost plus 10%,
amounted to $5600. The closing inventory of Jasmine Ltd included goods which cost Jasmine Ltd
$4400. Jasmine Ltd purchased this inventory from Poppy Ltd at cost plus 10%.
(e) On 31 December 2015, Poppy Ltd sold Jasmine Ltd office furniture for $3000. This furniture originally
cost Poppy Ltd $3000 and was written down to $2500 when sold. Jasmine Ltd depreciates furniture at
the rate of 10% p.a. on cost.

(f) The asset revaluation surplus relates to the use of the revaluation model for land. The following move-
ments occurred in this account:
1 July 2014 to 30 June 2015 $3 000 $(500)
1 July 2015 to 30 June 2016 $2 000 $ 500
(g) The tax rate is 30%.

Required
Prepare the consolidated statement of profit or loss and other comprehensive income for the year ended
30 June 2016.
CONSOLIDATED WORKSHEET, CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER

Exercise 22.7
★★★ COMPREHENSIVE INCOME
On 1 April 2015, Abby Ltd acquired all the issued ordinary shares (cum div.) of Ella Ltd for $100 000. At
that date, relevant balances in the records of Ella Ltd were:
Share capital $80 000

Dividend payable 4 000
All the identifiable assets and liabilities of Ella Ltd were recorded at fair values except for the following:

Inventory $10 000 $12 000
Plant (cost $80 000) 50 000 53 000
Immediately after the acquisition of its shares by Abby Ltd, Ella Ltd revalued its plant to fair value. The
plant was expected to have a further 5-year life. All the inventory on hand at 1 April 2015 was sold by the
end of the financial year.
At 1 April 2015, Ella Ltd had recorded goodwill of $2000. As a result of an impairment test on 31 March
2016, Ella Ltd wrote goodwill down by $1500 in the consolidation worksheet.
The dividend payable was subsequently paid in June 2015.
During the period ending 31 March 2016, intragroup sales consisted of $40 000 from Abby Ltd to Ella
Ltd at a profit to Abby Ltd of $10 000. These were all sold to external entities by Ella Ltd for $42 000 before
31 March 2016. Ella Ltd also sold some inventory to Abby Ltd for $10 000. This had cost Ella Ltd $6000.
Abby Ltd since has sold all the items to external entities for $8000, except one batch on which Ella Ltd
recorded a $500 profit before tax (original cost to Ella Ltd was $1000).
Both entities use the revaluation model in accounting for land. During the 2015–16 period, Abby Ltd
and Ella Ltd both recorded revaluation increments, these being $2200 and $1100 respectively.
The following information was obtained from the companies for the year ended 31 March 2016:
Abby Ltd Ella Ltd

Sales $146 000 $120 000
Proceeds on sale of non-current asset 30 000 —
180 000 120 000
132 000 87 000
Total available for appropriation 46 000 24 000
Dividend paid (8 000) (4 000)

Required
Prepare the consolidated statement of profit or loss and other comprehensive income as at 31 March 2016.
Assume a tax rate of 30%.
Exercise 22.8 CONSOLIDATION WORKSHEET, CONSOLIDATED FINANCIAL STATEMENTS

★★★ On 31 December 2011, Lara Ltd acquired all the issued shares of Jade Ltd. On this date, the share capital
of Jade Ltd consisted of 200 000 shares paid to 50c per share. Other reserves and retained earnings at this
date consisted of:
General reserve $25 000
At 31 December 2011, all the identifiable assets and liabilities of Jade Ltd were recorded at fair value
except for some plant and machinery. This plant and machinery, which cost $100 000, had a carrying
amount of $85 000 and a fair value of $90 000. The estimated remaining useful life was 10 years. Adjust-
ments for fair values are made on consolidation.
Immediately after acquisition, a dividend of $10 000 was declared and paid out of retained earnings.
Also, 1 year after acquisition, Jade Ltd used $20 000 from the general reserve on hand at acquisition date
to partly pay the balance unpaid on the issued shares.
The trial balances of Lara Ltd and Jade Ltd at 31 December 2016 were as shown below:
Trial Balances
as at 31 December 2016
Lara Ltd Jade Ltd
Credits
Share capital $ 500 000 $ 120 000
Asset revaluation surplus 10 000 6 000
Deferred tax liabilities 6 240 5 200
Payables 22 000 14 000
Proceeds from sale of property, plant and equipment 14 000 50 000
$ 924 240 $ 418 200
Debits
Income tax expense $ 20 000 $ 10 000
Dividend declared 10 000 8 000
Plant and machinery 425 000 337 000
Inventory 106 440 72 000
Bank 46 900 5 990
Deferred tax assets 12 700 6 300
Shares in Jade Ltd 160 000 —
Cost of sales 188 000 80 000
Carrying amount of property, plant and equipment sold 18 000 55 000
$ 924 240 $ 418 200
(a) During the current period, Lara Ltd sold inventory to Jade Ltd for $20 000. This had originally cost Lara
Ltd $18 200. Jade Ltd has, by 31 December 2016, sold half this inventory for $12 310.
(c) Certain specialised items of plant, considered a separate class of assets, are measured using the revalua-
tion model. At 1 January 2015, the balances of the asset revaluation surplus were $8000 (Lara Ltd) and
$7000 (Jade Ltd).

(d) The Other Components of Equity account reflects movements in the financial assets. The balances of
this account at 1 January 2015 were $12 000 (Lara Ltd) and $8000 (Jade Ltd).
Required
Prepare the consolidated financial statements as at 31 December 2016.
Exercise 22.9 CONSOLIDATION WORKSHEET

★★★ On 1 July 2014, Monique Ltd acquired all the shares of Madeleine Ltd for $137 200. At acquisition date,
the equity of Madeleine Ltd consisted of:

On this date, all the identifiable assets and liabilities of Madeleine Ltd were recorded at fair value except
for the following assets:

Inventory $50 000 $56 000
Motor vehicles (cost $18 000) 15 000 16 000
Furniture and fittings (cost $30 000) 24 000 32 000
Land 18 480 24 480
The inventory and land on hand in Madeleine Ltd at 1 July 2014 were sold during the following 12
months. The motor vehicles, which at acquisition date were estimated to have a 4-year life, were sold on
1 January 2016. Except for land, valuation adjustments are made on consolidation and, on realisation of
a business combination valuation reserve, a transfer is made to retained earnings on consolidation. The
furniture and fittings were estimated to have a further 8-year life. At 1 July 2014, Madeleine Ltd had not
recorded any goodwill.
The following trial balances were prepared for the companies at 30 June 2016:
Credits Monique Ltd Madeleine Ltd

Share capital $170 000 $ 80 000
Debentures 120 000 —
Final dividend payable 10 000 3 000
Other payables 34 800 10 100
Advance from Monique Ltd — 10 000
Accumulated depreciation
— Motor vehicles 4 000 2 000
— Furniture and fittings 2 000 6 000
$513 800 $252 100
Debits
Cost of sales $ 65 000 $ 53 500
Shares in Madeleine Ltd 137 200 —
Land — 24 480
Furniture and fittings 34 000 37 300
Inventory 171 580 70 320
Other assets 8 620 3 100
Interim dividend paid 4 000 2 000
Final dividend declared 10 000 3 000
Advance to Madeleine Ltd 10 000 —
$513 800 $252 100

(a) Intragroup transfers of inventory consisted of:
1/7/14 to 30/6/15:
Sales from Monique Ltd to Madeleine Ltd $12 000
Profit in inventory on hand 30/6/15 200
1/7/15 to 30/6/16:
Sales from Monique Ltd to Madeleine Ltd 15 000
Profit in inventory on hand 30/6/16
(incl. $50 from previous period sales) 1 000

Required
Prepare the consolidation worksheet for the preparation of the consolidated financial statements for the
period ended 30 June 2016.

23 Consolidation:
non-controlling interest

STANDARDS IFRS 3 Business Combinations
IN FOCUS
IAS 1 Presentation of Financial Statements
IFRS 12 Disclosure of Interests in Other Entities

OBJECTIVES
1 discuss the nature of the non-controlling interest (NCI)
2 explain the effects of the NCI on the consolidation process
3 explain how to calculate the NCI share of equity
4 explain how the calculation of the NCI is affected by the existence of intragroup transactions
5 explain how the NCI is affected by the existence of a gain on bargain purchase.
CHAPTER 23 Consolidation: non-controlling interest 635

LO1 23.1 NON-CONTROLLING INTEREST EXPLAINED
In chapters 21 and 22, the group under consideration consisted of two entities where the parent owned
all the share capital of the subsidiary. In this chapter, the group under discussion consists of a parent
that has only a partial interest in the subsidiary; that is, the subsidiary is less than wholly owned by
the parent.
23.1.1 Nature of the non-controlling interest (NCI)

Ownership interests in a subsidiary other than the parent are referred to as the non-controlling interest,
or NCI. Appendix A of IFRS 10 Consolidated Financial Statements contains the following definition of NCI:
Equity in a subsidiary not attributable, directly or indirectly, to a parent.
In figure 23.1, the group shown is illustrative of those discussed in this chapter. In this case, the parent
entity owns 75% of the shares of a subsidiary. There are two owners in this group — the parent share-
holders and the NCI. The NCI is a contributor of equity to the group.
Group
75%
Parent Subsidiary
FIGURE 23.1 The group
According to paragraph 22 of IFRS 10, the NCI is to be identified and presented within equity, separately
from the parent shareholders’ equity; that is, it is regarded as an equity contributor to the group, rather
than a liability of the group. This is because the NCI does not meet the definition of a liability as con-
tained in the Conceptual Framework, because the group has no present obligation to provide economic
outflows to the NCI. The NCI receives a share of consolidated equity, and is therefore a participant in the
residual equity of the group.
Classification of the NCI as equity affects both the calculation of the NCI as well as how it is disclosed
in the consolidated financial statements.
23.1.2 Calculation of the NCI share of equity

The NCI is entitled to a share of consolidated equity, because it is a contributor of equity to the
consolidated group. Because consolidated equity is affected by profits and losses made in relation to
transactions within the group, the calculation of the NCI is affected by the existence of intragroup
transactions. In other words, the NCI is entitled to a share of the equity of the subsidiary adjusted
for the effects of profits and losses made on intragroup transactions. This is discussed in more detail in
section 22.4.
23.1.3 Disclosure of the NCI

According to paragraph 22 of IFRS 10:
A parent shall present non-controlling interests in the consolidated statement of financial position within equity,
separately from the equity of the owners of the parent.
IAS 1 Presentation of Financial Statements confirms these disclosures. Paragraph 81B of IAS 1 requires the
profit or loss and other comprehensive income for the period to be disclosed in the statement of profit
or loss and other comprehensive income, showing separately the comprehensive income attributable to
non-controlling interests, and that attributable to owners of the parent. Figure 22.2 shows how the state-
ment of profit or loss and other comprehensive income may be shown. Note that in terms of the various
line items in the statement, such as revenues and expenses, it is the total consolidated amount that is dis-
closed. It is only the consolidated profit and comprehensive income that is divided into parent share and
NCI share.
According to paragraph 106(a) of IAS 1, the total comprehensive income for the period must be dis-
closed in the statement of changes in equity, showing separately the total amounts attributable to owners
of the parent and to non-controlling interests. Figure 23.3 provides an example of disclosures in the state-
ment of changes of equity. Note that the only line item for which the NCI must be shown is the total com-
prehensive income for the period. There is no requirement to show the NCI share of each equity account.

IRIS LTD
2016 2015
$m $m
Revenue 500 450
Expenses 280 260
Finance costs 40 35
180 155
Share of after-tax profit of associates 30 25
Income tax expense (28) (22)
PROFIT FOR THE YEAR 182 158
Other comprehensive income 31 24
Owners of the parent 151 140
182 158
Owners of the parent 179 160
213 182
FIGURE 23.2 Disclosure of NCI in the statement of profit or loss and other comprehensive income
IRIS LTD
Consolidated Statement of Changes in Equity (extract)
Total equity
Non- Owners
Share Revaluation Translation Retained controlling of the
capital surplus reserve earnings Total interest parent
$m $m $m $m $m $m $m
Balance at 1 July 2015 400 120 100 250 870 130 740
Changes in accounting
policy — — — — — — —
Total comprehensive
income for the period — 21 10 182 213 34 179
Dividends — — — (150) (150) (10) (140)
Issue of share capital — — — — — — —
Balance at 30 June 2016 400 141 110 282 933 154 779
FIGURE 23.3 Disclosure of NCI in the statement of changes in equity
Similarly, paragraph 54(q) of IAS 1 requires disclosure in the statement of financial position of the total
NCI share of equity while paragraph 54(r) requires disclosure of the issued capital and reserves attribut-
able to owners of the parent. The equity section of the statement of financial position could then appear
as in figure 23.4. In the statement of financial position, only the total NCI share of equity is disclosed,
rather than the NCI share of the different categories of equity. The NCI share of the various categories of
equity and the changes in those balances can be seen in the statement of changes in equity. Note that the
consolidated assets and liabilities are those for the whole of the group; it is only equity that is divided into
parent and NCI shares.

IRIS LTD
Statement of Financial Position (extract)
as at 30 June 2016
2014 2015
$m $m
EQUITY
Other reserves 251 220
933 870
Equity attributable to owners of the parent 779 740
FIGURE 23.4 Disclosure of NCI in the statement of financial position
IFRS 12 Disclosure of Interests in Other Entities also contains disclosures required for subsidiaries in which
there are non-controlling interests. Paragraph 12 of IFRS 12 states:
An entity shall disclose for each of its subsidiaries that have non-controlling interests that are material to the
reporting entity:
(a) the name of the subsidiary.
(b) the principal place of business (and country of incorporation if different from the principal place of busi-
ness) of the subsidiary.
(c) the proportion of ownership interests held by non-controlling interests.
(d) the proportion of voting rights held by non-controlling interests, if different from the proportion of owner-
ship interests held.
(e) the profit or loss allocated to non-controlling interests of the subsidiary during the reporting period.
(f) accumulated non-controlling interests of the subsidiary at the end of the reporting period.
(g) summarised financial information about the subsidiary (see paragraph B10).
LO2 23.2 EFFECTS OF AN NCI ON THE CONSOLIDATION

PROCESS
The acquirer shall recognise goodwill as of the acquisition date measured as the excess of (a) over (b) below:
(a) the aggregate of:
(i) the consideration transferred measured in accordance with this IFRS, which generally requires acquisition-
date fair value (see paragraph 37);
(ii) the amount of any non-controlling interest in the acquiree measured in accordance with this IFRS; and
(iii) in a business combination achieved in stages (see paragraphs 41 and 42), the acquisition date fair value
of the acquirer’s previously held equity interests in the acquiree.
(b) the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed meas-
ured in accordance with this IFRS.
Note that this choice is not an accounting policy choice, but is made for each business combination.
Consider a situation where A Ltd acquires 50% of the shares of B Ltd, having previously acquired 20%
of the shares of B Ltd. Holding 70% of the shares of B Ltd gives A Ltd control of that entity. At acquisition
date, there is an NCI of 30%. Note:
• Where the parent acquires less than all the shares of a subsidiary, it acquires only a portion of the total
equity or total net assets of the subsidiary. Hence, the consideration transferred is for only a portion of
the net assets of the subsidiary; in this example, 50%.
• In essence, the 20% investment held prior to the parent obtaining control must be revalued at
acquisition date to fair value.
The next step is to measure the amount of the 30% non-controlling interest in the subsidiary. The
problem with this step is that IFRS 3 allows alternative treatments. Paragraph 19 of IFRS 3 states:
For each business combination, the acquirer shall measure at the acquisition date components of non-controlling
interests in the acquiree that are present ownership interests and entitle their holders to a proportionate share of
the entity’s net assets in the event of liquidation at either:
(a) fair value; or
(b) the present ownership instruments’ proportionate share in the recognised amounts of the acquiree’s identi-
fiable net assets.
All other components of non-controlling interests shall be measured at their acquisition-date fair values, unless
another measurement basis is required by IFRSs.

Which alternative is chosen affects the determination of goodwill and the subsequent consolidation
adjustments. Where the first alternative is used, the goodwill attributable to both the NCI and the parent
is measured. Under the second alternative, only the goodwill attributable to the parent is measured. The
methods are sometimes referred to as the ‘full goodwill’ and the ‘partial goodwill’ methods — see para-
graph BC205 of the Basis for Conclusions on IFRS 3 for further elaboration. These terms are used in this
chapter to distinguish between the two methods. The methods are demonstrated in sections 23.2.1 and 23.2.2
and the reasons for the standard setters allowing optional measurements, as well as factors to consider in choosing
between the methods, is discussed in section 23.2.3.
23.2.1 Full goodwill method

Under this method, at acquisition date, the NCI in the subsidiary is measured at fair value. The fair value
is determined on the basis of the market prices for shares not acquired by the parent, or, if these are not
available, a valuation technique is used.
It is not sufficient to use the consideration paid by the acquirer to measure the fair value of the NCI.
For example, if a parent paid $80 000 for 80% of the shares of a subsidiary, then the fair value of the NCI
cannot be assumed to be $20 000 (i.e. 20/80 × $80 000). It may be that the acquirer paid a control pre-
mium in order to acquire a controlling interest in the subsidiary. Relating this to the nature of goodwill in
chapter 13, core goodwill includes the component of combination goodwill, relating to synergies arising
because of the combination of the parent and the subsidiary. The parent would increase the consideration
it was prepared to pay due to these synergies. However, these synergies may result in increased earnings
in the parent and not the subsidiary. In this case, the NCI does not receive any share of those synergies.
Hence, the consideration paid by the parent could not be used to measure the fair value of the NCI in the
subsidiary.
To illustrate the method, assume that P Ltd paid $169 600 for 80% of the shares of S Ltd on 1 July 2013.
All identifiable assets and liabilities of the subsidiary were recorded at fair value, except for land for which
the fair value was $10 000 greater than cost. The tax rate is 30%. The NCI in S Ltd was considered to have
a fair value of $42 000. At acquisition date, the equity of S Ltd consisted of:

The acquisition analysis is as follows:
Net fair value of identifiable assets

and liabilities of S Ltd = $100 000 + $60 000 + $40 000
+ $10 000(1 − 30%) (BCVR — land)
= $207 000
(a) Consideration transferred = $169 600
(b) Non-controlling interest in S Ltd = $42 000
Aggregate of (a) and (b) = $211 600
Goodwill = $211 600 − $207 000
= $4600
Goodwill of S Ltd
Fair value of S Ltd = $42 000/20%
= $210 000
and liabilities of S Ltd = $207 000
Goodwill of S Ltd = $210 000 − $207 000
= $3000
Goodwill of P Ltd
Goodwill acquired = $4600
Goodwill of S Ltd = $3000
Goodwill of P Ltd – control premium = $1600
Note the following:

• The acquired goodwill of $4600 calculated in the acquisition analysis consists of both the goodwill of
the subsidiary and the premium paid by the parent to acquire control over the subsidiary.

• As the fair value of the NCI (20%) is determined to be $42 000, if P Ltd were to acquire 80% of S
Ltd, it would expect to pay $168 000 (i.e. 80/20 × $42 000). As P Ltd paid $169 600, it paid a control
premium of $1600. This is recognised as goodwill attributable to P Ltd. Effectively the goodwill of
$4600 is broken down into:
Control premium paid by P Ltd $1600

Parent’s share of S Ltd’s goodwill $2400 [$4000 − $1600 or 80% × $3000]
NCI share of S Ltd’s goodwill $600 [20% × $3000]
• The goodwill attributable to P Ltd — both share of S Ltd’s goodwill and the control premium — could
be calculated as follows:
Net fair value acquired by P Ltd = 80% × $207 000

= $165 600
Goodwill attributable to P Ltd = $169 600 − $165 600
= $4000
• The control premium is recognised as part of goodwill on consolidation, but is not attributable to
the NCI.
In accounting for the goodwill, a business combination valuation reserve is raised for the goodwill of
the subsidiary, namely $3000. This reserve is then attributed on a proportional basis to the parent and
the NCI, being $2400 to the parent and $600 to the NCI. The control premium goodwill is recognised
in the adjustment to eliminate the investment in the subsidiary only as the earnings from this combination
goodwill flow into the parent’s earnings and not that of the subsidiary — otherwise it would be included
in the valuation of the NCI interest in the subsidiary.
The consolidation worksheet entries are as follows:
1. Business combination valuation entries

Land Dr 10 000
(Revaluation of land)
Goodwill Dr 3 000
(Recognition of subsidiary goodwill)
2. Elimination of investment in subsidiary

Retained Earnings [80% × $40 000] Dr 32 000
Share Capital [80% × $100 000] Dr 80 000
General Reserve [80% × $60 000] Dr 48 000
Business Combination Valuation Reserve [80% ($7000 + $3000)] Dr 8 000
Goodwill Dr 1 600
Shares in S Ltd Cr 169 600
Two business combination valuation entries are required: one for the revaluation of the land to fair value,
and the second to recognise the goodwill of the subsidiary.
In relation to the equity on hand at acquisition date, 80% is attributable to the parent, and 20% is
attributable to the NCI. The elimination of investment in subsidiary relates to the investment by the parent
in the subsidiary, and thus relates to 80% of the amounts shown in the acquisition analysis. The adjust-
ments to equity in the elimination of investment in subsidiary are then determined by taking 80% of the
recorded equity of the subsidiary and 80% of the business combination valuation reserves recognised as
a result of differences between fair values and carrying amounts of the subsidiary’s identifiable assets and
liabilities at acquisition date and the goodwill of the subsidiary. The goodwill relating to the control pre-
mium is recognised in the elimination of investment in subsidiary.
23.2.2 Partial goodwill method

Under the second option, at acquisition date, the NCI is measured as the NCI’s proportionate share of the
acquiree’s identifiable net assets. The NCI therefore does not get a share of any equity relating to goodwill as
goodwill is defined in Appendix A of IFRS 3 as the future economic benefits arising from assets not individually

identified. The only goodwill recognised is that acquired by the parent in the business combination — hence
the term ‘partial’ goodwill. According to paragraph 32 of IFRS 3, using the measurement of the NCI share of
equity based on the NCI’s proportionate share of the acquiree’s identifiable net assets:
Goodwill = consideration transferred plus previously acquired investment

by parent plus NCI share of identifiable assets and liabilities of
subsidiary less net fair value of identifiable assets and liabilities
of subsidiary.
To illustrate, using the same example as in section 23.2.1, assume that P Ltd paid $169 600 for 80% of
the shares of S Ltd on 1 July 2013. All identifiable assets and liabilities of the subsidiary were recorded at
fair value, except for land for which the fair value was $10 000 greater than cost. The tax rate is 30%. At
acquisition date, the equity of S Ltd consisted of:

The acquisition analysis is as follows:

and liabilities of S Ltd = $100 000 + $60 000 + $40 000
+ $10 000(1 − 30%) (BCVR — land)
= $207 000
(b) Non-controlling interest in S Ltd = 20% × $207 000
= $41 400
Goodwill = $211 000 − $207 000
= $4000
Note that the $4000 goodwill is the same as the parent’s share calculated in section 23.2.1, consisting of
the parent’s share of the subsidiary’s goodwill (80% × $3000 = $2400) and any control premium ($1600).
The consolidation worksheet entries are:
Business combination valuation entry

Land Dr 10 000
Elimination of investment in subsidiary

Retained Earnings [80% × $40 000] Dr 32 000
Share Capital [80% × $100 000] Dr 80 000
General Reserve [80% × $60 000] Dr 48 000
Business Combination Valuation Reserve [80% × $7000] Dr 5 600
Goodwill Dr 4 000
Shares in S Ltd Cr 169 600
Note firstly that there is no business combination valuation entry for goodwill. This is because only the
parent’s share of the goodwill is recognised. A business combination valuation adjustment to recognise
goodwill is only used under the full goodwill method where both the parent’s and the NCI’s share of
goodwill is recognised.
In relation to the equity on hand at acquisition date, only 80% is attributable to the parent, and 20%
is attributable to the NCI. The elimination of investment in subsidiary relates to the investment by the
parent in the subsidiary, and thus relates to 80% of the amounts shown in the acquisition analysis. The
adjustments to equity in the elimination of investment in subsidiary are then determined by taking 80%
of the recorded equity of the subsidiary and 80% of the business combination valuation reserves recog-
nised as a result of differences between fair value and carrying amounts of the subsidiary’s identifiable

assets and liabilities at acquisition date. Because only the parent’s share of goodwill is recognised, this is
accounted for in the elimination of investment in subsidiary which also relates to the investment by the
parent in the subsidiary.
23.2.3 Reasons for, and choosing between, the options

The International Accounting Standards Board (IASB®) supports the principle of measuring all compo-
nents of a business combination at fair value (paragraph BC212); however, paragraph BC213 notes some
arguments against applying this to the NCI in the acquiree:
• It is more costly to measure the NCI at fair value than at the proportionate share of the net fair value
of the identifiable net assets of the acquiree.
• There is not sufficient evidence to assess the marginal benefits of reporting the acquisition-date fair
value of NCIs.
• Respondents to the exposure draft saw little information of value in the reported NCI, regardless of
how it is measured.
One of the options considered by the IASB in writing the standard was to require the use of the fair
value method for measuring the NCI but allowing entities to use the proportionate method where there
exists ‘undue cost or effort’ in measuring the fair value. However, the IASB rejected this option as it did not
think the term undue cost or effort would be applied consistently (paragraph BC215).
The IASB noted three main differences in outcome that occur where the partial goodwill method is used
instead of the full goodwill method:
1. The amounts recognised for the NCI share of equity and goodwill would be lower.
2. Where IAS 36 Impairment of Assets is applied to a cash-generating unit containing goodwill, as the
goodwill recognised by the CGU is lower, this affects the impairment loss relating to goodwill.
3. There is also an effect where an acquirer subsequently obtains further shares in the subsidiary at a later
date. An explanation of this effect is beyond the scope of this book.
In choosing which method to use — full or partial goodwill — it is these three effects on the financial
statements, both current and in the future, that must be taken into consideration. For example, if management
has future intentions of acquiring more shares in the subsidiary (i.e. by acquiring some of the shares held by the
NCI), then the potential impact on equity when that acquisition occurs will need to be considered.
23.2.4 Intragroup transactions

As already noted (see chapter 22), because the transactions occur within the economic entity, the full effects
of transactions within the group are adjusted on consolidation. In essence, the worksheet adjustment
entries used in chapter 22 are the same regardless of whether the subsidiary is wholly or partly owned by
its parent. The only exception to the entries used in chapter 22 is for dividends.
Where an NCI exists, any dividends declared or paid by a subsidiary are paid proportionately (to
the extent of the ownership interest in the subsidiary) to the parent and proportionately to the NCI. In
adjusting for dividends paid by a subsidiary, only the dividend paid or payable to the parent is eliminated
on consolidation. In other words, there is a proportional adjustment of the dividend paid or declared.
As with other intragroup transactions, the adjustment relates to the flow within the group. A payment or
a declaration of dividends by a subsidiary reduces the NCI share of subsidiary equity because the equity
of the subsidiary is reduced by the payment or declaration of dividends. In calculating the NCI share of
subsidiary equity, the existence of dividends must be taken into consideration (see section 23.3.3). Where
a dividend is declared, the NCI share of equity is reduced, and a liability to pay dividends to the NCI is
shown in the consolidated statement of financial position.
To illustrate, assume a parent owns 80% of the share capital of a subsidiary. In the current period, the
subsidiary pays a $1000 dividend and declares a further $1500 dividend. The adjustment entries in the
consolidation worksheet in the current period are:
Dividend Revenue Dr 800

Dividend Paid Cr 800
(80% × $1000)

(80% × $1500)

(80% × $1500)

23.2.5 Consolidation worksheet
Because the disclosure requirements for the NCI require the extraction of the NCI share of various equity
items, the consolidation worksheet is changed to enable this information to be produced. Figure 23.5
contains an example of the changed worksheet. In particular, note that two new columns are added, a
debit column and a credit column for the calculation of the NCI share of equity. These two columns are not
adjustment or elimination columns. Instead, they are used to divide consolidated equity into NCI share
and parent entity share. The worksheet shown in figure 23.5 also contains a column showing the figures
for the consolidated group. This column is shown between the adjustment columns and the NCI
columns, and it is the summation of the financial statements of the group members and the consolidation
adjustments. The parent figures are then determined by subtracting the NCI share of equity from the total
consolidated equity of the group.
Adjustments Non-controlling interest
Financial statements P Ltd S Ltd Dr Cr Group Dr Cr Parent
Profit/(loss) 5 000 4 000 9 000 400 8 600

Retained earnings (opening
balance) 10 000 8 000 18 000 800 17 200
Transfer from reserves 4 000 2 000 6 000 200 5 800
Total available for appropriation 19 000 14 000 33 000 31 600
Interim dividend paid 2 000 1 500 3 500 150 3 350
Final dividend declared 4 000 2 500 6 500 250 6 250
Transfer to reserves 3 000 1 000 4 000 100 3 900
9 000 5 000 14 000 13 500
Retained earnings (closing
balance) 10 000 9 000 19 000 18 100
Share capital 50 000 40 000 90 000 4 000 86 000
Other reserves 30 000 20 000 50 000 2 000 48 000
90 000 69 000 159 000 152 100
Asset revaluation surplus
(opening balance) 4 000 5 000 9 000 500 8 500
Revaluation increases 2 000 2 000 4 000 200 3 800
Asset revaluation surplus
(closing balance) 6 000 7 000 13 000 12 300
Total equity: parent 164 400
Total equity: NCI 7 600 7 600
Total equity 96 000 76 000 172 000 8 100 8 100 172 000
Current liabilities 3 000 2 000 5 000
Non-current liabilities 8 000 6 000 14 000
Total equity and liabilities 107 000 84 000 191 000
FIGURE 23.5 Consolidation worksheet containing NCI columns
In figure 23.5, the amounts in the debit NCI column record the NCI share of the relevant equity item.
This amount is subtracted in the consolidation process so that the consolidation column contains the
parent’s share of consolidated equity.
The first line in figure 23.5 is the consolidated profit/(loss) for the period. This amount is then attrib-
uted to the parent and the NCI. In all subsequent equity lines, the NCI share is recorded in the debit NCI
column, and the parent’s share of each equity account is calculated. The total NCI share of equity is then
added to the parent column to give total consolidated equity.
The NCI share of retained earnings is increased by subsidiary profits and transfers from reserves, and
decreased by transfers to reserves and payments and declarations of dividends. The total NCI share of
equity is then the sum of the NCI share of capital, other reserves and retained earnings. The assets and
liabilities of the group are shown in total and not allocated to the equity interests in the group — see, for
example, the liabilities section in figure 23.5.

LO3 23.3 CALCULATING THE NCI SHARE OF EQUITY
Non-controlling interests in the net assets consist of the amount of those non-controlling interests at the
date of the original combination calculated in accordance with IFRS 3 and the non-controlling interests’
share of changes in equity since the date of the combination.
Changes in equity since the acquisition date must be taken into account. Note that these changes not
only are in the recorded equity of the subsidiary, but also relate to other changes in consolidated equity.
As noted earlier in this chapter, the NCI is entitled to a share of consolidated equity. This requires taking
into account adjustments for profits or losses made as a result of intragroup transactions because these
profits or losses are not recognised by the group.
The calculation of the NCI is done in two stages: (1) the NCI share of recorded equity is measured (see
section 23.3.1), and (2) this share is adjusted for the effects of intragroup transactions (see section 23.4).
23.3.1 NCI share of recorded equity of the subsidiary

The equity of the subsidiary consists of the equity contained in the actual records of the subsidiary as
well as any business combination valuation reserves created on consolidation at the acquisition date,
where the identifiable assets and liabilities of the subsidiary are recorded at amounts different from their
fair values. The NCI is entitled to a share of subsidiary equity at the end of the reporting period, which
consists of the equity on hand at acquisition date plus any changes in that equity between acquisition
date and the end of the reporting period. The calculation of the NCI share of equity at a point in time
is done in three steps:
1. Determine the NCI share of equity of the subsidiary at acquisition date.
2. Determine the NCI share of the change in subsidiary equity between the acquisition date and the begin-
ning of the current period for which the consolidated financial statements are being prepared.
3. Determine the NCI share of the changes in subsidiary equity in the current period.
The calculation could be represented diagrammatically, as shown in figure 23.6.
STEP 1 STEP 2 STEP 3

Share of equity recorded Share of change in equity Share of change in
at acquisition date from acquisition date to equity in current period
beginning of current period
Time Acquisition Beginning of End of

date current period current period
FIGURE 23.6 Calculating the NCI share of equity

Source: Based on a diagram by Peter Gerhardy, Ernst & Young, Adelaide.
Note that, in calculating the NCI share of equity at the end of the current period, the information
relating to the NCI share of equity from steps 1 and 2 should be available from the previous period’s con-
solidation worksheet.
To illustrate the above procedure, consider the calculation of the NCI share of retained earnings over a
5-year period. Assume the following information in relation to Cormorant Ltd:
Retained earnings as at 1 July 2011 $10 000

Retained earnings as at 30 June 2015 50 000
Profit for the 2015–16 period 15 000
Assume that Pelican Ltd had acquired 80% of the share capital of Cormorant Ltd at 1 July 2011, and the
consolidated financial statements were being prepared at 30 June 2016. The 20% NCI in Cormorant Ltd

is therefore entitled to a share of the retained earnings balance of $65 000, a share equal to $13 000. This
share is calculated in three steps:
Step 1. A share of the balance at 1 July 2011 (20% × $10 000) = $ 2 000
Step 2. A share of the change in retained earnings from the acquisition date
to the beginning of the current period (20% × [$50 000 − $10 000]) = 8 000
Step 3. A share of the current period increase in retained earnings (20% × $15 000) = 3 000
$13 000
The increase in retained earnings is broken into these three steps because accounting is based on
time periods. The NCI is entitled to a share of the profits of past periods as well as a share of the profits
of the current period. Note that, in calculating the NCI share of retained earnings for Cormorant Ltd at
30 June 2017 (1 year after the above calculation), the total of steps 1 and 2 for the 2017 calculation would
be $13 000, as calculated above. The only additional calculation would be the share of changes in retained
earnings in the 2016–17 period.
The separate calculations are not based on a division of equity into pre-acquisition and post-acquisition
equity. The division of equity is based on time — changes in equity are calculated on a period-by-period
basis for accounting purposes.
The NCI columns in the consolidation worksheet contain the amounts relating to the three steps noted
above. The journal entries used in the NCI columns of the consolidation worksheet to reflect the NCI
share of equity are based on the three-step approach. The form of these entries is:
Step 1: NCI at acquisition date

Share Capital Dr xxx
Business Combination Valuation Reserve Dr xxx
NCI Cr xxx
Step 2: NCI share of changes in equity between acquisition date and beginning of the current period
NCI Cr xxx
Step 3: NCI share of changes in equity in the current period
NCI Share of Profit/(Loss) Dr xxx
NCI Cr xxx
Asset Revaluation Increases Dr xxx
NCI Cr xxx
NCI Dr xxx
Dividend Paid Cr xxx
NCI Dr xxx
Dividend Declared Cr xxx
The effects of these journal entries can be seen in the consolidation worksheet in figure 23.5. The
above entries are illustrative only, and there may be others where there are transfers to or from reserves
that affect the balances of equity in the subsidiary. The effects of these transactions are illustrated in the
next section.
23.3.2 Accounting at acquisition date

This section illustrates the effects that the existence of an NCI has on the valuation entries, the acquisi-
tion analysis and the elimination of investment in subsidiary, as well as the step 1 calculation of the NCI
share of equity at acquisition date. As noted in section 23.2, the acquisition analysis and subsequent con-
solidation worksheet entries are affected by whether the full goodwill or partial goodwill option is used
in the measurement of the NCI’s share of the subsidiary at acquisition date. The choice of method affects
the accounting at acquisition date but has an effect on accounting subsequent to acquisition date only if
there is an impairment of goodwill or the parent changes its equity interest in the subsidiary. Neither of
these events is covered in this book.

Full goodwill method
ILLUSTRATIVE EXAMPLE 23.1 Consolidation worksheet entries at acquisition date
On 1 July 2013, Heron Ltd acquired 60% of the shares (cum div.) of Petrel Ltd for $45 600 when the
equity of Petrel Ltd consisted of:

At acquisition date, the liabilities of Petrel Ltd included a dividend payable of $1000. All the identifi-
able assets and liabilities of Petrel Ltd were recorded at fair value except for equipment and inventory:

Equipment (cost $250 000) $180 000 $200 000
Inventory 40 000 50 000
The tax rate is 30%. The fair value of the NCI in Petrel Ltd at 1 July 2013 was $28 000.
Net fair value of identifiable assets and

liabilities of Petrel Ltd = $40 000 (capital) + $2000 (general reserve)
+ $2000 (retained earnings)
+ $20 000(1 − 30%) (BCVR — equipment)
+ $10 000(1 − 30%) (BCVR — inventory)
= $65 000
(a) Consideration transferred = $45 600 − (60% × $1000) (dividend receivable)
= $45 000
(b) Non-controlling interest in Petrel Ltd = $28 000
Goodwill = $73 000 − $65 000
= $8000
Goodwill of Petrel Ltd
Fair value of Petrel Ltd = $28 000/40%
= $70 000
liabilities of Petrel Ltd = $65 000
Goodwill of Petrel Ltd = $70 000 − $65 000
= $5000
Goodwill of Heron Ltd
Goodwill of Petrel Ltd = $5000
Goodwill of Heron Ltd — control premium = $3000
Where an NCI exists, because the parent acquires only a part of the ownership interest of the sub-
sidiary, the parent acquires only a proportionate share of each of the equity amounts in the subsidiary.
(1) Business combination valuation entries
The valuation entries are unaffected by the existence of an NCI. The purpose of these entries,
in accordance with IFRS 3, is to show the assets and liabilities of the subsidiary at fair value at
acquisition date. The entries for a consolidation worksheet (see figure 23.7 overleaf) prepared at
acquisition date are:

Equipment Cr 50 000
Inventory Dr 10 000
Goodwill Dr 5 000
The business combination valuation reserve is pre-acquisition equity because it is recognised on

consolidation at acquisition date. The NCI is entitled to a proportionate share of this reserve.
(2) Elimination of investment and recognition of goodwill
The first journal entry is read from the pre-acquisition analysis. The parent’s proportional share of
the various recorded equity accounts of the subsidiary, as well as the parent’s share of the business
combination valuation reserves, are eliminated against the investment account in the pre-acquisition
entry. The goodwill relating to the control premium is also recognised. In this illustrative example,
the elimination of investment in subsidiary is:

[60% × $2000]
[60% × $40 000]
[60% × ($14 000 + $7000 + $5000)]
[60% × $2000]
Goodwill Dr 3 000
Shares in Petrel Ltd Cr 45 000
At acquisition date, the subsidiary has recorded a dividend payable and the parent entity a
dividend receivable. An adjustment entry is required because these are not dividends receivable
or payable to parties external to the group. The adjustment is a proportional one as it relates
only to the amount payable within the group:
Dividend Payable Dr 600

Dividend Receivable Cr 600
[60% × $1000]
No further adjustment is required once the dividend has been paid.

(3) NCI share of equity at acquisition date
The NCI at acquisition date (the step 1 calculation) is determined as the proportional share of the
equity recorded by the subsidiary at that date and the valuation reserves recorded on consolidation:
Share capital 40% × $40 000 = $16 000

General reserve 40% × $2000 = 800
Business combination valuation reserve 40% × ($14 000 + $7000 + $5000) = 10 400
Retained earnings 40% × $2000 = 800
$28 000
The following entry is then passed in the NCI columns of the consolidation worksheet:
Retained Earnings (1/7/13) Dr 800

General Reserve Dr 800
NCI Cr 28 000

This entry is passed as the step 1 NCI entry in all subsequent consolidation worksheets. It is never
changed. Any subsequent changes in pre-acquisition equity are dealt with in the step 2 NCI calculation.
Figure 23.7 shows an extract from a consolidation worksheet for Heron Ltd and its subsidiary, Petrel
Ltd, at acquisition date. Only the equity section of the worksheet is shown. The worksheet entries are
(1) the business combination valuation entries, (2) the elimination of the investment and the recog-
nition of goodwill (the dividend adjustment is not shown in figure 23.7 because only an extract from
the worksheet is reproduced), and (3) the NCI step 1 entry.

Heron Petrel
Financial statements Ltd Ltd Dr Cr Group Dr Cr Parent
Retained earnings (1/7/13) 50 000 2 000 2 1 200 50 800 3 800 50 000

Share capital 100 000 40 000 2 24 000 116 000 3 16 000 100 000
General reserve 20 000 2 000 2 1 200 20 800 3 800 20 000
valuation reserve 2 15 600 14 000 1 10 400 3 10 400 0
7 000 1
5 000 1
Total equity: NCI 28 000 3 28 000
Total equity 170 000 44 000 198 000 28 000 28 000 198 000
FIGURE 23.7 Consolidation worksheet (extract) at acquisition date
Note that, in figure 23.7, the adjustment columns eliminate the parent’s share of the pre-acquisition
equity accounts and the NCI columns extract the NCI share of total equity. The parent column
contains only the parent’s share of post-acquisition equity, which in this case, being at acquisition
date, is zero.
Partial goodwill method
ILLUSTRATIVE EXAMPLE 23.2 Consolidation worksheet entries at acquisition date
On 1 July 2013, Heron Ltd acquired 60% of the shares (cum div.) of Petrel Ltd for $45 600 when the
equity of Petrel Ltd consisted of:

At acquisition date, the liabilities of Petrel Ltd included a dividend payable of $1000. All the
identifiable assets and liabilities of Petrel Ltd were recorded at fair value except for equipment and
inventory:

Equipment (cost $250 000) $180 000 $200 000
Inventory 40 000 50 000


and liabilities of Petrel Ltd = $40 000 (capital) + $2000 (general reserve)
+ $2000 (retained earnings)
+ $20 000(1 − 30%) (BCVR — equipment)
+ $10 000(1 − 30%) (BCVR — inventory)
= $65 000
(a) Consideration transferred = $45 600 − (60% × $1000) (dividend receivable)
= $45 000
(b) Non-controlling interest in
Petrel Ltd = 40% × $65 000
= $26 000
Goodwill = $71 000 − $65 000
= $6000
Where an NCI exists, because the parent acquires only a part of the ownership interest of the sub-
sidiary, the parent acquires only a proportionate share of each of the equity amounts in the subsidiary.
The valuation entries are unaffected by the existence of an NCI. The purpose of these entries, in accord-
ance with IFRS 3, is to show the assets and liabilities of the subsidiary at fair value at acquisition date.
The entries for a consolidation worksheet (see figure 23.8 overleaf) prepared at acquisition date are:

Equipment Cr 50 000
Inventory Dr 10 000
Note that there is no business combination valuation entry for goodwill as under the partial
goodwill method only the parent’s share of goodwill is recognised, and this is done in the pre-
acquisition entry. The business combination valuation reserve is pre-acquisition equity because it
is recognised on consolidation at acquisition date. The NCI is entitled to a proportionate share of
this reserve. Because the reserve is recognised by the group, but not in the records of the subsidiary,
this affects later calculations for the NCI share of equity.
The first elimination of investment in subsidiary is read from the pre-acquisition analysis. The par-
ent’s proportional share of the various recorded equity accounts of the subsidiary, as well as the
parent’s share of the business combination valuation reserves, are eliminated against the investment
account in the pre-acquisition entry, and the parent’s share of goodwill is recognised. In this illustra-
tive example, the elimination of investment in subsidiary is:

[60% × $2000]
[60% × $40 000]
[60% × ($14 000 + $7000)]
[60% × $2000]
Goodwill Dr 6 000
At acquisition date, the subsidiary has recorded a dividend payable and the parent entity a div-
idend receivable. An adjustment entry is required because these are not dividends receivable or

payable to parties external to the group. The adjustment is a proportional one as it relates only to
the amount payable within the group:

[60% × $1000]
No further adjustment is required once the dividend has been paid.

(3) NCI share of equity at acquisition date
The NCI at acquisition date (the step 1 calculation) is determined as the proportional share of the
equity recorded by the subsidiary at that date and the valuation reserves recorded on consolidation:
Share capital 40% × $40 000 = $16 000

General reserve 40% × $2000 = 800
Business combination valuation reserve 40% × ($14 000 + $7000) = 8 400
Retained earnings 40% × $2000 = 800
$26 000
The following entry is then passed in the NCI columns of the consolidation worksheet:

NCI Cr 26 000
This entry is passed as the step 1 NCI entry in all subsequent consolidation worksheets. It is
never changed. Any subsequent changes in pre-acquisition equity are dealt with in the step 2 NCI
calculation.
Figure 23.8 shows an extract from a consolidation worksheet for Heron Ltd and its subsidiary, Petrel
Ltd, at acquisition date. Only the equity section of the worksheet is shown. The worksheet entries are (1)
the business combination valuation entries, (2) the elimination of investment and recognition of good-
will (the dividend adjustment is not shown in figure 23.8 because only an extract from the worksheet is
reproduced), and (3) the NCI step 1 entry.
Note that, in figure 23.8, the adjustment columns eliminate the parent’s share of the pre-acquisition
equity accounts and the NCI columns extract the NCI share of total equity. The parent column contains
only the parent’s share of post-acquisition equity, which in this case, being at acquisition date, is zero.

Heron Petrel
Retained earnings (1/7/13) 50 000 2 000 2 1 200 50 800 3 800 50 000

Share capital 100 000 40 000 2 24 000 116 000 3 16 000 100 000
General reserve 20 000 2 000 2 1 200 20 800 3 800 20 000
Business combination 2 12 600 14 000 1 8 400 3 8 400 0
valuation reserve 7 000 1

Total equity: NCI 26 000 3 26 000
Total equity 170 000 44 000 196 000 26 000 26 000 196 000
FIGURE 23.8 Consolidation worksheet (extract) at acquisition date

23.3.3 Accounting subsequent to acquisition date
Using illustrative example 23.2, the consolidation worksheet entries at the end of the period 3 years after the
acquisition date are now considered. These entries are based on the partial goodwill method. However, the effects
of the events occurring subsequent to acquisition date on the elimination of investment and recognition of
goodwill and business combination valuation entries are the same for the full goodwill method. Assume that:
• all inventory on hand at 1 July 2013 is sold by 30 June 2014
• the dividend payable at acquisition date is paid in August 2013
• the equipment has an expected useful life of 5 years
• goodwill has not been impaired
• in the 3 years after the acquisition date, Petrel Ltd recorded the changes in equity shown in figure 23.9.
In preparing the consolidated financial statements at 30 June 2016, the consolidation worksheet con-
tains the valuation entries, the elimination of investment and recognition of goodwill entries, the NCI
entries and the adjustments for the dividend transactions.
2013–14 2014–15 2015–16

Profit for the period $ 8 000 $12 000 $15 000
Retained earnings (opening balance) 2 000 7 800 16 000
10 000 19 800 31 000
Transfer from general reserve — — 500
10 000 19 800 31 500
Transfer to general reserve — 1 000 —
Dividend paid 1 000 1 200 1 500
Dividend declared 1 200 1 600 2 000
2 200 3 800 3 500
Retained earnings (closing balance) 7 800 16 000 28 000
Share capital 40 000 40 000 40 000
General reserve 2 000 3 000 2 500
Other components of equity* 2 000 2 500 2 400
* Resulted from movement in fair value of financial assets.
FIGURE 23.9 Changes in equity over a 3-year period

The valuation entries for the 2015–16 period differ from those prepared at acquisition date in that the
equipment is depreciated, and the inventory has been sold. The entries at 30 June 2016 are:

Equipment Cr 50 000

(20% × $20 000 p.a.)

(30% × $4000 p.a.)
(If the full goodwill method had been used, the business combination entry relating to goodwill
would be included at 30 June 2016 and would be the same as that used at acquisition date.)
The elimination of investment and recognition of goodwill entries have to take into consideration the
following events occurring since acquisition date:
• The dividend of $1000 on hand at acquisition date has been paid.
• The inventory on hand at acquisition date has been sold.

The entry at 30 June 2016 is:
Retained Earnings (1/7/15)* Dr 5 400

Business Combination Valuation Reserve** Dr 8 400
Goodwill Dr 6 000
* $1200 + (60% × $7000) (BCVR transfer — inventory)
** 60% × $14 000
(3) NCI share of equity at acquisition date (step 1)

The NCI share of equity at acquisition date is as calculated previously. This entry is never changed from
that calculated at that date — this applies whether the full goodwill or partial goodwill method is used.

NCI Cr 26 000
(4) NCI share of changes in equity between acquisition date and beginning of the current period (i.e. from 1 July 2013
to 30 June 2015) (step 2)
To calculate this entry, it is necessary to note any changes in subsidiary equity between the two dates.
The changes will generally relate to movements in retained earnings and reserves, but changes in share
capital, such as when a bonus dividend is paid, could occur.
In this example, there are four changes in subsidiary equity, as shown in figure 23.9:
• Retained earnings increased from $2000 to $16 000 — this will increase the NCI share of retained
earnings.
• In the 2014–15 period, $1000 was transferred to the general reserve. Because the transfer has
reduced retained earnings, the NCI share of retained earnings as calculated above has been reduced
by this transfer; an increase in the NCI share of general reserve needs to be recognised as well as an
increase in NCI in total.
• The sale of inventory in the 2013–14 period resulted in a transfer of $7000 from the business
combination valuation reserve to retained earnings. Because the profits from the sale of inventory
are recorded in the profits of the subsidiary, the NCI receives a share of the increased wealth
relating to inventory. The NCI share of the business combination valuation reserve as recognised in
step 1 must be reduced, with a reduction in NCI in total.
• Other components of equity increased by $2500, increasing the NCI share of equity by $1000.
Before noting the effects of these events in journal entry format, adjustments relating to the equip-
ment on hand at acquisition date need to be considered. In the business combination valuation entry,
the equipment on hand at acquisition date was revalued to fair value and the increase taken to the val-
uation reserve. By recognising the asset at fair value at acquisition date, the group recognises the extra
benefits over and above the asset’s carrying amount to be earned by the subsidiary. As expressed in
the depreciation of the equipment (see the valuation entries above), the group expects the subsidiary
to realise extra after-tax benefits of $2800 (i.e. $4000 depreciation expense less the credit of $1200 to
income tax expense) in each of the 5 years after acquisition. Whereas the group recognises these extra
benefits at acquisition date via the valuation reserve, the subsidiary recognises these benefits as profit
in its records only as the equipment is used. Hence, the profit after tax recorded by the subsidiary in
each of the 5 years after acquisition date will contain $2800 benefits from the equipment that the
group recognised in the valuation reserve at acquisition date.
In calculating the NCI share of equity from acquisition date to the beginning of the current period,
the NCI calculation will double-count the benefits from the equipment if there is no adjustment for
the depreciation of the equipment. This occurs because the share of the NCI in equity calculated at
acquisition date includes a share of the business combination valuation reserve created at that date in
the consolidation worksheet. Therefore, giving the NCI a full share of the recorded profits of the sub-
sidiary in the 5 years after acquisition date double-counts the benefits relating to the equipment. The
NCI has already received a share of the valuation reserve in the step 1 calculation. Hence, in calculating
the NCI share of changes in equity between acquisition date and the beginning of the current period
(the step 2 calculation), there needs to be an adjustment for the extra depreciation of the equipment
in relation to each of the years since acquisition date.

The adjustment for depreciation can be read directly from the valuation entry that records the depre-
ciation on the equipment since acquisition date. In the valuation entry required for the 2015–16 con-
solidated financial statements (see (1) Business combination valuation entries above), there is a net debit
adjustment to retained earnings (1/7/15) of $5600 (i.e. the $8000 adjustment for previous periods’
depreciation less the $2400 adjustment for previous periods’ tax effect) in relation to the after-tax
effects of depreciating the equipment. This reflects the extra benefits received by the subsidiary as a
result of using the equipment and recorded by the subsidiary in its retained earnings account.
In this example, the only adjustment to retained earnings in the business combination valuation
entry is that relating to the equipment. In other examples, there may be a number of adjustments to
retained earnings depending on the number of assets being revalued. All such adjustments must be
taken into account in order not to double-count the NCI share of equity. In other words, to determine
the adjustments needed to avoid double-counting, all adjustments to retained earnings in the valua-
tion entries must be taken into consideration.
In illustrative example 23.2, the NCI share of changes in retained earnings is determined by calculating
the change in retained earnings over the period, less the adjustment against retained earnings in the
valuation entry relating to depreciation of the equipment. The amount is calculated as follows:
40% × ($16 000 − $2000 − [$8000 − $2400]) = $3360
The NCI is also entitled to a share of the change in general reserve between acquisition date and the
beginning of the current period, the change being the transfer to general reserve in the 2014–15 period.
As the general reserve is increased, the NCI share of that account is also increased. The calculation is:
40% × $1000 = $400
The NCI is also entitled to a share of the movement in other components of equity. There was no
balance in this account at acquisition date, and balance at 30 June 2015 is $2500, so the NCI’s share is:
40% × $2500 = $1000
The NCI is also affected by the transfer on consolidation from the business combination valuation
reserve to retained earnings as a result of the sale of inventory. The NCI share of the valuation reserve is
decreased, with a reduction in NCI in total. The calculation is:
40% × $7000 = $2800
The consolidation worksheet entries in the NCI columns for the step 2 NCI calculation are:

NCI Cr 3 360
(40% × [$16 000 − $2000 − ($8000 − $2400)])
NCI Cr 400
(40% × $1000)
Other Components of Equity Dr 1 000
NCI Cr 1 000
(40% × $2500)
NCI Dr 2 800
(40% × $7000)
These entries may be combined as:

Other Components of Equity Dr 1 000
NCI Cr 1 960

(5) NCI share of current period changes in equity (step 3)
From figure 23.9 it can be seen that there are four changes in equity in the 2015–16 period:
• Petrel Ltd has reported a profit of $15 000.
• There has been a transfer from general reserve of $500.
• The subsidiary has paid a dividend of $1500 and declared a dividend of $2000.
• Other components of equity has decreased by $100.
In relation to both dividends and transfer to/from reserves, from an NCI perspective note that it is
irrelevant whether the amounts are from pre- or post-acquisition equity. The NCI receives a share of all
equity accounts regardless of whether it existed before acquisition date or was created after that date.
The NCI share of current period profit is based on a 40% share of the recorded profit of $15 000. How-
ever, just as in step 2, there must be an adjustment made to avoid the double counting caused by the
subsidiary recognising profits from the use of the equipment, these benefits having been recognised on
consolidation in the business combination valuation reserve. Again, reference needs to be made to the
valuation entries, and in particular to the amounts in these entries affecting current period profit. In the
valuation entries, there is a debit adjustment to depreciation expense of $4000 and a credit adjustment
to income tax expense of $1200. In other words, in the current period, Petrel Ltd recognised in its profit
an amount of $2800 from the use of the equipment that was recognised by the group in the business
combination valuation reserve. Since the NCI has been given a share of the valuation reserve in step 1,
to give the NCI a share of the recorded profit without adjusting for the current period’s depreciation
would double-count the NCI share of equity. The NCI share of current period profit is, therefore, 40%
of the net of recorded profit of $15 000 less the after-tax depreciation adjustment of $2800.
The consolidation worksheet entry in the NCI columns is:
NCI Share of Profit/(Loss) Dr 4 880

NCI Cr 4 880
(40% × [$15 000 − ($4000 − $1200)])
In the current period, a change in equity is caused by the $500 transfer from general reserve to retained
earnings. This transaction does not change the amount of equity in total because it is a transfer between
equity accounts, so there is no change to the NCI in total. However, the NCI share of general reserve has
decreased and the NCI share of retained earnings has increased. For the latter account, the appropriate
line item is ‘Transfer from General Reserve’. The consolidation worksheet entry in the NCI columns is:
Transfer from General Reserve Dr 200

General Reserve Cr 200
(40% × $500)
The third change in equity in the current period relates to dividends paid and declared. Dividends
are a reduction in retained earnings. The NCI share of equity is reduced as a result of the payment or
declaration of dividends. Where dividends are paid, the NCI receives a cash distribution as compensa-
tion for the reduction in equity. Where dividends are declared, the group recognises a liability to make
a future cash payment to the NCI as compensation for the reduction in equity. The consolidation
worksheet entries in the NCI column are:
NCI Dr 600
(40% × $1500)
NCI Dr 800
Dividend Declared Cr 800
(40% × $2000)
The fourth change in equity is the $100 reduction in other components of equity. This results in a
reduction in the NCI share of this account that relates to financial assets as well as a reduction in NCI
in total. The entry in the NCI columns is:
NCI Dr 40
Other Components of Equity Cr 40
(40% × $100)

(6) Adjustments for intragroup transactions: dividends
The entries below and shown in the adjustment columns of the worksheet are necessary to adjust for
the dividend transactions in the current period — note that the amounts are based on the proportion
of dividends paid within the group.

(60% × $1500)

(60% × $2000)

(60% × $2000)
Using the figures for the subsidiary for the year ended 30 June 2016, as given in figure 23.9, and
assuming information for the parent, a consolidation worksheet showing the effects of the entries
developed in illustrative example 23.2 is given in figure 23.10.

Heron Petrel
Profit/(loss) for the period 20 000 15 000 1 4 000 1 200 1 30 100 5 4 880 25 220
6 900
6 1 200
Retained earnings (1/7/17) 25 000 16 000 1 8 000 2 400 1 30 000 3 800 25 840
2 5 400
Transfer from general
reserve — 500 500 5 200 300
45 000 31 500 60 600 51 360
Dividend paid 10 000 1 500 900 2 10 600 600 5 10 000
300 6
Dividend declared 5 000 2 000 6 5 800 800 5 5 000
15 000 3 500 16 400 15 000
Retained earnings
(30/6/18) 30 000 28 000 44 200 36 660
Share capital 100 000 40 000 2 24 000 116 000 3 16 000
General reserve 20 000 2 500 2 1 200 21 300 3 800 200 5 20 300
4 400
valuation reserve — — 2 8 400 14 000 1 5 600 3 8 400 2 800 4 —
150 000 70 500 187 100 156 660
Other components of
equity (1/7/17) 10 000 2 500 12 500 4 1 000 11 500
Increases/(decreases) 2 000 (100) 1 900 40 5 1 940
Other components of
equity (30/6/18) 12 000 2 400 14 400 13 440
Total equity: NCI 5 600 26 000 3 31 400
5 800 1 960 4
5 40 4 880 5
Total equity 162 000 72 900 201 500 37 280 37 280 201 500
FIGURE 23.10 Consolidation worksheet with NCI columns

LO4 23.4 ADJUSTING FOR THE EFFECTS OF
INTRAGROUP TRANSACTIONS
The justification for considering adjustments for intragroup transactions in the calculation of the NCI
share of equity is that the NCI is classified as a contributor of capital to the group. Thus, the calculation
of the NCI is based on a share of consolidated equity and not equity as recorded by the subsidiary. Consoli-
dated equity is determined as the sum of the equity of the parent and the subsidiaries after making adjust-
ments for the effects of intragroup transactions. The NCI share of that equity must, therefore, be based on
subsidiary equity after adjusting for intragroup transactions that affect the subsidiary’s equity.
To illustrate, assume that during the current period a subsidiary in which there is an NCI of 20% has
recorded a profit of $20 000 which includes a before-tax profit of $2000 on sale of $18 000 inventory to the
parent. The inventory is still on hand at the end of the current period. In the adjustment columns of the
consolidation worksheet, the adjustment entries for the sale of inventory, assuming a tax rate of 30%, are:
Sales Dr 18 000
Inventory Cr 2 000
The group does not regard the after-tax profit of $1400 as being a part of consolidated profit. Hence,
in calculating the NCI share of consolidated profit, the NCI is entitled to $3720; that is, 20% × ($20 000
recorded profit − $1400 intragroup profit).
The NCI share of equity is therefore adjusted for the effects of intragroup transactions. However, note
that the NCI share of consolidated equity is essentially based on a share of subsidiary equity. Therefore,
only intragroup transactions that affect the subsidiary’s equity need to be taken into consideration. Profits
made on inventory sold by the parent to the subsidiary do not affect the calculation of the NCI because the
profit is recorded by the parent, not the subsidiary — the subsidiary equity is unaffected by the transaction.
In section 23.3, it is explained that the NCI share of the equity recorded by the subsidiary is calculated
in three steps:
Step 1. share of equity at acquisition date
Step 2. share of changes in equity between acquisition date and the beginning of the current period
Step 3. share of changes in equity in the current period.
These calculations are based on the recorded subsidiary equity; that is, equity that will include the effects
of the intragroup transactions. Having calculated the NCI as a result of the three-step process, the subsid-
iary needs to make further adjustments for the effects of intragroup transactions. Rather than adjust for
these transactions in the NCI entries relating to the three-step process, the adjustments to the NCI are
determined when the adjustments are made for the effects of the specific intragroup transactions.
For example, consider the case above where a subsidiary in which the NCI is 20% records a profit of
$20 000, which includes a $2000 before-tax profit on the sale of inventory to the parent (cost $4000,
selling price $6000). In the step 3 NCI calculation, the worksheet entry passed in the NCI columns is:

NCI Cr 4 000
[20% × $20 000 recorded profit]
In making the adjustment for the effects of intragroup transactions to be passed in the adjustment col-
umns of the worksheet, the following entries are made:
Profit in closing inventory: subsidiary to parent

Sales Dr 6 000
Inventory Cr 2 000
[30% × $2000]
As this adjustment affects the profit of the subsidiary by an amount of $1400 after tax (i.e. $2000 −
$600), this triggers the need to make an adjustment to the NCI, and the following entry is passed in the
NCI columns of the worksheet:

NCI Dr 280
NCI Share of Profit/(Loss) Cr 280
[20% × $1400]
[This entry is explained in more detail in illustrative example 23.3 later in this chapter.]
The combined effect of the step 3 NCI entry and this last entry is that the NCI totals $3720 — that is, $4000
less $280. Thus the NCI is given a share of recorded profit adjusted for the effects of intragroup transactions.
23.4.1 The concept of ‘realisation’ of profits or losses

Not all transactions require an adjustment entry for the NCI. For a transaction to require an adjustment to
the calculation of the NCI share of equity, it must have the following characteristics:
• The transaction must result in the subsidiary recording a profit or a loss.
• After the transaction, the other party to the transaction (for two-company structures this is the parent)
must have on hand an asset (e.g. inventory) on which the unrealised profit is accrued.
• The initial consolidation adjustment for the transaction should affect both the statement of
financial position and the statement of profit or loss and other comprehensive income (including
appropriations of retained earnings), unlike payments of debenture interest, which affect only the
statement of profit or loss and other comprehensive income.
In determining the transactions requiring an adjusting entry for the NCI, it is important to work out which
transactions involve unrealised profit. The concept of ‘realisation’ is discussed in chapter 22. The test for realisation is
the involvement of a party external to the group, based on the concept that the consolidated financial statements
report the affairs of the group in terms of its dealings with entities external to the group. Consolidated profits are
therefore realised profits as they result from dealing with entities external to the group. Profits made by trans-
acting within the group are unrealised because no external entity is involved. Once the profits or losses on an
intragroup transaction become realised, the NCI share of equity no longer needs to be adjusted for the effects of
an intragroup transaction because the profits or losses recorded by the subsidiary are all realised profits.
In this section, the key point to note is when, for different types of transactions, unrealised profits on
intragroup transactions become realised.
Inventory
With inventory, realisation occurs when the acquiring entity sells the inventory to an entity outside the
group. Consolidation adjustments for inventory are based on the profit or loss remaining in inventory on
hand at the end of a financial period. If inventory is sold in the current period by the subsidiary to the
parent at a profit, giving the NCI a share of the recorded profit will overstate the NCI share of consoli-
dated equity, because the group does not recognise the profit until the inventory is sold outside the group.
Hence, whenever consolidated adjustments are made for profit remaining in inventory on hand at the end
of the period, an NCI adjustment is necessary to reduce the NCI share of current period profit and the NCI
total. Following the consolidation adjustment for the unrealised profit in inventory, an NCI adjustment
entry is made in the NCI columns of the worksheet. The general form of the entry is:
NCI Dr xxx
NCI Share of Profit/(Loss) Cr xxx
If there is inventory on hand at the beginning of the current period, the NCI share of the previous period’s
profit must be reduced as the subsidiary’s previous year’s recorded profit contains unrealised profit. As
the group realises the profit in the current period when the inventory is sold to external parties, the NCI
share of the current period profit must be increased. Following the worksheet adjustment for the profit
remaining in beginning inventory, an NCI adjustment entry is made in the NCI columns of the worksheet.
The general form of the NCI entry is:
NCI Share of Profit/(Loss) Dr xxx

Retained Earnings (opening balance) Cr xxx
Intragroup transfers for services and interest

For transactions involving services and interest, the group’s profit is unaffected because the general con-
solidation adjustment reduces both expense and revenue equally. However, from the NCI’s perspective,
there has been a change in the equity of the subsidiary; for example, the subsidiary may have recorded
interest revenue as a result of a payment to the parent entity relating to an intragroup loan. The revenue

is unrealised in that no external entity has been involved in the transaction. Theoretically, the NCI should
be adjusted for such transactions. However, as noted in paragraph B86(c) of IFRS 10, it is profits or losses
‘recognised in assets’ that are of concern. In other words, where there are transfers between entities that do
not result in the retention within the group of assets on which the profit has been accrued, it is assumed
that the profit is realised by the group immediately on payment within the group. For transactions such as
payments for intragroup services, interest and dividends, there are no assets recorded with accrued profits
attached, since the transactions are cash transactions. Hence, the profit is assumed to be immediately real-
ised. The reason for the assumption of immediate realisation of profits on these types of transactions is a
pragmatic one based on the cost benefit of determining a point of realisation.
LO5 23.5 GAIN ON BARGAIN PURCHASE

This chapter has used examples of business combinations where goodwill has been acquired. In the rare case
that a gain on bargain purchase may arise, such a gain has no effect on the calculation of the NCI share of
equity. Further, whereas the goodwill of the subsidiary may be determined by calculating the goodwill acquired
by the parent entity and then grossing this up to determine the goodwill for the subsidiary, this process is not
applicable for the gain on bargain purchase. The gain is made by the parent paying less than the net fair value
of the acquirer’s share of the identifiable assets, liabilities and contingent liabilities of the subsidiary. The NCI
receives a share of the fair value of the subsidiary, and has no involvement with the gain on bargain purchase.
To illustrate, assume a subsidiary has the following statement of financial position:
Equity $80 000

Identifiable assets and liabilities $80 000
Assume all identifiable assets and liabilities of the subsidiary are recorded at amounts equal to fair
value. If a parent acquires 80% of the shares of the subsidiary for $63 000, then the acquisition analysis,
assuming the use of the partial goodwill method, is:
Net fair value of subsidiary = $80 000

(b) Non-controlling interest in subsidiary = 20% × $80 000
= $16 000
Gain on bargain purchase $80 000 − $79 000
= $1000
Assuming all fair values have been measured accurately, the consolidation worksheet entries at acquisi-
tion date are:
Business combination valuation entry
No entry required in this simple example.
Elimination of investment in subsidiary
Equity Dr 64 000
Shares in Subsidiary Cr 63 000
Non-controlling interest (step 1)
Equity Dr 16 000
NCI Cr 16 000
(20% × $80 000)
Note that the NCI does not receive any share of the gain on bargain purchase.
An example of the process of calculating NCI when intragroup transactions exist is given in illustrative
example 23.3.

ILLUSTRATIVE EXAMPLE 23.3 NCI and intragroup transactions
Bat Ltd owns 80% of the issued shares of Snake Ltd. In the year ending 30 June 2014, the following
transactions occurred:
(a) In July 2013, Bat Ltd sold $2000 worth of inventory that had been sold to it by Snake Ltd in May
2013 at a profit to Snake Ltd of $500.
(b) In February 2014, Bat Ltd sold $10 000 worth of inventory to Snake Ltd, recording a profit before tax
of $2000. At 30 June 2014, 20% of this inventory remained unsold by Snake Ltd.
(c) In March 2014, Snake Ltd sold $12 000 worth of inventory to Bat Ltd at a mark-up of 20%. At 30
June 2014, $1200 of this inventory remained unsold by Bat Ltd.
(d) At 30 June 2014, Bat Ltd recorded depreciation of $10 000 in relation to plant sold to it by Snake Ltd
on 1 July 2011. Bat Ltd uses a 10% p.a. straight-line depreciation method for plant. At date of sale to
Bat Ltd, this plant had a carrying amount of $90 000 in the accounts of Snake Ltd.
Required
Given a tax rate of 30%, prepare the consolidation worksheet entries for these transactions as at 30 June
2014.
Solution
(a) Sale of inventory in previous period: Snake Ltd to Bat Ltd
The entry in the adjustment columns of the worksheet is:

Cost of Sales Cr 500
Since the inventory was originally sold by the subsidiary to the parent, the entry in the NCI col-
umns of the worksheet is:
NCI Share of Profit/(Loss) Dr 70

(20% × $350)
(b) Sale of inventory in current period: Bat Ltd to Snake Ltd
Sales Dr 10 000
Inventory Cr 400
Because the sale was from parent to subsidiary, there is no NCI adjustment required.
(c) Sale of inventory in current period: Snake Ltd to Bat Ltd
The entries in the adjustment columns of the worksheet are:
Sales Dr 12 000
Inventory Cr 200
Because the sale was from subsidiary to parent, the following entry is required in the NCI columns
of the worksheet:
NCI Dr 28
(20% × $140)

(d) Sale of plant in prior period: Snake Ltd to Bat Ltd

Plant Cr 10 000
Since the plant was sold by the subsidiary to the parent, the entry in the NCI columns of the work-
sheet is:
NCI Dr 1 400
(20% × $7000)
Depreciation on plant

Depreciation Expense Cr 1 000

Deferred Tax Asset Cr 600
The entry in the NCI column of the worksheet is:

NCI Cr 280
(20% × $700 p.a.)
SUMMARY
Where a subsidiary is not wholly owned, the equity of the subsidiary is divided into two parts, namely
the parent’s share and the non-controlling interest (NCI) share. IAS 1 Presentation of Financial Statements
requires that, with the disclosure of specific equity amounts, the parent’s share and the NCI share should
be separately disclosed. This affects the consolidation process. The NCI is classified as equity with the
result that in statements of profit or loss and other comprehensive income and statements of financial
position where equity amounts are disclosed the parent’s share and the NCI share are separately disclosed.
The existence of an NCI will have different effects on the consolidation worksheet entries used, depending
on whether the full goodwill or partial goodwill method is used. Under the full goodwill method, goodwill
is recognised in the business combination valuation entries, and shared between the parent and the NCI.
Where the partial goodwill method is used, the existence of an NCI has no effect on the business combi-
nation valuation entries. However, as a result of these entries, business combination valuation reserves are
created of which the NCI has a share. With the elimination of investment in subsidiary, the existence of an
NCI has an effect as this entry is based on the parent’s share of pre-acquisition equity only. Hence, a pro-
portionate adjustment is required. The adjustments for intragroup transactions also affect the calculation of
the NCI share of equity. There is no effect on the adjustment for an intragroup transaction itself — this is
the same regardless of the ownership interest of the parent in the subsidiary. However, the adjustment for an
intragroup transaction affects the calculation of the NCI share of equity. Since the NCI is entitled to a share of
consolidated equity rather than the recorded equity of the subsidiary, where an intragroup transaction affects
the equity of the subsidiary, entries in the NCI columns of the worksheet are required, affecting the calcu-
lation of the NCI. It is then necessary to observe the flow of the transaction — upstream or downstream —
to determine whether an NCI adjustment is necessary. One area where the NCI is unaffected is where a gain
on bargain purchase arises, because the elimination of investment in subsidiary adjusts for the parent’s share
only. The gain calculated relates only to the parent and not the NCI.

DEMONSTRATION PROBLEM 23.1 Consolidated fi nancial statements
Seal Ltd acquired 80% of the shares of Swan Ltd on 1 July 2012 for $540 000, when the equity of Swan
Ltd consisted of:

All identifiable assets and liabilities of Swan Ltd are recorded at fair value at this date except for inven-
tory for which the fair value was $10 000 greater than carrying amount, and plant which had a carrying
amount of $150 000 (net of $40 000 accumulated depreciation) and a fair value of $170 000. The inven-
tory was all sold by 30 June 2013, and the plant had a further 5-year life with depreciation based on the
straight-line method.
Financial information for both companies at 30 June 2016 is as follows:
Seal Ltd Swan Ltd

Sales revenue $ 720 000 $ 530 000
Other revenue 240 000 120 000
960 000 650 000
Cost of sales (610 000) (410 000)
Other expenses (230 000) (160 000)
(840 000) (570 000)
Tax expense (40 000) (25 000)
Retained earnings at 1/7/15 200 000 112 000
280 000 167 000
Dividend paid (20 000) (10 000)
Dividend declared (25 000) (15 000)
(45 000) (25 000)
Asset revaluation surplus* 20 000 60 000
Total equity 935 000 802 000
Dividend payable 25 000 15 000
Other liabilities 25 000 25 000
Total equity and liabilities $ 985 000 $ 842 000
Receivables $ 80 000 $ 30 000
Inventory 100 000 170 000
Land at fair value 100 000 80 000
Shares in Swan Ltd 540 000 —
Other assets 30 000 110 000
Total assets $ 985 000 $ 842 000
*The balances of the surplus at 1 July 2015 were $35 000 (Seal Ltd) and $50 000 (Swan Ltd).

The following transactions took place between Seal Ltd and Swan Ltd:
(a) During the 2015–16 period, Swan Ltd sold inventory to Seal Ltd for $23 000, recording a profit
before tax of $3000. Seal Ltd has since resold half of these items.
(b) During the 2015–16 period, Seal Ltd sold inventory to Swan Ltd for $18 000, recording a profit
before tax of $2000. Swan Ltd has not resold any of these items.
(c) On 1 June 2016, Swan Ltd paid $1000 to Seal Ltd for services rendered.
(d) During the 2014–15 period, Swan Ltd sold inventory to Seal Ltd. At 30 June 2015, Seal Ltd still had
inventory on hand on which Swan Ltd had recorded a before-tax profit of $4000.
(e) On 1 July 2014, Swan Ltd sold plant to Seal Ltd for $150 000, recording a profit of $20 000 before
tax. Seal Ltd applies a 10% p.a. straight-line method of depreciation in relation to these assets.
Required
1. Given an income tax rate of 30%, prepare the consolidated financial statements for Seal Ltd for the
year ended 30 June 2016 using the partial goodwill method to measure the non-controlling interest at
acquisition date.
2. What differences would occur in the consolidation worksheet entries at 30 June 2016 if the full good-
will method was used to calculate the non-controlling interest at acquisition date? Assume the value of
the non-controlling interest in the subsidiary at acquisition date is $134 500.
Solution
1. Consolidated financial statements using partial goodwill method
The first step is to prepare the acquisition analysis. Determining the net fair value is the same as for
wholly owned subsidiaries. Where an NCI exists, it is necessary to determine the net fair value acquired
by the parent.
In this problem, the parent acquired 80% of the shares of the subsidiary. The net fair value of what
was acquired is then compared with the consideration transferred, and a goodwill or gain is determined.
Note that the goodwill or gain is only that attributable to the parent, since the residual relates to what
was paid by the parent and the proportion of net fair value of the subsidiary acquired by the parent.
Net fair value of the identifiable assets

and liabilities of Swan Ltd = $500 000 + $80 000 + $50 000 + $20 000
+ $10 000(1 − 30%) (BCVR — inventory)
+ $20 000(1 − 30%) (BCVR — plant)
= $671 000
(b) Non-controlling interest in Swan Ltd = 20% × $671 000
= $134 200
Goodwill = $674 200 − $671 000
= $3200
Consolidation worksheet entries at 30 June 2016

(1) Business combination valuation reserve entries
The business combination entries are unaffected by the existence of an NCI. Under IFRS 3, all iden-
tifiable assets and liabilities acquired in the acquiree/subsidiary must be measured at fair value. This
principle is unaffected by the existence of an NCI.

Plant Cr 20 000



(2) Elimination of investment in subsidiary

Asset Revaluation Surplus (1/7/15) Dr 16 000
Goodwill Dr 3 200
Shares in Swan Ltd Cr 540 000
These elimination of investment and recognition of goodwill entries differ from the entries pre-
pared for a wholly owned subsidiary in that the adjustment to equity accounts is measured as the
parent’s share of the equity accounts. This can be seen in the acquisition analysis where the parent’s
share of equity (80%) is applied to the net fair value before making a comparison with the cost of
the combination. Hence the adjustment to share capital is $400 000; that is, 80% of the recorded
$500 000. With retained earnings (1/7/15), the adjustment is calculated as:
(80% × $50 000) (opening balance) + (80% × $7000) (BCVR inventory)
The adjustment to the BCVR is:
80% × $14 000 (BCVR plant)
Non-controlling interest
The next three adjustment entries relate to the calculation of the NCI. These entries are passed in the
NCI columns of the worksheet, not the adjustment columns. The three entries cover the three steps used
in the calculation of the NCI share of total equity.
(3) NCI share of equity at acquisition date, 1 July 2012 (step 1)
Step 1 is to calculate the NCI share of the equity of the subsidiary at acquisition date. This consists
of the recorded equity of the subsidiary plus any reserves raised on consolidation at acquisition date,
namely the business combination valuation reserve.
Pre-acquisition equity of Swan Ltd 20%

Asset revaluation surplus (1/7/12) 20 000 4 000
Business combination valuation reserve 21 000 4 200
$134 200
The worksheet entry in the NCI columns is:

NCI Cr 134 200
Note that the adjustments to the equity accounts are debits, because these amounts will be sub-
tracted from the balances in the group column in order to determine the parent’s share of equity. On
the other hand, the NCI account has a credit adjustment because the NCI is classified as equity, and
the balance of pre-acquisition equity is a positive amount.
(4) NCI share of equity from 1 July 2012 to 30 June 2015 (step 2)
In step 2, the calculation is of the NCI share of equity between the acquisition date and the begin-
ning of the current period; that is, between 1 July 2012 and 30 June 2015. This requires the calcula-
tion of movements in the subsidiary’s equity accounts between these two dates.

General reserve: The balance at 30 June 2015, read from the financial information at 30 June 2016 and
noting no transfers occurred in the current period, is $100 000. The difference between this and the
balance at 1 July 2012 of $80 000 is $20 000. The NCI is entitled to 20% of this increase in equity. The
combination of step 1 and step 2 effectively gives the NCI a 20% share of the total $100 000 balance.
Retained earnings: The balance at 30 June 2015 is the same as the opening balance in the current
period, which is read from the financial information provided, namely $112 000. The difference
between this amount and the balance recorded by the subsidiary at acquisition reflects movements
in the amounts recorded by the subsidiary, such as reserve transfers and dividends. What is not
reflected in the difference calculated are amounts affecting retained earnings not recorded by the
subsidiary but recognised on consolidation. In this problem, the transaction that needs to be taken
into account is the depreciation of the plant on hand at acquisition date, as shown in the business
combination valuation reserve entries. As the plant is used, the recorded profit of the subsidiary rec-
ognises the extra benefits received. The NCI in relation to retained earnings (1/7/15) is therefore:
20% × [$112 000 (balance at 1/7/15) − $50 000 (balance at acquisition)

− ($12 000 − $3600)]
Asset revaluation surplus: The balance at acquisition date is $20 000 and the balance at 30 June 2015
is $50 000. The NCI is entitled to a 20% share of the difference between these two amounts.
Business combination valuation reserve: The balance at acquisition date was $21 000. As a result of the sale
of the inventory, this has been reduced at 30 June 2015 to $14 000, a reduction of $7000, because there
has been a transfer from this reserve to retained earnings. Since the reserve has decreased in amount, this
results in a decrease in the NCI share of this account. The total NCI in equity has not changed because the
recorded retained earnings has increased by $7000 as a result of the sale of inventory by the subsidiary.
A summary of these movements is then:
Change in equity 20%

General reserve ($100 000 − $80 000) $ 20 000 $ 4 000
Retained earnings ($112 000 − $50 000 − ($12 000 − $3600)) 53 600 10 720
Asset revaluation surplus ($50 000 − $20 000) 30 000 6 000
Business combination valuation reserve ($14 000 − $21 000) (7 000) (1 400)

NCI Cr 19 320
(5) NCI in equity from 1 July 2015 to 30 June 2016 (step 3)

Steps 1 and 2 determine the NCI share of equity recorded up to the beginning of the current year. Step 3
calculates the NCI share of changes in equity in the current year — 1 July 2015 to 30 June 2016.
The combination of all three steps determines the NCI share of equity at the end of the reporting period.
There are a number of changes in equity in the current period, with each change attracting its own
adjustment entry in the NCI columns of the worksheet.
Profit for the period:
The NCI receives a share of recorded profit of the subsidiary. As with step 2, this is adjusted by the
depreciation on the plant on hand at acquisition date. The recorded profit of the subsidiary includes
benefits gained by use of the plant. The NCI share is then:
20% [$55 000 – ($4000 – $1200)]

NCI Cr 10 440

The first line in the entry is a debit because in the consolidation worksheet this is deducted from
group profit in order to calculate the parent share of profit. Note that, in later calculations, increases
in the NCI share of profit require a debit adjustment to this account and decreases in the NCI share
of profit require a credit adjustment.
Dividend paid:
The dividend paid by the subsidiary reduces the equity of the subsidiary. The adjustment to the NCI
share of equity as a result of the dividend paid must take into consideration the full dividend paid
with the effect of reducing the NCI share of total equity. The entry in the NCI columns of the work-
sheet is:
NCI Dr 2 000
(20% × $10 000)
Dividend declared:
As with the dividend paid, the NCI has been given a full share of equity before the declaration of
dividends. Because the dividend declared reduces the equity of the subsidiary, the NCI share of
equity is also reduced. The entry in the NCI columns of the worksheet is:
NCI Dr 3 000
(20% × $15 000)
Asset revaluation surplus:

The balance of the subsidiary’s asset revaluation surplus at 1 July 2015 was $50 000. The balance
at 30 June 2016 is $60 000. The NCI share of equity is increased by 20% of the change during the
period. The debit adjustment is recognised in the worksheet against the Gains/Losses on Asset Reval-
uation account as this account reflects the increase in the reserve balance. The adjustment is a debit
because it reduces the group gain so that the left-hand column of the worksheet shows the parent
share of the gain. The entry in the NCI columns of the worksheet is:
Gains/Losses on Asset Revaluation Dr 2 000

NCI Cr 2 000
(20% × [$60 000 − $50 000])
Intragroup transactions
(6) Dividend paid
The entry in the adjustment columns of the consolidation worksheet to adjust for the $10 000 divi-
dend paid is:

(80% × $10 000)
(7) Dividend declared

The subsidiary declared a dividend of $15 000 of which $12 000 is payable within the group.



(8) Sale of inventory: Swan Ltd to Seal Ltd
The worksheet entries in the adjustment columns are:
Sales Dr 23 000
Inventory Cr 1 500
(Unrealised profit on sale of inventory 50% × $3000)

(Tax effect, 30% × $1500)
(9) Adjustment to NCI: unrealised profit in ending inventory

The profit on sale was made by the subsidiary. The NCI is therefore affected. The total after-tax
profit on the intragroup sale of inventory was $2100 (i.e. $3000 − $900 tax). However, since half
the inventory is sold to an external entity, this portion is realised. The adjustment to the NCI
relates only to the unrealised profits remaining in the inventory still on hand (half of $2100, or
$1050). This is the same after-tax figure used to adjust profits in entry (8) above.
The transaction occurs in the current period. Therefore, it is the NCI share of current period
profit that is affected. In adjustment entry (5), the NCI is given a share of the total recorded sub-
sidiary profit for the current period. Because the realised profit is less than the recorded profit, the
NCI share of equity must be reduced, specifically the NCI share of current period profit.
The worksheet entry in the NCI columns of the worksheet is:
NCI Dr 210
(20% × $1050)
The debit adjustment shows a reduction in total equity attributable to the NCI, and the credit
adjustment shows a reduction in the NCI share of current period profits.
(10) Sale of inventory: Seal Ltd to Swan Ltd
Sales Dr 18 000
Inventory Cr 2 000

Because the profit on the transaction is made by the parent entity and does not affect the equity
of the subsidiary, there is no need to make any adjustment to the NCI.
(11) Payment for services: Swan Ltd to Seal Ltd
Other Revenues Dr 1 000

Other Expenses Cr 1 000
The profit of the subsidiary is affected by the transaction even though the payment may, in
effect, be from the parent to the subsidiary. However, if it is assumed that realisation occurs on
payment for the services for this type of transaction, then no unrealised profit or loss exists in the
subsidiary. Hence, there is no need to make any adjustment to the NCI share of equity.
(12) Sale of inventory in previous period: Swan Ltd to Seal Ltd


(13) Adjustment to NCI: unrealised profit in beginning inventory
The profit on this transaction was made by the subsidiary, so an adjustment to the NCI share of
equity is required. There are two effects on the NCI because the transaction affects both last year’s
and the current period’s figures.
First, the profit made by the subsidiary in the previous period was unrealised last year. Hence,
the subsidiary’s retained earnings (1/7/15) account contains $2800 unrealised profit. An adjust-
ment is necessary to reduce the NCI share of the previous period’s profit:
NCI Dr 560
(20% × $2800)
Second, in relation to the current period, because the inventory transferred last period is sold in
the current period to an external entity, the profit previously recorded by the subsidiary becomes
realised in the current period. Since the profit is realised to the NCI in the current period but was
recorded by the subsidiary last period, the NCI share of current period profit needs to be increased.
The adjustment is:

NCI Cr 560
(20% × $2800)
These two entries can be combined and passed in the NCI columns of the worksheet:

This entry has no effect on the total NCI share of equity. It simply reduces the NCI share of
equity recorded last period and increases the NCI share of current period profit. This reflects the
fact that the subsidiary recorded the profit in the previous period whereas the group recognised the
profit in the current period.
The consolidation worksheet for Seal Ltd at 30 June 2016 is shown in figure 23.11.
FIGURE 23.11 Consolidation worksheet showing NCI and the effects of intragroup transactions

Seal Swan
Sales revenue 720 000 530 000 8 23 000 1 209 000
10 18 000
Other revenues 240 000 120 000 6 8 000
7 12 000
11 1 000
960 000 650 000 1 548 000
Cost of sales (610 000) (410 000) 21 500 8 (978 500)
16 000 10
4 000 12
Other expenses (230 000) (160 000) 1 4 000 1 000 11 (391 000)
(840 000) (570 000) (1 369 500)
Profit before tax 120 000 80 000 178 500
Tax expense (40 000) (25 000) 12 1 200 1 200 1 (63 950)
600 10
450 8
Profit 80 000 55 000 112 550 5 10 440 210 9
13 560 101 760
(continued)


Seal Swan
Retained earnings
(1/7/15) 200 000 112 000 1 12 000 3 600 1 3 10 000 560 13 235 040
2 45 600 4 10 720
12 2 800 242 600
280 000 167 000 355 150 336 800
Dividend paid (20 000) (10 000) 8 000 6 (22 000) 2 000 5 (20 000)
Dividend declared (25 000) (15 000) 12 000 7 (28 000) 3 000 5 (25 000)
(45 000) (25 000) (50 000) (45 000)
Retained earnings
(30/6/16) 235 000 142 000 306 550 291 800
Share capital 600 000 500 000 2 400 000 700 000 3 100 000 600 000
General reserve 80 000 100 000 2 64 000 116 000 3 16 000 96 000
4 4 000
valuation reserve 0 0 2 11 200 14 000 1 2 800 3 4 200 1 400 4 0
915 000 742 000 1 16 000 1 125 350 987 800
Asset revaluation
surplus (1/7/15) 35 000 50 000 69 000 3 4 000 59 000
4 6 000
Gains/losses on asset
revaluation (15 000) 10 000 (5 000) 5 2 000 (7 000)
Asset revaluation
surplus (30/6/16) 20 000 60 000 64 000 52 000
Total equity: parent 1 039 800
Total equity: NCI 5 2 000 134 200 3 160 750
5 3 000 19 320 4
9 210 10 440 5
2 000 5
Total equity 935 000 802 000 1 189 350 182 370 182 370 1 200 550
Dividend payable 25 000 15 000 7 12 000 28 000
Other liabilities 25 000 25 000 1 4 800 6 000 1 51 200
Total equity and
liabilities 985 000 842 000 1 279 750
Receivables 80 000 30 000 12 000 6 98 000
Inventory 100 000 170 000 1 500 8 266 500
2 000 10
Plant and equipment 200 000 500 000 20 000 1 680 000
Accumulated
depreciation (115 000) (88 000) 1 40 000 16 000 1 (179 000)
Land 100 000 80 000 180 000
Shares in Swan Ltd 540 000 0 540 000 2 0
Deferred tax asset 50 000 40 000 8 450 91 050
10 600
Goodwill 0 0 2 3 200 3 200
Other assets 30 000 110 000 140 000
Total assets 985 000 842 000 705 050 705 050 1 279 750

The consolidated financial statements for Seal Ltd and its subsidiary, Swan Ltd, for the year ended
30 June 2016 are as shown in figure 23.12(a), (b) and (c).
SEAL LTD
Revenue:
Sales $ 1 209 000
Other 339 000
Total revenue 1 548 000
Expenses:
Other (391 000)
Total expenses (1 371 500)
PROFIT FOR THE PERIOD $ 112 550
Revaluation decreases $ (5 000)
TOTAL COMPREHENSIVE INCOME $ 107 550

Owners of the parent $ 101 760
Non-controlling interest 10 790
$ 112 550
Comprehensive income attributable to:
Owners of the parent $ 94 760
Non-controlling interest 12 790
$ 107 550
SEAL LTD
Business
Asset combination Total: Non-
Share Retained General revaluation valuation Owners of controlling Total
capital earnings reserve surplus reserve the parent interest equity
Balance at
1 July 2015 $600 000 $235 040 $96 000 $59 000 0 $ 990 040 $154 960 $ 1 145 000
Total comprehensive
income 101 760 (7 000) 94 760 10 790 105 550
Dividends paid (20 000) (20 000) (2 000) (22 000)
Dividends declared (25 000) (25 000) (3 000) (28 000)
Balance at
30 June 2016 $600 000 $291 800 $96 000 $52 000 $ 1 039 800 $160 750 $ 1 200 550

SEAL LTD
as at 30 June 2016
ASSETS
Current assets
Receivables $ 98 000
Inventory 266 500
Non-current assets
Land 180 000
Goodwill 3 200
Other 140 000
Total assets $ 1 279 750
LIABILITIES
Current liabilities: Dividend payable $ 28 000
Non-current liabilities 51 200
Total liabilities $ 79 200
Net assets $ 1 200 550
EQUITY
Parent interest $ 1 039 800
Non-controlling interest $ 160 750
Total equity $ 1 200 550
2. Consolidation worksheet changes under full goodwill method

Under the full goodwill method, the acquisition analysis would change as goodwill is calculated by
taking into consideration the fair value of the NCI in the subsidiary.
Net fair value of the identifiable assets and

liabilities of Swan Ltd = $500 000 + $80 000 + $50 000 + $20 000
+ $10 000(1 − 30%) (BCVR — inventory)
+ $20 000(1 − 30%) (BCVR — plant)
= $671 000
(b) Non-controlling interest in
subsidiary = $134 500
Goodwill = $674 500 − $671 000
= $3500
Goodwill of Swan Ltd
Fair value of Swan Ltd = $134 500/20%
= $672 500
liabilities of Swan Ltd = $671 000
Goodwill of Swan Ltd = $672 500 − $671 000
= $1500

Goodwill of Seal Ltd
Goodwill of Swan Ltd = $1500
Goodwill of Seal Ltd — control premium = $2000
Consolidation worksheet entries at 30 June 2016

(1) Business combination valuation reserve entries
Because the full goodwill method is used, there will need to an extra business combination valua-
tion entry in relation to the goodwill of the subsidiary:
Goodwill Dr 1 500
(2) Elimination of investment and recognition of goodwill entries

Business Combination Valuation Reserve [80% × ($14 000 Dr 12 400
+ $1 500)]
Goodwill Dr 2 000
Shares in Swan Ltd Cr 540 000
(3) NCI share of equity at acquisition date, 1 July 2012 (step 1)

Under the full goodwill method this will change as the business combination valuation reserve in
relation to goodwill has been recognised. The NCI share is calculated to be:
Pre-acquisition equity of Swan Ltd

Retained earnings (1/7/12): 20% × $50 000 = $ 10 000
Share capital: 20% × $500 000 = 100 000
General reserve: 20% × $80 000 = 16 000
Asset revaluation surplus (1/7/12):
20% × $20 000 = 4 000
Business combination valuation reserve:
20% × ($14 000 + $7 000 + $1 500) = $ 4 500
$ 134 500

NCI Cr 134 500
No other changes are required.

1. What is meant by the term ‘non-controlling interest’ (NCI)?
2. How does the existence of an NCI affect the business combination valuation entries?
3. How does the existence of an NCI affect the elimination of investment and recognition of goodwill
entries?
4. Why is it necessary to change the format of the worksheet where an NCI exists in the group?
5. Explain how the adjustment for intragroup transactions affects the calculation of the NCI share of equity.
6. Explain whether an NCI adjustment needs to be made for all intragroup transactions.
7. What is meant by ‘realisation of profit’?
Exercise 23.1 EQUITY CLASSIFICATION

★ Len Inn is the accountant for Falcon Trucks Ltd. This entity has an 80% holding in the entity Tyres-R-Us Ltd.
Len is concerned that the consolidated financial statements prepared under IFRS 10 may be misleading. He
believes that the main users of the consolidated financial statements are the shareholders of Falcon Trucks
Ltd. The key performance indicators are then the profit numbers relating to the interests of those share-
holders. He therefore wants to prepare the consolidated financial statements showing the non-controlling
interest in Tyres-R-Us Ltd in a category other than equity in the statement of financial performance, and for
the statement of changes in equity to show the profit numbers relating to the parent shareholders only.
Required
Discuss the differences that would arise in the consolidated financial statements if the non-controlling
interests were classified as debt rather than equity, and the reasons the standard setters have chosen the
equity classification in IFRS 10.
Exercise 23.2 CONSOLIDATION WORKSHEET, CONSOLIDATED FINANCIAL STATEMENTS,

★ PARTIAL GOODWILL METHOD
Jellyfish Ltd purchased 75% of the capital of Mouse Ltd for $250 000 on 1 July 2010. At this date the
equity of Mouse Ltd was:

At this date, Mouse Ltd had not recorded any goodwill, and all identifiable assets and liabilities were
recorded at fair value except for the following assets:

Inventory $ 70 000 $100 000
Plant (cost $170 000) 150 000 190 000
Land 50 000 100 000
The plant has a remaining useful life of 10 years. As a result of an impairment test, all goodwill was
written off in 2013. All the inventory on hand at 1 July 2010 was sold by 30 June 2011. Differences beween
carrying amounts and fair values are recognised on consolidation. The tax rate is 30%. Jellyfish Ltd uses
the partial goodwill method.
The trial balances of Jellyfish Ltd and Mouse Ltd at 30 June 2016 are:
Jellyfish Ltd Mouse Ltd

Shares in Mouse Ltd $ 250 000 —
Plant 425 500 $190 000
Land 110 000 50 000
Current assets 162 000 84 000
Cost of sales 225 000 35 000
$1 287 500 $371 000

Share capital $400 000 $100 000
Payables 72 900 12 000
Accumulated depreciation (plant) 124 000 24 000
$1 287 500 $371 000
Required
1. Prepare the consolidation worksheet entries immediately after acquisition date.
2. Prepare the consolidation worksheet entries for Jellyfish Ltd at 30 June 2017. Assume a profit for Mouse
Ltd for the 2010–11 period of $40 000.
3. Prepare the consolidated financial statements as at 30 June 2016.
Exercise 23.3 CONSOLIDATION WORKSHEET ENTRIES INCLUDING NCI

★ On 1 July 2016, Norilsk Ltd acquired 90% of the capital of Rudny Ltd for $290 160. The equity of Rudny
Ltd at this date consisted of:

The carrying amounts and fair values of the assets and liabilities recorded by Rudny Ltd at 1 July 2016
were as follows:

Fittings $ 20 000 $ 20 000
Land 90 000 100 000
Inventory 10 000 12 000
Machinery (net) 200 000 220 000
Liabilities 40 000 40 000
The machinery and fittings have a further 10-year life, benefits to be received evenly over this period.
Differences between carrying amounts and fair values are recognised on consolidation. Norilsk Ltd uses
the partial goodwill method.
The tax rate is 30%. All inventory on hand at 1 July 2016 is sold by 30 June 2017.
Required
1. What are the entries for the consolidation worksheet if prepared immediately after 1 July 2016?
2. What are the entries for the consolidation worksheet if prepared at 30 June 2017? Assume a profit for
Rudny Ltd for the 2016–17 period of $20 000.
3. If the non-controlling interest had a fair value of $31 800 on 1 July 2016, and the full goodwill method
had been used, what entries in parts 1 and 2 above would change? Prepare the changed entries.
Exercise 23.4 CONSOLIDATION WORKSHEET ENTRIES, BARGAIN PURCHASE, RECORDED GOODWILL

★ On 1 July 2013, Petrel Ltd acquired 75% of the shares of Ibis Ltd for $123 525. At this date, the statement
of financial position of Ibis Ltd consisted of:
Share capital — 100 000 shares $ 100 000 Cash $ 5 000

General reserve 20 000 Inventories 20 000
Retained earnings 40 000 Plant (cost $100 000) 80 000
Liabilities 60 000 Fitting (cost $80 000) 50 000
Receivables 5 000
Land 60 000
$ 220 000 $ 220 000

In relation to the assets of Ibis Ltd, the fair values at 1 July 2013 were:
Cash $ 5 000
Inventories 25 000
Plant 86 000
Fittings 51 000
Receivables 4 000
Land 80 000
The inventories were all sold and the receivables all collected by 30 June 2014. The plant and fittings
each have an expected useful life of 5 years. The plant was sold on 1 January 2016. The tax rate is 30%.
(a) At 1 July 2015, the retained earnings of Ibis Ltd were $80 000, and the general reserve was $30 000.
(b) During the 2015–16 period, Ibis Ltd recorded a total comprehensive income of $18 000. This consisted
of a profit of $15 000 and gains on revaluation of land of $3000.
(c) In June 2015, a dividend of $8000 was declared by Ibis Ltd, and was paid in August 2015. An interim
dividend of $5000 was paid in January 2016, and a final dividend of $4000 declared in June 2016.
Required
Prepare the worksheet entries for the preparation of the consolidated financial statements of Petrel Ltd and
its subsidiary, Ibis Ltd, at 30 June 2016.
Exercise 23.5 CONSOLIDATION WORKSHEET ENTRIES, MULTIPLE YEARS, PARTIAL GOODWILL METHOD
★ On 1 July 2012, Eagle Ltd acquired 75% of the issued shares of Heron Ltd for $125 750. At this date, the
accounts of Heron Ltd included the following balances:

All the identifiable assets and liabilities of Heron Ltd were recorded at fair value except for the following:

Plant (cost $50 000) $35 000 $41 000
Land 50 000 70 000
Inventory 20 000 24 000
Adjustments for the differences between carrying amounts and fair values are to be made on con-
solidation except for land which is to be measured in Heron Ltd’s accounts at fair value. The plant has
a further 3-year life. All the inventory was sold by 30 June 2013. Eagle Ltd uses the partial goodwill
method.
During the 4 years since acquisition, Heron Ltd has recorded the following annual results:
Total comprehensive
Year ended Profit/(loss) income
30 June 2013 $10 000 $ 12 000
30 June 2014 23 000 28 000
30 June 2015 (6 000) 1 000
30 June 2016 22 000 22 000
The other comprehensive income relates to gains/losses on revaluation of land.

There have been no transfers to or from the general reserve or any dividends paid or declared by Heron
Ltd since the acquisition date.
The land owned by Heron Ltd on 1 July 2012 was sold on 1 March 2014 for $75 000. The group transfers
the valuation reserves to retained earnings when an asset is sold or fully consumed. The tax rate is 30%.

Required
1. Prepare the consolidation worksheet entries as at 1 July 2012.
2. Prepare the consolidation worksheet entries for the year ended 30 June 2013.
Exercise 23.6 CONSOLIDATION WORKSHEET, CONSOLIDATED FINANCIAL STATEMENTS, FULL GOODWILL METHOD
★ In June 2014, Osprey Ltd made an offer to the shareholders of Kite Ltd to acquire a controlling interest in
the company. Osprey Ltd was prepared to pay $1.50 cash per share, provided that 70% of the shares could
be acquired (enough shares to gain control).
The directors of Kite Ltd recommended that the offer be accepted. By 1 July 2014, when the offer expired,
75% of the shares had changed hands and were now in the possession of Osprey Ltd. The statement of
financial position of Kite Ltd on that date is shown below.
KITE LTD
Statement of financial position
as at 1 July 2014
Current assets $ 368 000

Non-current assets 244 000
$ 612 000
Share capital — 400 000 shares $ 400 000
Other components of equity 30 000
$ 612 000
At 1 July 2014, all the identifiable assets and liabilities of Kite Ltd were recorded at amounts equal to
fair value. Osprey Ltd uses the full goodwill method. The fair value of the non-controlling interest at 1 July
2014 was $147 000.
The draft financial statements of the two companies on 30 June 2015 revealed the following details:
Osprey Ltd Kite Ltd

Sales revenue $ 878 900 $ 388 900
Cost of sales 374 400 112 400
Gross profit 504 500 276 500
Other income 282 100 102 500
786 600 379 000
Profit from trading 570 400 263 200
Gain on sale of non-current assets 20 000 10 000
Profit 478 000 223 200
590 000 263 200
Dividend paid 40 000 30 000
90 000 40 000
(continued)

Osprey Ltd Kite Ltd
Share capital 1 200 000 400 000
Asset revaluation surplus 70 000 60 000
Current liabilities 177 000 124 400
$ 2 001 000 $ 897 600
Financial assets $ 280 000 $ 204 000

Inventory 287 500 210 600
Investments — Shares in Kite Ltd 450 000 —
— Other investments 47 000 —
Equipment 650 000 360 000
Land 216 500 108 000
$ 2 001 000 $ 897 600
(a) Osprey Ltd had made an advance of $80 000 to Kite Ltd. This advance was repayable in June 2016.
(b) The directors of Osprey Ltd and Kite Ltd had declared final dividends of $50 000 and $10 000 respec-
tively, from current period’s profits.
(c) Kite Ltd holds at the end of the reporting period inventory purchased from Osprey Ltd during the year
for $55 000. Osprey Ltd invoices goods to its subsidiary at cost plus 10%.
(d) On 1 July 2014, Kite Ltd sold to Osprey Ltd some display equipment for $60 000. At that date, the car-
rying amount of the equipment was $52 000 and the equipment was estimated to have a useful life of
10 years if used constantly over that period.
(e) Assume a tax rate of 30%.
(f) For Osprey Ltd, balances of Asset Revaluation Surplus and Other Components of Equity at 1 July 2014
were $40 000 and $25 000 respectively.
Required
Prepare the consolidated financial statements for Osprey Ltd and its subsidiary as at 30 June 2015.
Exercise 23.7 ADJUSTMENT FOR THE NCI SHARE OF EQUITY

★★ The consolidated financial statements of Whale Submarine Works Ltd are being prepared by the group
accountant, Raz Putin. He is currently in dispute with the auditors over the need to adjust for the NCI
share of equity in relation to intragroup transactions. He understands the need to adjust for the effects of
the intragroup transactions, but believes that it is unnecessary to adjust for the NCI share of equity. He
argues that the NCI group of shareholders has its interest in the subsidiary and as a result is entitled to
a share of what the subsidiary records as equity. He also disputes with the auditors about the notion of
‘realisation’ of profit in relation to the NCI. If realisation requires the involvement of an external entity
in a transaction, then in relation to transactions such as intragroup transfers of vehicles and services such
as interest payments, there is never any external party involved. Those transactions are totally within the
group and never involve external entities. As a result, the more appropriate accounting is to give the NCI
a share of subsidiary equity and not be concerned with the fictitious involvement of external entities.
Required
Write a report to Raz convincing him that his argument is fallacious.
Exercise 23.8 THE STEP APPROACH

★★ In December 2013, Frog Ltd acquired 60% of the shares of Kovrov Ltd. The accountant for Frog Ltd, Nikki
Romanov, is concerned about the approach she should take in preparing the consolidated financial state-
ments for the newly established group. In particular, she is concerned about the calculation of the NCI
share of equity, particularly in the years after acquisition date. She has heard accountants in other com-
panies talking about a ‘step’ approach, and in particular how this makes accounting in periods after the
acquisition date very easy as it is then necessary to prepare only one step.

Required
Prepare a report for Nikki, explaining the step approach to the calculation of NCI and the effects of this
approach in the years after acquisition date.
Exercise 23.9 EFFECTS OF INTRAGROUP TRANSACTIONS

★★ Because the Moth Cement Works Ltd has a number of subsidiaries, Star Lin is required to prepare a set of
consolidated financial statements for the group. She is concerned about the calculation of the NCI share of
equity particularly where there are intragroup transactions. The auditors require that when adjustments are
made for intragroup transactions the effects of these transactions on the NCI should also be adjusted for.
Star has two concerns. First, why is it necessary to adjust the NCI share of equity for the effects of intragroup
transactions? Second, is it necessary to make NCI adjustments in relation to all intragroup transactions?
Required
Prepare a report for Star, explaining these two areas of concern.
Exercise 23.10 CONSOLIDATION WORKSHEET ENTRIES, DIVIDENDS, EQUITY TRANSFERS

★★ On 1 July 2012, Crocodile Ltd acquired 80% of the shares (cum div.) of Turtle Ltd for $202 000. At this
date, the equity of Turtle Ltd consisted of:
Share capital — 100 000 shares $100 000

The carrying amounts and fair values of the assets of Turtle Ltd were as follows:

Land $70 000 $90 000
Plant (cost $100 000) 80 000 85 000
Fittings (cost 40 000) 20 000 20 000
Goodwill 5 000 10 000
Any adjustment for the differences in carrying amounts and fair values is recognised on consolidation.
Crocodile Ltd uses the partial goodwill method.
Both plant and fittings were expected to have a further 5-year life, with benefits being received evenly
over those periods. The plant was sold on 1 January 2015. In the year of the sale of plant, on consolidation
the valuation reserve relating to the plant was transferred to retained earnings. At 1 July 2012, Turtle Ltd
had not recorded an internally generated trademark that Crocodile Ltd considered to have a fair value of
$50 000. This intangible asset was considered to have an indefinite useful life.
(a) The following profits were recorded by Turtle Ltd:
For the 2012–13 period $ 20 000

For the 2013–14 period 25 000
For the 2014–15 period 30 000
(b) In June 2014, Turtle Ltd transferred $5000 to general reserve, and in June 2015, a further $6000 was
transferred.
(c) In August 2012, the dividend payable of $5000 on hand at 1 July 2012 was paid by Turtle Ltd.
(d) Other dividends declared or paid since 1 July 2012 are:
• $8000 dividend declared in June 2013, paid in August 2013
• $6000 dividend declared in June 2014, paid in August 2014
• $5000 dividend paid in December 2014
• $8000 dividend declared in June 2015, expected to be paid in August 2015.
Required
1. Prepare the worksheet entries for the preparation of the consolidated financial statements of Crocodile
Ltd and its subsidiary, Turtle Ltd, at 30 June 2015.
2. Assume Crocodile Ltd uses the full goodwill method and the value of the non-controlling interest at
1 July 2012 was $49 250. Prepare the entries that would differ from those in requirement 1.

24 Translation of the financial
statements of foreign
entities
ACCOUNTING IAS 21 The Effects of Changes in Foreign Exchange Rates
STANDARDS
IN FOCUS

OBJECTIVES
1 identify the reason for translation of financial statements and the applicable accounting standard
2 explain the difference between functional and presentation currencies
3 discuss the rationale underlying the choice of a functional currency
4 apply the indicators in choosing a functional currency
5 translate a set of financial statements from local currency into the functional currency
6 account for changes in the functional currency
7 translate financial statements into the presentation currency
8 prepare consolidated financial statements including foreign subsidiaries when the local currency
is the functional currency
9 prepare consolidated financial statements including foreign subsidiaries when the functional
currency is that of the parent entity
10 explain what constitutes the net investment in a foreign operation
11 prepare the disclosures required by IAS 21.
CHAPTER 24 Translation of the financial statements of foreign entities 679

LO1 24.1 TRANSLATION OF A FOREIGN SUBSIDIARY’S
STATEMENTS
A parent entity may have subsidiaries that are domiciled in a foreign country. In most cases, the financial
statements of the foreign subsidiary are prepared in the currency of the foreign country. In order for the
financial statements of the foreign operation to be included in the consolidated financial statements of
the parent, it is necessary to translate the foreign operation’s financial statements to the currency used by
the parent entity for reporting purposes. The purpose of this chapter is to discuss the process for translating
and presenting the consolidated financial statements of a parent entity where at least one of its subsidiaries
is a foreign subsidiary.
The accounting standard that deals with this process is IAS 21 The Effects of Changes in Foreign Exchange
Rates. IAS 21 was first issued by the IASC in July 1983, revised in 1993, and further revised as a part of the
Improvements project in 2003. This latter revision provided convergence with GAAP in the United States,
in particular Statement of Financial Accounting Standards No. 52 (SFAS 52) Foreign Currency Translation.
Other minor revisions have been made up to January 2016.
LO2 24.2 FUNCTIONAL AND PRESENTATION CURRENCIES

Paragraph 3 of IAS 21 notes that its two areas of application are:
• translating the results and financial position of foreign operations that are included in the financial
statements of the entity by consolidation or the equity method
• translating an entity’s results and financial position into a presentation currency.
Note that there are two different translation processes here. In order to understand this, it is necessary to
distinguish between three different types of currency: local currency, functional currency and presentation
currency. Not all foreign subsidiaries experience all three currencies.
• Local currency. This is the currency of the country in which the foreign operation is based.
• Functional currency. This is defined in paragraph 8 of IAS 21 as ‘the currency of the primary economic
environment in which the entity operates’. As is explained in more detail later, this is the currency of
the country in which the foreign operation is based. This term is not defined in IAS 21.
• Presentation currency. Paragraph 8 defines this as ‘the currency in which the financial statements are
presented’.
To illustrate, Foreign Ltd is a subsidiary of Parent Ltd. Parent Ltd is an Australian company and For-
eign Ltd is based in Singapore. The operations in Singapore are to sell goods manufactured in France. In
this case, Foreign Ltd would most likely maintain its accounts in Singaporean dollars, the local currency,
while the functional currency could be the euro, reflecting the major economic operations in France.
However, for presentation in the consolidated financial statements of Parent Ltd, the presentation cur-
rency could be the Australian dollar. As the accounts are maintained in Singaporean dollars, they may
firstly have to be translated into the functional currency, the euro, and then translated again into the
Australian dollar for presentation purposes. It is these two translation processes that are referred to in
paragraph 3 of IAS 21.
LO3 24.3 THE RATIONALE UNDERLYING THE FUNCTIONAL

CURRENCY CHOICE
This section relies heavily on the discussion in the seminal paper by Lawrence Revsine, published in 1983,
in which he emphasised the need to understand the rationale underlying the choice of an exchange rate as
an entity’s functional currency.
As noted by Revsine (1984, p. 514):
A much more real danger is that firms, their auditors, and outside analysts may not understand the subtle phil-
osophy that underlies the functional currency choice. As a consequence, innocent but incorrect choices and
assessments may be made, and compatibility may not be achieved.
According to paragraphs 4(a) and 4(b) of SFAS 52, the objectives of the translation process are:
1. to provide information that is generally compatible with the expected economic effects of an exchange
rate change on an entity’s cash flows and equity
2. to reflect in consolidated statements the financial results and relationships of the individual consolida-
ted entities as measured in their functional currencies in conformity with US generally accepted
accounting principles.
Note in particular the first objective. As the foreign subsidiary operates in another country, it is impor-
tant that the financial effects on the parent entity of a change in the exchange rate are apparent from the
translation process. The parent entity has an investment in a foreign operation and so has assets that are
exposed to a change in the exchange rate. Capturing the extent of this exposure should be reflected in the

choice of translation method. The economic relationship between the parent and the subsidiary affects the
extent to which a change in exchange rate affects the parent entity. This can be seen by noting the differ-
ences in the following three cases adapted from Revsine (1984).
24.3.1 Case 1
Protea Ltd is an Australian company that wants to sell its product in Hong Kong. On 1 January 2013, when
the exchange rate is A$1 = HK$5, Protea Ltd acquires a building in Hong Kong to be used to distribute
the Australian product. The building cost HK$1 million, equal to A$200 000. It also deposited A$55 000
(equal to HK$275 000) in a Hong Kong bank. By 31 January 2013, the company had made credit sales in
Hong Kong of HK$550 000. The exchange rate at this time was still A$1 = HK$5. The goods sold had cost
A$90 000 to manufacture. The receivables were collected in February 2013 when the exchange rate was A$1 =
HK$5.5. This cash receipt is transferred back to Australia immediately.
Note, in this case the company has no subsidiary but acquired an overseas asset, deposited money in
an overseas bank and sold goods overseas. The company would record these transactions as follows, in
Australian dollars:
Building Dr 200 000

Cash Cr 200 000
Cash — HK Bank Dr 50 000

Cash Cr 50 000
Receivables Dr 110 000
Sales Cr 110 000
Inventory Cr 90 000
Foreign Exchange Loss Dr 10 000
(Loss on receivables when exchange rate changed
from 1:5 to 1:5.5)
Cash Dr 100 000
Cash in HK Bank Cr 5 000
(Loss on holding HK$55 000 when exchange rate
changed from 1:5.0 to 1:5.5)
Note two effects of this accounting procedure:

• Foreign currency transactions, whether completed (the sale) or uncompleted (the deposit), have an
immediate or potentially immediate effect on the future cash flows of the parent. As a result, foreign
currency gains/losses are recorded as they occur and immediately affect income.
• Non-monetary assets held in the foreign country are recorded at historical cost and are unaffected by
exchange rate changes.
24.3.2 Case 2
Assume that, instead of transacting directly with customers in Hong Kong, Protea Ltd formed a subsidiary,
Banksia Ltd, to handle the Hong Kong operation. As with case 1, all goods are transferred from the
Australian parent to the Hong Kong subsidiary, which sells them in Hong Kong and remits profits back to
the Australian parent.
Hence, Banksia Ltd is established with a capital structure of HK$1 250 000 (equal to A$250 000), an
amount necessary to acquire the Hong Kong building and establish the bank account. On selling the
inventory to Banksia Ltd, Protea Ltd passes the following entries:
Receivable — Banksia Ltd Dr 110 000


Inventory Cr 90 000

Assuming that the parent bills the subsidiary in Hong Kong dollars, namely HK$110 000, on receipt of
the cash, the parent would pass the entry:

Cash Dr 100 000
Receivable Cr 110 000
The subsidiary will show:
Sales HK$ 110 000

Cost of sales 110 000
Profit —
Equity HK$ 1 250 000
Building HK$ 1 000 000
Cash 250 000
HK$ 1 250 000
Note that the underlying transactions are the same in case 1 and case 2. The organisational form does
not change the underlying economic effects of the transactions. The translation of the HK subsidiary must
therefore show the position as if the parent had undertaken the transactions itself. This is the purpose
behind the choice of the functional currency approach.
Where the subsidiary is simply a conduit for transforming foreign currency transactions into dollar cash
flows, the consolidation approach treats the foreign currency statements of the subsidiary as artefacts that
must be translated into the currency of the parent.
In case 2, the translation of the subsidiary’s statements must show:
• the assets of the subsidiary at cost to the parent; that is, what the parent would have paid in its
currency at acquisition date
• the revenues and expenses of the subsidiary at what it would have cost the parent in its currency at the
date those transactions occurred
• monetary gains and losses being recognised immediately in income as they affect the parent directly.
Note, in case 2, that the functional currency of the subsidiary is the Australian dollar. It is the currency of
the primary economic environment in which the entity operates. The inventories are sourced in Australian
dollars, the dollars financing the subsidiary are Australian dollars, and the cash flows that influence the
actions of the parent in continuing to operate in Hong Kong are Australian dollars.
The key to determining the functional currency in case 2 is the recognition of the subsidiary as an inter-
mediary for the parent’s activities. The alternative is for the subsidiary to act as a free-standing unit. Consider
case 3 in this regard.
24.3.3 Case 3
Assume that Protea Ltd establishes a subsidiary in Hong Kong for HK$1 250 000, the money again being
used to acquire a building and set up a bank account. However, in this case the Hong Kong operation is
established to manufacture products in Hong Kong for sale in Hong Kong.
Chinese labour is used in the manufacturing process and profits are used to reinvest in the business for
expansion purposes. Remittances of cash to the parent are in the form of dividends.
The economics of case 3 are different from those in case 2. The subsidiary is not just acting as a conduit
for the parent. Apart from the initial investment, the cash flows, both inflows and outflows, for the sub-
sidiary are dependent on the economic environment of Hong Kong rather than Australia. The effect of a
change in the exchange rate between Australia and Hong Kong has no immediate effect on the operations
of the Hong Kong subsidiary. It certainly affects the worth of the parent’s investment in the subsidiary, but
it has no immediate cash flow effect on the parent. In this circumstance, the functional currency is the
Hong Kong dollar rather than the Australian dollar.
In analysing the success of the overseas subsidiary, the interrelationships between variables such as sales,
profits, assets and equity should be the same whether they are expressed in Hong Kong or Australian dol-
lars. In other words, the translation process should adjust all items by the same exchange rate to retain
these interrelationships.
The key point of Revsine’s article is that the choice of translation method should be such as to reflect
the underlying economics of the situation. In particular, it is necessary to select the appropriate functional
currency to reflect these underlying economic events.

LO4 24.4 IDENTIFYING THE FUNCTIONAL CURRENCY
Paragraphs 9–14 of IAS 21 provide information on determining the functional currency. As the assessment
of the functional currency requires judgement, in accordance with paragraph 12 of IAS 21, management
gives priority to the primary indicators in paragraph 9 before considering the indicators in paragraphs
10 and 11, which supply supporting evidence to that determined from assessment using the paragraph 9
indicators. The indicators are:
Paragraph 9: normally the one in which it primarily generates and expends cash
Consider the currency:
• in which sales prices are denominated or which influences sales prices
• of the country whose competitive forces and regulations influence sales prices
• in which input costs — labour, materials — are denominated and settled, or which influences such costs.
Paragraph 10: consider two factors:
• the currency in which funds from financing activities are generated
• the currency in which receipts from operating activities are retained.
Paragraph 11: consider:
• whether the activities of the foreign operation are carried out as an extension of the reporting entity
• whether transactions with the reporting entity are a high or 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
reporting entity and are readily available for remittance to it
• whether cash flows from the foreign operation are sufficient to service existing and expected debt
obligations without funds being made available by the reporting entity.
Paragraph 12: management should use judgement to determine which currency most faithfully reflects the
economic effects of the underlying transactions and events.
These factors are not significantly different from those stated in paragraph 42 of the US FASB’s SFAS 52.
Jeter and Chaney (2003) provided the basis for the information provided in figure 24.1, which illustrates
the functional currency indicators as set down by the FASB.
Economic Indicators pointing to local overseas currency as Indicators pointing to parent entity’s currency as
indicators functional currency functional currency
Cash flows Primarily in the local currency and do not affect the Directly affect the parent’s cash flows on a current basis
parent’s cash flows. and are readily available for remittance to the parent.
Sales prices Are not primarily responsive in the short term to Are primarily responsive to exchange rate changes
exchange rate changes. They are determined primarily in the short term and are determined primarily by
by local conditions. worldwide competition.
Sales Active local market, although there may be significant Sales are mostly in the country of the parent entity, or
market amounts of exports. denominated in the parent entity’s currency.
Expenses Production costs and operating expenses are Production costs and operating expenses are obtained
determined primarily by local conditions. primarily from parent entity sources.
Financing Primarily denominated in the local currency, and the Primarily from parent or other parent country-
foreign entity’s cash flow from operations is sufficient to denominated obligations, or the parent entity is
service existing and normally expected obligations. expected to service the debt.
Intragroup Low volume of intragroup transactions and there is not High volume of intragroup transactions; there is an
transactions an extensive interrelationship between the operations extensive interrelationship between the operations of the
of the foreign entity and those of the parent. However, parent and those of the foreign entity, or the foreign entity
the foreign entity may rely on the parent’s or affiliates’ is an investment or financing device for the parent.
competitive advantages, such as patents and trademarks.
FIGURE 24.1 Functional currency indicators — FASB

Source: Jeter and Chaney (2003, p. 618).
In applying the criteria shown in figure 24.1 for a parent and a single subsidiary, such as an Australian
parent and a subsidiary in Hong Kong, there are three scenarios:
1. the functional currency of the subsidiary is the Australian dollar
2. the functional currency is the Hong Kong dollar
3. the functional currency is another currency, say, the Malaysian ringgit.
In relation to the choice between the first two alternatives, the extreme situations are those alluded to
in the analysis of the Revsine cases. For the Australian dollar to be the functional currency, the expectation

is that the subsidiary is a conduit for the parent entity. In the easy case, the product being sold is made
in Australia, and the selling price is determined by worldwide competition. Further, because the entire
product sold by the subsidiary emanates from the parent, there is significant traffic between the two enti-
ties, including cash being transferred from the subsidiary to the parent. For the Hong Kong dollar to be the
functional currency, it is expected that the Hong Kong operation is independent of the parent entity. The
products are sourced in Hong Kong and the sales prices depend on the local currency. The only regular
transactions between the two entities are the annual dividends.
However, between these two scenarios there are many others where the determination of the functional
currency is blurred. For example, the product being sold may require some Australian raw materials but be
assembled in Hong Kong using some local raw materials. There are then material transactions between the
two entities, but the subsidiary may be self-sufficient in terms of finance. In these cases, cash is generated
in Hong Kong but expended in both Australia and Hong Kong. In determining the functional currency,
management will need to apply judgement. The key to making a correct decision is, in accordance with
Revsine, understanding what the translation process is trying to achieve in terms of reporting the under-
lying economic substance of the events and transactions.
In relation to the situation where another currency, such as the Malaysian ringgit, is the functional cur-
rency, this could occur where the Australian parent establishes a subsidiary in Hong Kong that imports raw
materials from Malaysia and elsewhere, assembles them in Hong Kong and sells the finished product in
Malaysia.
It is possible therefore for a parent entity that has a large number of foreign subsidiaries to have a
number of functional currencies, particularly if the foreign subsidiaries are all relatively independent.
LO5 24.5 TRANSLATION INTO THE FUNCTIONAL CURRENCY

In the situation where it is determined that the Hong Kong dollar is the functional currency for the Hong
Kong subsidiary, the financial statements of the subsidiary prepared in Hong Kong dollars are automatically
in the functional currency. Where the Hong Kong subsidiary uses the Australian dollar as its functional cur-
rency, it is necessary to translate the Hong Kong accounts from Hong Kong dollars into Australian dollars.
The process of translating one currency into another is given in paragraphs 21 and 23 of IAS 21. Para-
graph 21 deals with items reflected in the statement of profit or loss and other comprehensive income that
concern transactions occurring in the current period:
A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to
the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at
the date of the transaction.
Hence, in translating the revenues and expenses in the statement of profit or loss and other compre-
hensive income, theoretically each item of revenue and expense should be translated at the spot exchange
rate between the functional currency and the foreign currency on the date that the transaction occurred.
However, given the large number of transactions being reported on in the statement of profit or loss and
other comprehensive income, paragraph 22 of IAS 21 provides for an averaging system to be used. A rate
that approximates the actual rate at the date of the transaction can be used; for example, an average rate
for a week or month might be used for all transactions within those periods. The extent to which averaging
can be used depends on the extent to which there is a fluctuation in the exchange rate over a period and
the evenness with which transactions occur throughout the period. For example, where the transactions
are made evenly throughout a financial year — no seasonal effect, for example — and there is an even
movement of the exchange rate over that year, a yearly average exchange rate could be used.
In relation to statement of financial position accounts, paragraph 23 of IAS 21 states:
At the end of each reporting period:
(a) foreign currency monetary items shall be translated using the closing rate;
(b) non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated
using the exchange rate at the date of the transaction; and
(c) non-monetary items that are measured at fair value in a foreign currency shall be translated using the
exchange rates at the date when the value was measured.
Monetary items are defined in paragraph 8 as ‘units of currency held and assets and liabilities to be
received or paid in a fixed or determinable number of units of currency’. As noted in paragraph 16, exam-
ples of monetary liabilities include pensions and other employee benefits to be paid in cash and provisions
to be settled in cash, including cash dividends that are recognised as a liability. Examples of monetary
assets include cash and accounts receivable. All of these items are translated using the spot exchange rate at
the end of the reporting period — the closing rate. As noted in case 1 previously, this reflects the amounts
available in the functional currency.
For non-monetary items such as plant and equipment, IAS 16 Property, Plant and Equipment (see chapter 11)
allows the use of the cost basis or the revaluation model of measurement. Where the cost basis is used,
the appropriate translation rate is the spot rate at the date the asset was initially recorded by the subsid-
iary. Where the revaluation model is used, the appropriate rate is the spot rate at the date of the valuation

to fair value. Paragraph 25 of IAS 21 notes that certain non-monetary assets such as inventory are to be
reported at the lower of cost and net realisable value in accordance with IAS 2 Inventories. In such a case,
it is necessary to calculate the cost, translated using the spot rate at acquisition date, and the net realisable
value translated at the spot rate at the date of valuation. The lower amount is then used — this may require
a write-down in the functional currency statements that would not occur in the local currency statements.
The basic principles of the translation method follow.
24.5.1 Statement of financial position items

• Assets. Assets should first be classified as monetary or non-monetary. Monetary assets are translated at
the current rate existing at the end of the reporting period. With a non-monetary asset, the exchange
rate used is that current at the date at which the recorded amount for the asset has been entered into
the accounts. Hence, for non-monetary assets recorded at historical cost, the rates used are those
existing when the historical cost was recorded. For non-monetary assets that have been revalued,
whether upwards or downwards, the exchange rates used will relate to the dates of revaluation.
• Liabilities. The principles enunciated for assets apply also for liabilities. The liabilities are classified as
monetary and non-monetary and, for the latter, it is the date of valuation that is important.
• Equity. In selecting the appropriate exchange rate two factors are important. First, equity existing at the
date of acquisition or investment is distinguished from post-acquisition equity. Second, movements
in other reserves and retained earnings constituting transfers within or internal to equity are treated
differently from other reserves.
• Share capital. If on hand at acquisition or created by investment, the capital is translated at the rate
existing at acquisition or investment. If the capital arises as the result of a transfer from another equity
account, such as a bonus dividend, the rate is that current at the date the amounts transferred were
originally recognised in equity.
• Other reserves. If on hand at acquisition, the reserves are translated at the rate existing at acquisition. If
the reserves are post-acquisition and result from internal transfers, the rate used is that at the date the
amounts transferred were originally recognised in equity. If the reserves are post-acquisition and not
created from internal transfers, the rate used is that current at the date the reserves are first recognised
in the accounts.
• Retained earnings. If on hand at acquisition, the retained earnings are translated at the rate of exchange
current at the acquisition date. Any dividends paid from pre-acquisition profits are also translated at
this rate. Post-acquisition profits are carried forward balances from translation of previous periods’
statements of profit or loss and other comprehensive income.
24.5.2 Statement of profit or loss and other comprehensive

income items
• Income and expenses. In general, these are translated at the rates current at the dates the applicable
transactions occur. For items that relate to non-monetary items, such as depreciation and amortisation,
the rates used are those used to translate the related non-monetary items.
• Dividends paid. These are translated at the rate current at the date of payment.
• Dividends declared. These are translated at the rate current at the date of declaration.
• Transfers to/from reserves. As noted earlier, if internal transfers are made, the rates applicable are those
existing when the amounts transferred were originally recognised in equity.
The application of these rules will result in exchange differences. Exchange differences arise mainly from
translating the foreign operation’s monetary items at current rates in the same way as for the foreign cur-
rency monetary items of the entity. Because the non-monetary items are translated using a historical rate
that is the same from year to year, no exchange differences arise in relation to the non-monetary items.
Further, items in the statement of profit or loss and other comprehensive income such as sales, purchases
and expenses give rise to monetary items such as cash, receivables and payables. Hence, the exchange
difference over the period can be explained by examining the movements in the monetary items over the
period. The accounting for the exchange difference is explained in paragraph 28 of IAS 21:
Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different
from those at which they were translated on initial recognition during the period or in previous financial state-
ments shall be recognised in profit or loss in the period in which they arise, except as described in paragraph 32.
The exchange differences are then taken to the current period’s statement of profit or loss and other
comprehensive income in the same way as movements in the exchange rates on an entity’s own foreign
currency monetary items. See section 24.10 for a discussion of the paragraph 32 exception.
As stated in paragraph 34 of IAS 21, the application of the basic principles of the translation method
means that when an entity keeps its records in a currency other than its functional currency all amounts
are remeasured in the functional currency. This produces the same amounts in that currency as would have
occurred had the items been recorded initially in the functional currency.

ILLUSTRATIVE EXAMPLE 24.1 Translation from local currency into functional currency
Sentosa Ltd, a company operating in Singapore, is a wholly owned subsidiary of Taupo Ltd, a company
listed in New Zealand. Taupo Ltd formed Sentosa Ltd on 1 July 2015 with an investment of NZ$310 000.
Sentosa Ltd’s records and financial statements are prepared in Singaporean dollars (S$). Sentosa Ltd has
prepared the financial information at 30 June 2016, as shown in figure 24.2.
SENTOSA LTD
as at 30 June 2016
2016
S$
Current assets:
Inventory 210 000
Monetary assets 190 000
Non-current assets:
Land — acquired 1/7/15 100 000
Buildings — acquired 1/10/15 120 000
Plant and equipment — acquired 1/11/15 110 000
Current liabilities:
Borrowings 50 000
Payables 100 000
Total current liabilities 220 000
Non-current liabilities:
Borrowings 150 000
Total liabilities 370 000
Net assets 360 000
Equity:
Total equity 360 000
SENTOSA LTD
S$ S$
Sales revenue 1 200 000
Cost of sales:
Purchases 1 020 000
Ending inventory 210 000 810 000
Expenses:
Selling 120 000
Depreciation 10 000
Interest 20 000
Other 90 000 240 000

The only movement in equity, other than in profit, was a dividend paid during the period of S$40 000.
(a) Exchange rates over the period 1 July 2015 to 30 June 2016 were:
S$1.00 = NZ$
1 July 2015 1
1 October 2015 0.95
1 November 2015 0.9
1 January 2016 0.85
1 April 2016 0.75
30 June 2016 0.75
Average rate for year 0.85
Average rate for final quarter 0.77
(b) Proceeds of long-term borrowings were received on 1 July 2015 and are payable in four annual
instalments commencing 1 July 2016. Interest expense relates to this loan.
(c) The inventory on hand at balance date represents approximately the final 3 months’ purchases.
(d) Revenues and expenses are spread evenly throughout the year.
(e) Deferred tax asset relates to depreciation of the plant and equipment.
(f) The dividends were paid on 1 April 2016.
Required
The functional currency is determined to be the New Zealand dollar. Translate the financial statements
of Sentosa Ltd into the functional currency.
Solution
The translation process is as shown in figure 24.2.
FIGURE 24.2 Translation into functional currency
S$ Rate NZ$
Sales 1 200 000 0.85 1 020 000

Cost of sales:
Purchases 1 020 000 0.85 867 000
Ending inventory 210 000 0.77 161 700
810 000 705 300
Gross profit 390 000 314 700
Expenses:
Selling 120 000 0.85 102 000
Depreciation 10 000 0.90 9 000
Interest 20 000 0.85 17 000
Other 90 000 0.85 76 500
240 000 204 500
110 200
Foreign exchange translation loss 0 1 000
Income tax expense 60 000 0.85 51 000
Retained earnings at 1/7/15 0 0
90 000 58 200
Dividends paid 40 000 0.75 30 000
Share capital 310 000 1.00 310 000
Non-current borrowings 150 000 0.75 112 500
Current tax liability 70 000 0.75 52 500
Current borrowings 50 000 0.75 37 500
Payables 100 000 0.75 75 000
730 000 615 700
(continued)

Inventory 210 000 0.77 161 700

Monetary assets 190 000 0.75 142 500
Land 100 000 1.00 100 000
Buildings 120 000 0.95 114 000
Plant and equipment 110 000 0.90 99 000
Accumulated depreciation (10 000) 0.90 (9 000)
Deferred tax asset 10 000 0.75 7 500
730 000 615 700
Exchange differences arise mainly from translating the foreign operation’s monetary items at current
rates in the same way as for the foreign currency monetary items of the entity. Because the non-monetary
items are translated using a historical rate that is the same from year to year, exchange differences in
relation to non-monetary items arise only in the periods in which they are acquired or sold. Items in the
statement of profit or loss and other comprehensive income such as sales, purchases and expenses give
rise to monetary items such as cash, receivables and payables. Hence, exchange differences are going to
arise by examining the movements in the monetary items over the period.
From figure 24.2, the net monetary assets of Sentosa Ltd at 30 June 2016 consist of:
S$
Monetary assets 190 000
Borrowings: non-current (150 000)
Borrowings: current (50 000)
Current tax liability (70 000)
Payables (100 000)
Net monetary assets at 1/7/15 (170 000)
The changes in the net monetary assets are determined from the statement of profit or loss and other
comprehensive income. The exchange differences are calculated by comparing the difference between
the exchange rate used in the translation process and the current rate at the reporting date:
Current rate less NZ$

S$ rate applied gain (loss)
Net monetary assets at 1 July 2015 310 000 (0.75–1.00) (77 500)
Increases in monetary assets:
Sales 1 200 000 (0.75–0.85) (120 000)
1 510 000 (197 500)
Decreases in monetary assets:
Land 100 000 (0.75–1.00) 25 000
Buildings 120 000 (0.75–0.95) 24 000
Plant 110 000 (0.75–0.90) 16 500
Purchases 1 020 000 (0.75–0.85) 102 000
Selling expenses 120 000 (0.75–0.85) 12 000
Interest 20 000 (0.75–0.85) 2 000
Other expenses 90 000 (0.75–0.85) 9 000
Dividend paid 40 000 (0.75–0.75) —
Income tax expense* 60 000 (0.75–0.85) 6 000
1 680 000 196 500
Net monetary assets at 30 June 2016 (170 000) (1 000)
*The entry for the period is:

S$ S$
Income tax expense Dr 60 000
Deferred tax asset Dr 10 000
Current tax liability Cr 70 000
In preparing the translated financial statements for the following period, it should be noted that the
balance of retained earnings at 30 June 2016, as translated in figure 24.2, is carried forward into the next
period. In other words, there is no direct translation of the retained earnings (opening balance) within
the translation process.

LO6 24.6 CHANGING THE FUNCTIONAL CURRENCY
In the example used in the previous section, the foreign operation in Singapore used the New Zealand
dollar as its functional currency. Because of changes in the foreign operation’s circumstances, such as the
source of raw materials or the variables that determine the selling price of the entity’s products, it may be
that the functional currency changes into, for example, Japanese yen. According to paragraph 33 of IAS 21,
where there is a change in the functional currency the translation procedures apply from the date of the
change. Further, paragraph 35 notes that the effect of a change is accounted for prospectively.
Assume, therefore that the Singaporean operation used New Zealand dollars as the functional currency
until 1 June 2017, and then decided that the Japanese yen was the appropriate functional currency. The
financial statements of the Singaporean entity at the date of change, 1 June 2017, would then be translated
at the rate of exchange between the Japanese yen and the Singaporean dollar. This rate would be the his-
torical rate for all non-monetary assets held at the date of change. Any exchange differences recognised in
the statements translated into New Zealand dollars would not be recognised in the new translation. These
gains/losses would resurface until the parent disposed of the foreign operation, and all exchange gains/
losses would be taken into account at that point.
LO7 24.7 TRANSLATION INTO THE PRESENTATION CURRENCY

Consider an Australian entity that has two subsidiaries, one in Malaysia and one in Hong Kong, and the
functional currency for each of these subsidiaries is the Hong Kong dollar. The Australian parent will have
to prepare a set of consolidated financial statements for the group. In which currency should the consoli-
dated financial statements be prepared?
Theoretically, any currency could be the presentation currency. It may be the Australian dollar if man-
agement perceives it as the currency in which users prefer to read the financial statements. In that case, the
two subsidiaries’ financial statements would be prepared in Hong Kong dollars, which is the functional
currency for them both. These would then be translated into Australian dollars and consolidated with the
parent entity’s statements.
It is possible that the presentation currency could be the Hong Kong dollar, for example if the majority
of shareholders in the parent entity were Hong Kong residents. In that case, the parent entity’s statements
would be translated from the Australian dollar into the Hong Kong dollar and consolidated with those of
the subsidiaries as presented in their functional currency.
Hence, having prepared the parent’s and the subsidiaries’ financial statements in the relevant functional
currencies, a presentation currency is chosen and all statements not already in that currency are translated
into the presentation currency. Obviously, a number of presentation currencies could be chosen, and mul-
tiple translations undertaken.
Paragraph 39 of IAS 21 states the principles for translating from the functional currency into the pres-
entation currency:
The results and financial position of an entity whose functional currency is not the currency of a hyperinfla-
tionary economy shall be translated into a different presentation currency using the following procedures:
(a) assets and liabilities for each statement of financial position presented (i.e. including comparatives) shall be
translated at the closing rate at the date of that statement of financial position;
(b) income and expenses for each statement presenting profit or loss and other comprehensive income (i.e.
including comparatives) shall be translated at exchange rates at the dates of the transactions; and
(c) all resulting exchange differences shall be recognised in other comprehensive income.
Paragraph 40 notes that average rates over a period for statement of profit or loss and other comprehen-
sive income items may be used unless exchange rates fluctuate significantly over the period.
An elaboration of these procedures for a foreign subsidiary is as follows.
24.7.1 Statement of financial position items

• Assets. All assets, whether current or non-current, monetary or non-monetary, are translated at the
exchange rate current at the reporting date. This includes all contra-asset accounts such as accumulated
depreciation and allowance for doubtful debts.
• Liabilities. All liabilities are translated at the same rate as assets, namely the exchange rate current at the
reporting date.
• Equity. In selecting the appropriate rate, two factors need to be kept in mind. First, equity existing at
the acquisition date or investment is distinguished from post-acquisition equity. Second, movements in
other reserves and retained earnings constituting transfers within or internal to shareholders’ equity are
treated differently from other reserves.
• Share capital. If on hand at acquisition date or created by investment, this is translated at the rate
current at acquisition date or investment. If created by transfer from a reserve, such as general reserve
via a bonus issue, this is translated at the rate current at the date the amounts transferred were
originally recognised in equity.

• Other reserves. If on hand at acquisition date, these are translated at the current exchange rate existing
at acquisition date. If reserves are post-acquisition and created by an internal transfer within equity,
they are translated at the rate existing at the date the reserve from which the transfer was made was
originally recognised in the accounts. If post-acquisition and not the result of an internal transfer
(e.g. an asset revaluation surplus), the rate used is that current at the date the reserve is recognised in
the accounts.
• Retained earnings. If on hand at acquisition date, they are translated at the current exchange rate
existing at acquisition. Any dividends from pre-acquisition profits are also translated at this rate. Post-
acquisition profits are carried forward balances from translation of previous periods’ statements of
profit or loss and other comprehensive income.
24.7.2 Statement of profit or loss and other comprehensive

income items
• Income and expenses. These are translated at the rates current at the applicable transaction dates.
For items, such as purchases of inventory and sales, that occur regularly throughout the period, for
practical reasons average or standard rates that approximate the relevant rates may be employed.
This will involve considerations of materiality. In relation to items such as depreciation, which
are allocations for a period, even though they may be recognised in the accounts only at year-end
(because they reflect events occurring throughout the period) an average-for-the-period exchange rate
may be used.
• Dividends paid. These are translated at the rates current when the dividends were paid.
• Dividends declared. These are translated at the rates current when the dividends are declared, generally
at end-of-year rates.
• Transfers to/from reserves. As noted earlier, if these are transfers internal to equity, the rate used for the
transfer and the reserve created is that existing when the amounts transferred were originally recognised
in equity.
Using the example in figure 24.2 and, assuming that the functional currency of Sentosa Ltd is
Singaporean dollars, the translation into New Zealand dollars as a presentation currency is shown in
figure 24.3.
FIGURE 24.3 Translation into presentation currency
S$ Rate NZ$
Sales 1 200 000 0.85 1 020 000
Cost of sales:
Purchases 1 020 000 0.85 867 000
Ending inventory 210 000 0.77 161 700
810 000 705 300
Gross profit 390 000 314 700
Expenses:
Selling 120 000 0.85 102 000
Depreciation 10 000 0.85 8 500
Interest 20 000 0.85 17 000
Other 90 000 0.85 76 500
240 000 204 000
Income tax expense 60 000 0.85 51 000
Retained earnings at 1/7/15 0 0
90 000 59 700
Dividends paid 40 000 0.75 30 000
Share capital 310 000 1.00 310 000
Non-current borrowings 150 000 0.75 112 500
Current tax liability 70 000 0.75 52 500
Current borrowings 50 000 0.75 37 500
Payables 100 000 0.75 75 000
Foreign currency translation reserve (69 700)
730 000 547 500

Inventory 210 000 0.75 157 500

Monetary assets 190 000 0.75 142 500
Land 100 000 0.75 75 000
Buildings 120 000 0.75 90 000
Plant and equipment 110 000 0.75 82 500
Accumulated depreciation (10 000) 0.75 (7 500)
Deferred tax asset 10 000 0.75 7 500
730 000 547 500
The exchange difference arising as a result of the translation is NZ$(86 500) — there has been an
exchange loss over the period. This loss arises for two reasons, as explained in paragraph 41 of IAS 21:
• The income and expense items are translated at dates of the transactions and not the closing rate: The profit
represents the net movements in income and expenses:
Profit = S$90 000

Profit as translated = NZ$59 700
Profit × closing rate = S$90 000 × 0.75
= NZ$67 500
Translation gain = NZ$7 800
• In the case of a net investment in a foreign operation, translating the opening net assets at an exchange rate
different from the closing rate:
Net investment at 1 July 2015 = S$310 000

Net investment × opening rate = S$310 000 × 1.00
= NZ$310 000
Net investment × closing rate = S$310 000 × 0.75
= NZ$232 500
Translation loss = NZ$(77 500)
• The total translation loss is NZ$(69 700) equal to (NZ$7800 + NZ$(77 500)).
Note the following in relation to the translation into presentation currency:
• The exchange differences are not taken into current period income or expense. As explained in
paragraph 41 of IAS 21, these exchange differences have little or no direct effect on the present and
future cash flows from operations. The translation is for presentation only. It is the functional currency
statements that recognise exchange differences in current period income and expense.
• In the Basis for Conclusions to IAS 21, in paragraphs BC10–BC14, the International Accounting
Standards Board (IASB®) discusses whether the entity should (a) be permitted to present its financial
statements in a currency other than the functional currency, (b) be allowed a limited choice of
presentation currencies or (c) be permitted to present their financial statements in any currency. The IASB
concluded that entities should be permitted to present in any currency or currencies. The IASB noted that
some jurisdictions require the use of a specific presentation which will put constraints on some entities
anyway. Further, many large groups have a large number of functional currencies and it is not clear which
currency should be the presentation currency. In fact, in such circumstances management may prefer to
use a number of presentation currencies.
LO8 24.8 CONSOLIDATING FOREIGN SUBSIDIARIES — WHERE

LOCAL CURRENCY IS THE FUNCTIONAL CURRENCY
Paragraphs 44–47 of IAS 21 deal with matters relating to the consolidation of foreign subsidiaries. As
noted in paragraph 45, normal consolidation procedures as set down in IFRS 10 apply to foreign sub-
sidiaries. Where a parent establishes or sets up a subsidiary in a foreign country, the determination of
what exists at acquisition date is relatively simple. This is because generally the investment recorded by
the parent is equal to the initial share capital of the subsidiary. Where a parent entity obtains an overseas
subsidiary by acquiring an already existing operation, the date of control determines the point of time at
which historical rates for translation are determined.
For example, assume on 1 July 2015 Canberra Ltd acquires all the shares of Tokyo Ltd, a Japanese entity
that has been in existence for many years. The group commences on the date of control, namely 1 July
2015. Tokyo Ltd may have some land that it acquired in 2006 for 1000 yen. The historical cost in the
records of the company is 1000 yen. In other words, even though the overseas entity has held the land
prior to the date that Canberra Ltd obtained control over the foreign entity, the date for measurement of

the historical rate is the date of control. This is because, under IFRS 3 Business Combinations, all assets and
liabilities of the subsidiary are measured at fair value at acquisition date.
24.8.1 Acquisition analysis

Assume that Canberra Ltd acquired all the shares of Tokyo Ltd at 1 July 2015 for A$30 000, when the
exchange rate between the Australian dollar and the Japanese yen was 1:5. At acquisition date, the equity
of that company consisted of:
¥ A$
All the identifiable assets and liabilities of Tokyo Ltd were recorded at fair value except for plant, for
which the fair value was ¥5000 (equal to A$1000) greater than the carrying amount. The plant has a fur-
ther 5-year life. The Japanese tax rate is 20%. The Australian tax rate is 30%. At 30 June 2016, the exchange
rate is A$1 = ¥6. The average rate for the year is A$1 = ¥5.5.
At acquisition date:
and liabilities of Tokyo Ltd = A$20 000 + 8 000 + 1 000(1 − 20%) (BCVR — plant)
= A$28 800
Consideration transferred = A$30 000
Goodwill = A$1 200
= ¥(1 200 × 5)
= ¥6 000
As noted in paragraph 47 of IAS 21, the goodwill is regarded as an asset of the subsidiary.

Goodwill
At acquisition date, the entry in Japanese yen is:
¥ ¥
Goodwill Dr 6 000
The valuation reserve continues to be translated at the rate at acquisition date as it is pre-acquisition
equity. Assuming the functional currency is the yen, the financial statements of Tokyo Ltd would be trans-
lated into Australian dollars for presentation purposes. The goodwill is translated at the closing rate of
1:5, giving rise to a foreign currency translation loss, recognised in equity. Hence, on consolidation, the
worksheet entry at 30 June 2016 is:
A$ A$
Goodwill Dr 1 000
Foreign Currency Translation Reserve Dr 200
Plant
Similarly to goodwill, as noted in paragraph 47 of IAS 21, any fair value adjustments to the carrying amounts
of assets and liabilities at acquisition date are treated as assets and liabilities of the foreign operation.
At acquisition date, the valuation entry is:
A$ A$
Plant (¥5000/5) Dr 1 000
Business Combination Valuation Reserve Cr 800
At 30 June 2016, the valuation reserve is translated at the exchange rate at acquisition date and, as with
goodwill, a foreign exchange loss is recognised — in this case on both the plant and the deferred tax liability:

A$ A$
Plant (¥5000/6) Dr 833
Deferred Tax Liability (20% × 833) Cr 167
Business Combination Valuation Reserve Cr 800
The plant is depreciated at 20% per annum. This is based on the ¥5000 adjustment, giving a depreciation of
¥1000 per annum. The plant is translated at closing rates while the depreciation is translated at average rates.
Depreciation Expense [¥1000/5.5] Dr 182

Accumulated Depreciation [¥1000/6.0] Cr 167
Foreign Currency Translation Reserve Cr 15
Deferred Tax Liability [¥200/6.0 or 20% × 167] Dr 33

Income Tax Expense [¥200/5.5] Cr 36
24.8.3 Elimination of investment

The entry at acquisition date and at 30 June 2016 is:

Business Combination Valuation Reserve [800 + 1200] Dr 2 000
Shares in Tokyo Ltd Cr 30 000
24.8.4 Non-controlling interest (NCI)

The NCI receives a share of the recorded equity of the subsidiary as well as the valuation reserves raised
on consolidation. The NCI also receives a share of the foreign currency translation reserve raised on the
translation into the presentation currency. This share will need to be adjusted for any movements in that
reserve as a result of movements raised via the revaluation process.
24.8.5 Intragroup transactions

As with any transactions within the group, the effects of transactions between a parent and its foreign sub-
sidiaries, or between foreign subsidiaries, must be eliminated in full. Neither IAS 21 nor IFRS 10 provide
specific guidance in relation to transactions with foreign entities. A key matter of concern is whether the
adjustment should be affected by changes in the exchange rate. In this regard, note paragraphs 136 and
137 of the Basis for Conclusions relating to the US Statement of Financial Accounting Standards (SFAS)
No. 52 Foreign Currency Translation:
136. An intercompany sale or transfer of inventory, machinery, etc., frequently produces an intercompany profit
for the selling entity and, likewise, the acquiring entity’s cost of the inventory, machinery, etc., includes a compo-
nent of intercompany profit. The Board considered whether computation of the amount of intercompany profit
to be eliminated should be based on exchange rates in effect on the date of the intercompany sale or transfer, or
whether that computation should be based on exchange rates as of the date the asset (inventory, machinery, etc.)
or the related expense (cost of sales, depreciation, etc.) is translated.
137. The Board decided that any intercompany profit occurs on the date of sale or transfer and that exchange
rates in effect on that date or reasonable approximations thereof should be used to compute the amount of any
intercompany profit to be eliminated. The effect of subsequent changes in exchange rates on the transferred asset
or the related expense is viewed as being the result of changes in exchange rates rather than being attributable
to intercompany profit.
It needs to be emphasised that the process of making the consolidation adjustments is to eliminate the
effects of intragroup transactions. The exchange rate change is not an effect of the transaction but an eco-
nomic effect on the group resulting from having assets in foreign entities.
Example 1: Parent sells inventory to foreign subsidiary

Assume Aust Ltd, an Australian company, owns 100% of the shares of a foreign operation, F Ltd.
During the current period, when the exchange rate is F1 = $2, Aust Ltd sells $10 000 worth of
inventory to F Ltd, at a before-tax profit of $2000. At the end of the period, F Ltd still has all inventory
on hand. At the year-end reporting date, the exchange rate is F1 = $2.50. The Australian tax rate is 30%,
while the tax rate in the foreign country is 20%.

Assuming the financial statements of F Ltd have been translated from the functional currency (F) to the
presentation currency (Australian dollars), the consolidation worksheet adjustment entries for the intra-
group transaction are:
Sales Dr 10 000
Inventory Cr 2 000

(20% × 2000)
The above entries eliminate the sales and cost of sales as recorded by the parent. The inventory would
have been recorded by F Ltd at F5000. The translation process at balance date would mean the F5000 of
inventory would be translated using the closing rate of F1 = $2.50, giving a translated figure for inventory
of $12 500. After passing the consolidation adjustment entry, inventory in the consolidated statement
of financial position would be reported at $10 500 (i.e. $12 500 – $2000). This figure is greater than the
original cost of $8000 due to the exchange rate change between the transaction date and the balance date.
The US FASB would argue that no further entry is necessary as the effect of changes in the exchange rates
on the transferred asset is viewed as the result of changes in exchange rates rather than intragroup profit.
Note that the tax rate used is that of the country holding the asset — in this case, the foreign country.
This is because the adjustment for the tax effect is required because of the adjustment to the carrying
amount of the inventory in the first journal entry. As the inventory is held by the foreign entity, it is the
foreign country’s tax rate that is applicable.
Example 2: Foreign subsidiary sells inventory to parent

Assume F Ltd, the foreign subsidiary, sells an item of inventory to Aust Ltd, the Australian parent,
during the current period. The inventory had cost F Ltd F5000 and was sold to Aust Ltd for F7500.
At the date of sale, the exchange rate was F1 = $2. The tax rate in Australia is 30%. All inventory was
still on hand at the end of the period when the closing exchange rate was F1 = $2.50.
The consolidation worksheet entry is:
Sales Dr 15 000
Inventory Cr 5 000
Both sales and cost of sales as recorded by F Ltd are translated at the exchange rate existing at the date of
the transaction, namely F1 = $2. The inventory sold to the parent is recorded by that entity at $15 000. The
profit on sale is adjusted against inventory at the exchange rate existing at date of sale, giving an adjust-
ment of $5000. Hence, in the consolidated statement of financial position at the end of the period, the
inventory is reported at $10 000, equal to the original cost to F Ltd.
ILLUSTRATIVE EXAMPLE 24.2 Consolidation — functional currency is the subsidiary’s local currency
On 1 January 2016, Kangaroos Ltd, an Australian company, acquired 80% of the shares of All Blacks
Ltd, a New Zealand company, for A$2 498 000. The 2016 trial balance of All Blacks Ltd prepared in New
Zealand dollars, which is also the functional currency, showed the following information:
1 January 2016 1 December 2016

NZ$’000 NZ$’000
Revenue 6 450
Cost of sales 4 400
Gross profit 2 050
Expenses:
Depreciation 280
Other 960
1 240
Profit before income tax 810
Income tax expense 120

1 January 2016 1 December 2016
NZ$’000 NZ$’000
Profit 690
Retained earnings at beginning of year 1 440
2 130
Dividend paid 100
Dividend declared 100
200
Retained earnings at end of year 1 930
Cash and receivables 1 000 1 760
Inventories 1 200 1 000
Land 800 800
Buildings 2 200 2 200
Accumulated depreciation (900) (990)
Equipment 1 130 1 330
Accumulated depreciation (200) (390)
Total assets 5 230 5 710
Non-current liabilities 1 200 1 360
Net assets 3 440 3 930
1. Direct exchange rates for the New Zealand dollar are as follows:
1 January 2016 1.20
1 July 2016 1.25
1 November 2016 1.35
31 December 2016 1.40
Average for the year 1.30
2. At 1 January 2016, all the assets and liabilities of All Blacks Ltd were recorded at fair value except for
the land, for which the fair value was NZ$1 000 000, and the equipment, for which the fair value was
$1 010 000. The undervalued equipment had a further 4-year life. The tax rate in New Zealand is 25%.
3. Additional equipment was acquired on 1 July 2016 for NZ$200 000 by issuing a note for NZ$160 000
and paying the balance in cash.
4. Sales and expenses were incurred evenly throughout the year.
5. Dividends of NZ$100 000 were paid on 1 July 2016.
6. On 1 November 2016, All Blacks Ltd sold inventory to Kangaroos Ltd for NZ$25 000. The inventory
had cost All Blacks Ltd $20 000. Half of the inventory is still on hand at 31 December 2016. The Aus-
tralian tax rate is 30%.
Required
1. Translate the New Zealand financial statements into the Australian dollar, which is the presentation
currency.
2. Prepare the consolidation worksheet entries for consolidating the New Zealand subsidiary into the
consolidated financial statements of Kangaroos Ltd. The partial goodwill method is used.
Solution
1. Translation into presentation currency
NZ$ Rate A$
Revenue 6 450 1/1.30 4 962
Cost of sales 4 400 1/1.30 3 385
Gross profit 2 050 1 577
Depreciation 280 1/1.30 215
Other 960 1/1.30 739
1 240 954

NZ$ Rate A$
Income tax expense 120 1/1.30 92
Profit 690 531
Retained earnings as at 1/1/16 1 440 1/1.20 1 200
2 130 1 731
Dividend paid 100 1/1.25 80
Dividend declared 100 1/1.40 71
200 151
Retained earnings as at 31/12/16 1 930 1 580
Share capital 2 000 1/1.20 1 667
Non-current liabilities 1 360 1/1.40 971
Current liabilities 420 1/1.40 300
Foreign currency translation reserve (439)
5 710 4 079
Cash and receivables 1 760 1/1.40 1 257
Inventories 1 000 1/1.40 714
Land 800 1/1.40 572
Buildings 2 200 1/1.40 1 572
Accumulated depreciation (990) 1/1.40 (707)
Equipment 1 330 1/1.40 950
Accumulated depreciation (390) 1/1.40 (279)
5 710 4 079
In relation to the foreign currency translation reserve:

• The income and expense items are translated at dates of the transactions and not the closing rate:
The profit represents the net movements in income and expenses:
Profit = NZ$690 000

Profit as translated = A$530 800
Profit × closing rate = NZ$690 000 × 1/1.40
= A$492 857
Translation loss = A$(37 943)
Dividend paid as translated = A$80 000
Dividend paid at closing rate = NZ$100 000 × 1/1.40
= A$71 429
Translation gain = A$8 571
• In the case of a net investment in a foreign operation, translating the opening net assets at an exchange rate
different from the closing rate:
Net investment at 1 January 2016 = NZ$3 440 000

Net investment × opening rate = NZ$3 440 000 × 1/1.20
= A$2 866 667
Net investment × closing rate = NZ$3 440 000 × 1/1.40
= A$2 457 143
Translation loss = A$(409 524)
• Total translation loss is A$(438 896) = (A$(37 943) + A$(409 524)) + A$8 571
2. Consolidation worksheet entries: (in $000)

liabilities of All Blacks Ltd = A$[2 000 + 1 440 + 200(1 × 25%) (land)
+ 80(1 – 25%) (equipment)] 1/1.20
= A$[1 667 + 1 200 + 125 + 50]
Net fair value acquired = 80% × A$[1 667 + 1 200 + 125 + 50]
= A$[1 334 + 960 + 100 + 40]
Consideration transferred = A$2 434
Goodwill acquired = A$2 498
= NZ$77 (i.e. 64 × 1.20)

(i) Business combination valuation entries
Land (200/1.40) Dr 143

Business Combination Valuation Reserve (150/1.20) Cr 125
Deferred Tax Liability (50/1.40) Cr 36
Accumulated Depreciation (200/1.40) Dr 143

Equipment (120/1.40) Cr 86
Deferred Tax Liability (25% × (80/1.40)) Cr 14
Depreciation Expense ([1/4 × 80]/1.30) Dr 15

Accumulated Depreciation ([1/4 × 80]/1.40) Cr 14
Deferred Tax Liability ([25% × 20]/1.30) Dr 3.5

Foreign Currency Translation Reserve Dr 0.3
Income Tax Expense ([25% × 20]/1.30) Cr 3.8
(At acquisition the deferred tax liability was NZ$20 = 25% × NZ$80)
(ii) Elimination of investment

Business Combination Valuation Reserve Dr 140
Goodwill Dr 64
Shares in All Blacks Ltd Cr 2 498

Goodwill ((77/1.40) − 64) Cr 9
(iii) Non-controlling interest
Share at acquisition date
Retained Earnings (1/1/16) (20% × 1200) Dr 240

Share Capital (20% × 1667) Dr 333
Business Combination Valuation Reserve (20% [125 + 50]) Dr 35
NCI Cr 608
Share from 1/1/16–31/12/16

(i) Current period profit — the share is based on the translated profit of the subsidiary
NCI Share of Profit Dr 104

NCI Cr 104
(20% × A$[531 – (15 – 3.8)])
(ii) The share of the foreign currency translation reserve is based on the amount of the reserve calculated as a
result of the translation process adjusted by any changes in that reserve recognised in the valuation entries
NCI Dr 93
(20% [439 + 18 + 7 + 1 + 0.3])
(iii) Dividend paid
NCI Dr 16
Dividend Paid Cr 16
(20% × A$80)

(iv) Dividend declared
NCI Dr 14
(20% × A$71)
Intragroup transactions:
(i) Dividends
Dividend Paid Cr 64
(80% × (100/1.25))
(80% × (100/1.40))
(ii) Sale of inventory: subsidiary to parent
Sales Revenue (25/1.35) Dr 19

Cost of Sales Cr 17
Inventory (1/2 × 5 × 1/1.35) Cr 2
Deferred Tax Asset (30% × 2) Dr 0.6

Income Tax Expense Cr 0.6
(iii) Adjustment to NCI
NCI Dr 0.28
NCI Share of Profit Cr 0.28
(20% × (2 – 0.6))
LO9 24.9 CONSOLIDATING FOREIGN SUBSIDIARIES —

WHERE FUNCTIONAL CURRENCY IS
THAT OF THE PARENT ENTITY
In this circumstance, the subsidiary’s financial statements are prepared in the local currency, and, as the
parent’s currency is the functional currency, they are translated into the parent’s currency. The main dif-
ference in preparing the consolidated financial statements in this case is in the valuation entries. This is
because the translation of non-monetary assets differs when the translation is for presentation purposes
rather than for functional currency purposes.
Under the method described in paragraph 23 of IAS 21, the non-monetary assets of the subsidiary are
translated using exchange rates at the date of the transaction (i.e. historical rates). In contrast, in illustrative
example 24.2, where the translation is based on paragraph 39 of IAS 21, the non-monetary assets are trans-
lated at the closing rate.
Using the information in illustrative example 24.2:
• at acquisition date, 1 January 2016, goodwill of the subsidiary was measured to be NZ$96
• the land had a fair value-carrying amount difference of NZ$200
• the equipment had a fair value-carrying amount difference of NZ$80, with an expected remaining
useful life of 25%
• the NZ tax rate is 25%
• the direct exchange rates for the NZ dollar were:
1 January 2016 1.20

1 July 2016 1.25
1 November 2016 1.35
31 December 2016 1.40
Average for the year 1.30

The business combination valuation entries are then:
The goodwill balance is translated at the historical rate:
Goodwill (96/1.20) Dr 80
The land is translated at the historical rate, but the deferred tax liability is translated at the closing rate. As the
net monetary assets held at the beginning of the period are affected by changes in the exchange rate, an exchange
gain is recognised:
Land (200/1.20) Dr 167

Foreign Exchange Gain Cr 6
Deferred Tax Liability (50/1.40) Cr 36
The equipment and related accumulated depreciation are translated at the historical rate, while the deferred tax
liability is translated at the closing rate, giving rise to a foreign exchange gain.
Subsequent depreciation is based on the historical rate:
Accumulated Depreciation (200/1.20) Dr 167

Equipment (120/1.20) Cr 100
Foreign Exchange Gain Cr 3
Deferred Tax Liability ([25% × 80]/1.40) Cr 14
Depreciation Expense ([1/4 × 80]/1.20) Dr 17

Accumulated Depreciation ([1/4 × 80]/1.20) Cr 17
Deferred Tax Liability ([25% × 20]/1.40) Dr 3.5

Foreign Currency Exchange Loss Dr 0.3
Income Tax Expense ([25% × 20]/1.30) Cr 3.8
(At acquisition the deferred tax liability was NZ$20 = 25% × NZ$80)
LO10 24.10 NET INVESTMENT IN A FOREIGN OPERATION

Paragraph 15 of IAS 21 notes that the investment in a foreign operation may consist of more than just the
ownership of shares in that operation. An entity may have a monetary item that is receivable or payable to
the foreign subsidiary. According to paragraph 15, where there is an item for which settlement is neither
planned nor likely to occur in the foreseeable future, it is in substance a part of the entity’s net investment
in that foreign operation. These items include long-term receivables and payables but not trade receivables
or payables.
Consider the situation where an Australian parent entity has made a long-term loan of 100 000 yen to a
Japanese subsidiary when the exchange rate is $2 = ¥1. The parent entity records a receivable of $200 000,
while the subsidiary records a payable of ¥100 000. If during the following financial period the exchange
rate changes to $3 = ¥1, in accordance with paragraph 28 of IAS 21 the Australian parent passes the fol-
lowing entry in its own records:
Loan Receivable Dr 100 000

Exchange Gain Cr 100 000
This results in the receivable being recorded at $300 000. The subsidiary does not pass any entry because
it still owes ¥100 000. On translation of the subsidiary into the presentation currency (the Australian dollar),
the payable is translated into $300 000. On consolidation of the subsidiary, both the payable and the receiv-
able are eliminated. However, because the receivable is regarded as part of the parent’s net investment in the
subsidiary, the accounting for the exchange gain is in accord with paragraph 32 of IAS 21:
Exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a for-
eign operation (see paragraph 15) shall be recognised in profit or loss in the separate financial statements of the
reporting entity or the individual financial statements of the foreign operation, as appropriate. In the financial
statements that include the foreign operation and the reporting entity (e.g. consolidated financial statements where
the foreign operation is a subsidiary), such exchange differences shall be recognised initially in a separate compo-
nent of equity and recognised in profit or loss on disposal of the net investment in accordance with paragraph 48.

Hence, the exchange gain of $100 000 recognised as income by the parent must, on consolidation, be
reclassified to the foreign currency translation reserve raised as part of the translation process. Hence, in
the consolidation worksheet the adjustment entry is:
Exchange Gain Dr 100 000

Foreign Currency Translation Reserve Cr 100 000
LO11 24.11 DISCLOSURE

Paragraphs 51–57 contain the disclosure requirements under IAS 21. In particular, an entity must disclose:
• the amount of exchange differences included in profit or loss for the period
• net exchange differences classified in a separate component of equity, and a reconciliation of the
amount of such exchange differences at the beginning and end of the period
• when the presentation currency of the parent entity is different from the functional currency:
– the fact that they are different
– the functional currency
– the reason for using a different presentation currency
• when there is a change in the functional currency, the fact that such a change has occurred.
Illustrative disclosures relating to paragraph 52 of IAS 21 are given in figure 24.4.
IAS 21
NOTE paragraph
Movements in reserves
Foreign Currency Translation Reserve 2013 2012 52(b)
Balance at beginning of period (2 420) (3 020)
Exchange differences arising on translation of overseas
operations (540) 600
Balance at end of period (2 960) (2 420)
Profit from operations

2010 2009
Profit from operations has been arrived at after charging:

Amortisation x x
Research and development costs x x
Net foreign exchange losses/(gains) 765 (346) 52(a)
FIGURE 24.4 Disclosures required by paragraph 50 of IAS 21
SUMMARY
A parent entity may have investments in subsidiaries that are incorporated in countries other than that
of the parent. The foreign operation will record its transactions generally in the local currency. However,
the local currency may not be that of the economy that determines the pricing of those transactions. To
this end, IAS 21 requires the financial statements of a foreign operation to be translated into its functional
currency, being the currency of the primary economic environment in which the entity operates. Deter-
mination of the functional currency is a matter of judgement, and the choice of the appropriate currency
requires an analysis of the underlying economics of the foreign operation. A further problem addressed
by IAS 21 is where the financial statements of the foreign operation need to be presented in a currency
different from the functional currency. IAS 21 then provides principles relating to the translation of a set of
financial statements into the presentation currency. Whenever a translation process is undertaken, foreign
exchange translation adjustments arise. It is necessary to determine whether these adjustments are taken to
profit or loss or to other comprehensive income.
Where the foreign operation is a subsidiary, having translated the financial statements of the foreign
operation into the currency in which the consolidated financial statements are to be presented, consoli-
dation worksheet adjustments are required as a part of the normal consolidation process. In assessing the
assets and liabilities held by the subsidiary at acquisition date, as well as any goodwill or gain on bargain
purchase arising as a result of the acquisition, the effects of movements in exchange rates on these assets
and liabilities must be taken into consideration. The consolidation adjustments are affected by the process
of translation used to translate the foreign entity’s financial statements from the local currency into either
the functional currency or the presentation currency.

1. What is the purpose of translating financial statements from one currency to another?
2. What is meant by ‘functional currency’?
3. What is the rationale behind the choice of an exchange rate as an entity’s functional currency?
4. What guidelines are used to determine the functional currency of an entity?
5. How are statement of profit or loss and other comprehensive income items translated from the local
currency into the functional currency?
6. How are statement of financial position items translated from the local currency into the functional
currency?
7. How are foreign exchange gains and losses calculated when translating from local currency to functional
currency?
8. What is meant by ‘presentation currency’?
9. How are statement of profit or loss and other comprehensive income items translated from functional
currency to presentation currency?
10. How are statement of financial position items translated from functional currency to presentation currency?
11. What causes a foreign currency translation reserve to arise?
12. Why are gains/losses on translation taken to a foreign currency translation reserve rather than to profit
or loss for the period?
References
AASB 2003, Presentation Currency of Australia Financial Reports (Agenda paper 12.2), collation of submissions
on the invitation to comment meeting of the Australian Accounting Standards Board, 15–16 October,
Glenelg, South Australia.
FASB 1981, Foreign currency translation: Statement of Financial Accounting Standards No. 52, Norwalk,
CT: Financial Accounting Standards Board.
Jeter, D.C. and Chaney, P.K. 2003, Advanced accounting, 2nd edn, John Wiley & Sons Inc.
Radford, J. 1996, Foreign currency translation: clarity or confusion?, project written as part of a Masters of
Commerce degree, Curtin University of Technology, Perth, Western Australia.
Revsine, L. 1984, ‘The rationale underlying the functional currency choice’, The Accounting Review, 59(3),
505–514.
Exercise 24.1 TRANSLATION INTO FUNCTIONAL CURRENCY

★ Auckland Ltd is a manufacturer of sheepskin products in New Zealand. It is a fully owned subsidiary of a
Hong Kong company, China Ltd. The following assets are held by Auckland Ltd at 30 June 2016:
Cost Useful life Acquisition Exchange rate on acquisition

Plant NZ$ (years) date date (NZ$1 = HK$)
Tanner 40 000 5 10/8/2012 5.4

Benches 20 000 8 8/3/2014 5.8
Presses 70 000 7 6/10/2015 6.2
Plant is depreciated on a straight-line basis, with zero residual values. All assets acquired in the first half
of a month are allocated a full month’s depreciation.
Inventory:
• At 1 July 2015, the inventory on hand of $25 000 was acquired during the last month of the 2014–15 period.
• Inventory acquired during the 2015–16 period was acquired evenly throughout the period. Total
purchases of $420 000 was acquired during that period.
• The inventory of $30 000 on hand at 30 June 2016 was acquired during June 2016.
Relevant exchange rates (quoted as NZ$1 = HK$) are as follows:
Average for June 2015 7.2

1 July 2016 7.0
Average for 2015–16 7.5
Average for June 2016 7.7
30 June 2016 7.8

Required
1. Assuming the functional currency for Auckland Ltd is the NZ$, calculate:
(a) the balances for the plant items and inventory in HK$ at 30 June 2016
(b) the depreciation and cost of sales amounts in the statement of profit or loss and other comprehen-
sive income for 2015–16.
2. Assuming the functional currency is the HK$, calculate:
(a) the balances for the plant items and inventory in HK$ at 30 June 2016
(b) the depreciation and cost of sales amounts in the statement of profit or loss and other comprehen-
sive income for 2015–16.
3. Discuss the differences in the results achieved in requirements 1 and 2 above, and why the choice of the
functional currency gives a different set of accounting numbers.
Exercise 24.2 TRANSLATION OF FINANCIAL STATEMENTS INTO FUNCTIONAL CURRENCY

★★ Faber Ltd, a company incorporated in Singapore, acquired all the issued shares of Lantau Ltd, a Hong
Kong company, on 1 July 2015. The trial balance of Lantau Ltd at 30 June 2016 was:
HK$ HK$
Dr Cr
Retained earnings (1/7/15) 240 000
Payables 160 000
Provisions 80 000
Sales 610 000
Proceeds on sale of land 250 000
Accumulated depreciation — plant 340 000
Plant 920 000
Land 400 000
Cash 240 000
Inventory at 1 July 2015 60 000
Purchases 260 000
Depreciation — plant 156 000
Carrying amount of land sold 200 000
Other expenses 134 000
2 720 000 2 720 000
1. Exchange rates based on equivalence to HK$1 were:
S$
1 July 2015 0.2
8 October 2015 0.25
1 December 2015 0.28
1 January 2016 0.3
2 April 2016 0.27
30 June 2016 0.22
Average during last quarter 2015–16 0.24
Average 2015–16 0.26
2. Inventory was acquired evenly throughout the year. The closing inventory of HK$60 000 was acquired
during the last quarter of the year.
3. Sales and other expenses occurred evenly throughout the year.
4. The Hong Kong tax rate is 20%.
5. The land on hand at the beginning of the year was sold on 8 October 2015. The land on hand at the
end of the year was acquired on 1 December 2015.

6. Movements in plant over 2015–16 were:
Plant at 1 July 2012 HK$600 000

Acquisitions — 8 October 2015 200 000
— 2 April 2016 120 000
Plant at 30 June 2016 920 000
Depreciation on plant is measured at 20% per annum on cost. Where assets are acquired during a
month, a full month’s depreciation is charged.
7. The functional currency of the Hong Kong operation is the Singaporean dollar.
Required
1. Prepare the financial statements of Lantau Ltd in Singaporean dollars at 30 June 2016.
2. Verify the translation adjustment.
Exercise 24.3 TRANSLATION INTO PRESENTATION CURRENCY, CONSOLIDATION ADJUSTMENTS

★★★ Dragon Ltd is an international company resident in Singapore. It acquired 80% of the issued shares of an
Australian company, Swan Ltd, on 1 July 2015 for A$560 000. All the identifiable assets and liabilities of
Swan Ltd were recorded at fair value except for the following:

A$ A$
Plant (net) 180 000 240 000
Inventory 68 000 90 000
Brand names 0 140 000
The plant is considered to have a remaining life of 5 years, with depreciation being calculated on a
straight-line basis. All inventory on hand at acquisition date was sold within the following 12-month
period. The brand names are considered to have an indefinite life, and are adjusted only if impaired.
At 30 June 2016, the following information was available about the two companies:
Dragon Ltd Swan Ltd

S$ A$
Retained earnings as at 1/7/15 330 000 170 000
Payables 14 000 40 000
Sales 620 000 310 000
Dividend revenue 6 400 0
Accumulated depreciation — plant 210 000 160 000
1 785 400 1 060 000
Cash 92 100 30 000
Inventory 110 000 80 000
Shares in Swan Ltd 336 000 0
Buildings (net) 84 000 220 000
Plant 420 000 400 000
Cost of sales 390 000 120 000
Depreciation — plant 85 000 40 000
Tax expense 23 000 15 000
Dividend paid 20 000 10 000
Dividend provided 30 000 20 000
1 785 400 1 060 000
1. Sales, purchases and other expenses were incurred evenly throughout the 2015–16 period. The dividend
was paid by Swan Ltd on 1 January 2016, while the dividend was declared on 30 June 2016.
2. The tax rate in Australia is 30% and the tax rate in Singapore is 20%.
3. Swan Ltd acquired A$100 000 of additional new plant on 1 January 2016. Of the depreciation charged
in the 2015–16 period, A$8000 related to the new plant.

4. The rates of exchange between the Australian dollar and the Singapore dollar were (expressed as A$1 = S$):
1 July 2015 0.60

1 December 2015 0.64
1 January 2016 0.68
30 June 2016 0.7
Average for the 2015–16 period 0.65
5. The functional currency of the Australian subsidiary is the Australian dollar.

6. On 1 January 2016, Swan Ltd sold some inventory to Dragon Ltd for A$20 000. The inventory had cost the
subsidiary $18 000. Only 10% of this inventory remained unsold by the parent entity at 30 June 2016.
Required
1. Translate the financial statements of Swan Ltd into Singapore dollars for inclusion in the consolidated
financial statements of Dragon Ltd.
2. Verify the translation adjustment.
3. Prepare the consolidation worksheet entries necessary for the preparation of the consolidated financial
statements at 30 June 2016, assuming the use of the partial goodwill method.
Exercise 24.4 TRANSLATION INTO PRESENTATION CURRENCY, CONSOLIDATION ENTRIES

★★★ On 1 July 2015, Cricket Ltd, an Australian company, acquired 80% of the issued shares of Baseball Ltd, a
company incorporated in the United States, for US$789 600 (= A$1 579 200). The draft statement of profit
or loss and other comprehensive income and statement of financial position of Baseball Ltd at 30 June
2016 are shown below.
US$ US$
Sales revenues 1 600 000
Cost of sales:
Opening inventory 140 000
Purchases 840 000
980 000 700 000
Closing inventory 280 000 900 000
Gross profit
Expenses:
Depreciation 90 000
Other 270 000 360 000
Profit 340 000
Retained earnings as at 1 July 2015 200 000
540 000
Dividend paid 120 000
2016 2015
US$ US$
Current assets:
Inventory 280 000 140 000
Cash 20 000 570 000
Non-current assets:
Patent 80 000 80 000
Plant 720 000 600 000
Land 500 000 300 000
Buildings 920 000 820 000
Total non-current assets 1 970 000 1 640 000

2016 2015
US$ US$
Total assets 2 290 000 2 480 000
Current liabilities:
Provisions 500 000 620 000
Total current liabilities 820 000 1 560 000
Non-current liabilities:
Loan from Cricket Ltd 530 000 —
Net assets 940 000 920 000
Equity:
Total equity 940 000 920 000
1. At acquisition date, all the assets and liabilities of Baseball Ltd were recorded at fair value except for:
Fair value
US$
Plant 540 000
Land 324 000
Inventory 182 000
The plant was expected to have a further 5-year life. The inventory was all sold by July 2016. The US tax
rate is 25%.
2. On 1 January 2016, Baseball Ltd acquired new plant for US$120 000. This plant is depreciated over a
5-year period.
3. On 1 April 2016, Baseball Ltd acquired US$200 000 worth of land.
4. On 1 October 2015, Baseball Ltd acquired US$100 000 worth of new buildings. These buildings are
depreciated evenly over a 10-year period.
5. The interim dividend was paid on 1 January 2016, half of which was from profits earned prior to 1 July
2015, while the dividend payable was declared on 30 June 2016.
6. Sales, purchases and expenses occurred evenly throughout the period. The inventory on hand at 30
June 2016 was acquired during June 2016.
7. The loan of US$530 000 from Cricket Ltd was granted on 1 July 2015. The interest rate is 8% per an-
num. Interest is paid on 30 June and 1 January each year.
8. Cricket Ltd sold raw materials to Baseball Ltd at 20% mark-up on cost. During the 2015–16 period
there were three shipments of raw materials, costing Baseball Ltd:
1 October 2015 US$ 120 000

1 January 2016 US$ 96 000
1 April 2016 US$ 132 000
At 30 June 2016, 20% of the shipment in April remains on hand in Baseball Ltd. The Australian tax
rate is 30%.
9. On consolidation, the partial goodwill method is used.
10. The exchange rates for the financial year were as follows:
US$1 = A$
1 July 2015 2.00
1 October 2015 1.80
1 January 2016 1.70
1 April 2016 1.60
30 June 2016 1.50
Average June 2016 1.52
Average for 2015–16 1.75

Required
1. If the functional currency for Baseball Ltd is the US dollar, prepare the financial statements of Baseball
Ltd at 30 June 2016 in the presentation currency of the Australian dollar.
2. Verify the foreign currency translation adjustment.
3. Prepare the consolidation worksheet entries to consolidate the translated financial statements of Base-
ball Ltd with its parent entity at 30 June 2016.
Exercise 24.5 TRANSLATION INTO FOREIGN CURRENCY, CONSOLIDATION EFFECTS

★★★ Use the information in problem 24.4.
Required
1. If the functional currency for Baseball Ltd is the Australian dollar, prepare the financial statements of
Baseball Ltd at 30 June 2016 in the functional currency.
2. Verify the foreign currency translation adjustment.
3. Prepare the consolidation worksheet entries to consolidate the translated financial statements of Base-
ball Ltd with its parent entity at 30 June 2016.
4. Assume on 1 January 2016, Baseball Ltd sold the patent to Cricket Ltd for US$100 000 and that Cricket
Ltd depreciates this asset evenly over a 20-year period. Prepare the consolidation worksheet adjustment
entries at 30 June 2016.

GLOSSARY
Accounting estimates: Measurement judgements applied (b) held-to-maturity investments or (c) financial assets at
in preparing the financial statements. fair value through profit or loss.
Accounting policies: The specific principles, bases, Bargain purchase option: A clause in the lease agreement
conventions, rules and practices applied by an entity in allowing the lessee to purchase the asset at the end of
preparing and presenting financial statements. the lease for a preset amount, significantly less than the
Accounting profit: Profit for a period (determined in expected residual value at the end of the lease term.
accordance with accounting standards) before deducting Bargain renewal option
tax expense. Biological asset: A living animal or plant.
Accrual basis: Recognising the effects of transactions and Bonus issue or bonus shares: An issue of shares to
other events when they occur, rather than when cash or existing owners as a substitute for the payment of cash,
its equivalent is received or paid. particularly as a substitute for a cash dividend.
Acquirer: The entity that obtains control of the acquiree. Business: An integrated set of activities and assets that
Acquisition date: The date on which the acquirer obtains is capable of being conducted and managed for the
control of the acquiree. purpose of providing a return in the form of dividends,
Active market: A market in which all the following lower costs or other economic benefits directly to
conditions exist: (a) the items traded in the market investors or other owners, members or participants.
are homogeneous; (b) willing buyers and sellers Business combination: A transaction or other event
can normally be found at any time; and (c) prices in which an acquirer obtains control of one or more
are available to the public. A market in which businesses.
transactions for the asset or liability take place with Business segment: A distinguishable component of an
sufficient frequency and volume to provide pricing entity that is engaged in providing an individual product
information on an ongoing basis (IFRS 13 Fair Value or service or a group of related products or services and
Measurement). that is subject to risks and returns that are different from
Adjusting event after the reporting period: An event that those of other business segments.
provides evidence of conditions that existed at the end of Call: An account used to record amounts of money
the reporting period. receivable on shares that have been allotted by
Agreement date: The date that a substantive agreement shareholders whose shares were forfeited.
between the combining parties is reached. Carrying amount: The amount at which an asset
Agricultural produce: The harvested product of an entity’s is recognised after deducting any accumulated
biological assets. depreciation (amortisation) and accumulated
Allotment: The process whereby directors of the company impairment losses thereon.
allocate shares to applicants. Alternatively, an account Cash: Includes cash on hand, currency, cheques, money
recording an amount of money receivable from orders or electronic transfer that a bank will accept as a
successful applicants once shares are allotted. deposit.
Amortisation: The systematic allocation of the depreciable Cash basis: Recognising the effects of transactions and other
amount of an intangible asset over its useful life. See events when cash or its equivalent is received or paid,
depreciation. rather than when the transactions or other events occur.
Amortised cost: The amount at which the financial asset or Cash dividends
financial liability is measured at initial recognition minus Cash equivalents: Short-term, highly liquid investments
principal repayments, plus or minus the cumulative that are readily convertible to known amounts of cash
amortisation using the effective interest method of any and which are subject to an insignificant risk of changes
difference between that initial amount and the maturity in value.
amount, and minus any reduction (directly or through Cash flow statement: Provides information about the
the use of an allowance account) for impairment or cash payments and cash receipts of an entity during a
uncollectability. period.
Application: The process whereby prospective shareholders Cash or settlement discount: An incentive for early
apply to the company for an allotment of shares. payment of amounts owing on credit transactions,
Alternatively, an account used to record the amount of normally quoted as a percentage.
money receivable by the company from applicants for Cash-generating unit: The smallest identifiable group
shares. of assets that generates cash inflows that are largely
Asset: A resource controlled by an entity as a result of past independent of the cash inflows from other assets or
events and from which future economic benefits are groups of assets.
expected to flow to the entity. Cash-settled share-based payment transaction: A share-
Associate: An entity over which the investor has significant based payment transaction in which the entity acquires
influence and that is neither a subsidiary nor an interest goods or services by incurring a liability to transfer
in a joint venture. cash or other assets to the supplier of those goods or
Available-for-sale financial assets: Those non-derivative services for amounts that are based on the price (or
financial assets that are designated as available for sale value) of the entity’s shares or other equity instruments
or that are not classified as (a) loans and receivables, of the entity.
GLOSSARY 707
Class of assets: A category of assets having a similar nature Contingent rent: The part of the lease payments that is not
or function in the operations of an entity, and which, fixed in amount but is based on the future amount of
for the purposes of disclosure, is shown as a single item a factor that changes other than with the passage of time.
without supplementary disclosure. Contributed capital
Closing rate: The spot exchange rate at the end of the Control: An investor controls an investee when the
reporting period. investor is exposed, or has rights, to variable returns
Comparability: The quality of accounting information from its involvement with the investee and has the
that results from similar accounting recognition, ability to affect those returns through its power over
measurement, disclosure, and presentation standards the investee.
being used by all entities. Corporate assets: Assets other than goodwill that
Compensation: All employee benefits including share- contribute to the future cash flows of both the cash-
based payments. This includes all forms of consideration generating unit under review and other cash-generating
provided by the entity, or on its behalf, in exchange for units.
services rendered to the entity. Corporate governance: The system by which companies
Component of an entity: Operations and cash flows are directed and managed. It influences how the
that can be clearly distinguished, operationally and for objectives of the company are set and achieved, how
financial reporting purposes, from the rest of the entity. risk is monitored and assessed, and how performance
Conceptual Framework for Financial Reporting: The is optimised. Good corporate governance structures
pronouncement of the International Accounting encourage companies to create value (through
Standards Board that sets out the concepts underlying entrepreneurialism, innovation, development and
the preparation and presentation of financial statements exploration) and provide accountability and control
for external users. systems commensurate with the risks involved.
Consolidated financial statements: The financial Cost: The amount of cash or cash equivalents paid or the
statements of a group in which the assets, liabilities, fair value of the other consideration given to acquire an
equity, income, expenses and cash flows of the parent asset at the time of its acquisition or construction or,
and its subsidiaries are presented as those of a single where applicable, the amount attributed to that asset
economic entity. when initially recognised in accordance with the specific
Constructive obligation: An obligation that derives from requirements of other accounting standards, e.g. IFRS 2
an entity’s actions where: (a) by an established pattern of Share-based Payment.
past practice, published policies or a sufficiently specific Cost approach: A valuation technique that reflects the
current statement, the entity has indicated to other parties amount that would be required currently to replace the
that it will accept certain responsibilities; and (b) as a service capacity of an asset (often referred to as current
result, the entity has created a valid expectation on the replacement cost).
part of those other parties that it will discharge those Costs of conversion: Costs directly related to the units
responsibilities. of production plus a systematic allocation of fixed
Contingency: A condition arising from past events that and variable overheads that are incurred in converting
exists at reporting date and gives rise to either a possible materials into finished goods.
asset or a possible liability, the outcome of which will Costs of disposal: Incremental costs directly attributable
be confirmed only on the occurrence of one or more to the disposal of an asset or cash-generating unit,
uncertain future events that are outside the control of excluding finance costs and income tax expense.
the entity. Costs of purchase: Costs such as purchase price, import
Contingent asset: A possible asset that arises from past duties and other taxes (other than those subsequently
events and whose existence will be confirmed only recoverable by the entity from the taxing authorities),
by the occurrence or non-occurrence of one or more transport, handling and other costs directly attributable
uncertain future events not wholly within the control of to the acquisition of finished goods, materials and
the entity. services.
Contingent consideration: Usually, an obligation of the Costs to sell: The incremental costs directly attributable to
acquirer to transfer additional assets or equity interests the disposal of an asset (or disposal group), excluding
to the former owners of an acquiree as part of the finance costs and income tax expense.
exchange for control of the acquiree if specified future Cumulative: In relation to preference shares, shares on
events occur or conditions are met. However, contingent which undeclared dividends in one year accumulate to
consideration also may give the acquirer the right to the the following year/s until paid.
return of previously transferred consideration if specified Current liability: A liability that (a) is expected to be
conditions are met. settled in the normal course of the entity’s operating
Contingent liability: (a) A possible obligation that arises cycle, or (b) is at call or due or expected to be settled
from past events and whose existence will be confirmed within 12 months of the reporting date.
only by the occurrence or non-occurrence of one or more Current tax: The amount of income taxes payable in
uncertain future events not wholly within the control respect of the taxable profit for a period.
of the entity, or (b) a present obligation that arises Customer options: Customer options are opportunities
from past events but is not recognised because (i) it is provided to the customer to purchase additional goods
not probable that an outflow of resources embodying or services. These additional goods and services may
economic events will be required to settle the obligation, be priced at a discount or may even be free of charge.
or (ii) the amount of the obligation cannot be measured Options to acquire additional goods or services at a
with sufficient reliability. discount can come in many forms, including sales
708 GLOSSARY
incentives, customer award credits (e.g. frequent flyer transaction, and liabilities directly associated with those
programmes), contract renewal options (e.g. waiver of assets that will be transferred in the transaction.
certain fees, reduced future rates) or other discounts on Dividends: A distribution of profit to the equity holders of
future goods or services. a company.
Date of exchange: The date when each individual Economic life: Either the period over which an asset is
investment is recognised in the financial report of the expected to be economically usable by one or more
acquirer. users, or the number of production or similar units
Deductible temporary differences: Temporary differences expected to be obtained from the asset by one or more
that will result in amounts that are deductible in users.
determining taxable profit of future periods when the Effective interest method: A method of calculating the
carrying amount of the asset or liability is recovered or amortised cost of a financial asset or a financial liability,
settled. and of allocating the interest income or interest expense
Deferred tax asset: Amounts of income taxes recoverable over the relevant period.
in future periods in respect of deferred temporary Effective interest rate: The rate that exactly discounts
differences; the carry forward of unused tax losses and estimated future cash payments or receipts through
the carry forward of unused tax credits. the expected life of the financial instrument (or, when
Deferred tax liability: Amounts of income taxes payable appropriate, a shorter period) to the net carrying amount
in future periods in respect of taxable temporary of the financial asset or financial liability.
differences. Embedded derivative: A component of a combined (or
Defined benefit post-employment plans: A defined ‘hybrid’) instrument that also includes a non-derivative
benefit post-employment plan is an arrangement to host contract, with the effect that some of the cash flows
provide benefits after completion of employment that of the combined instrument vary in a way similar to a
does not satisfy the definition of a defined contribution stand-alone instrument.
post employment plan (refer defined contribution post- Employee benefits: All forms of consideration given by an
employment plan) entity in exchange for services rendered by employees.
Defined contribution post-employment plans: A define Employees and others providing similar services:
contribution post-employment plan is an arrangement Individuals who render personal services to the entity
to provide benefits after completion of employment, in and either (a) the individuals are regarded as employees
which the entity pays predetermined contributions to for legal or tax purposes, (b) the individuals work for the
a separate entity which, in turn, pays post-employment entity under its direction in the same way as individuals
benefits to former employees of the first-mentioned who are regarded as employees for legal or tax purposes,
entity. or (c) the services rendered are similar to those rendered
Depreciable amount: The cost of an asset, or other by employees. For example, the term encompasses all
amount substituted for cost, less its residual value. management personnel, that is, those persons having
Depreciation (amortisation): The systematic allocation of authority and responsibility for planning, directing and
the depreciable amount of an asset over its useful life. controlling the activities of the entity, including non-
Derivatives: A financial instrument that derives its value executive directors.
from another underlying item, such as a share price Entity-specific value: The present value of the cash flows
or an interest rate. The definition requires all of the an entity (1) expects to arise from the continuing use of
following three characteristics to be met: (a) its value an asset and from its disposal at the end of its useful life,
must change in response to a change in an underlying or (2) expects to incur when settling a liability.
variable such as a specified interest rate, price, or Entry price: The price paid to acquire an asset or received
foreign exchange rate; (b) it must require no initial net to assume a liability in an exchange transaction.
investment or an initial net investment that is smaller Equitable obligation
than would be required for other types of contracts with Equity: The residual interest in the assets of the entity after
similar responses to changes in market factors; and (c) it deducting all its liabilities.
is settled at a future date. Equity instrument granted: The right (conditional or
Development: The application of research findings or unconditional) to an equity instrument of the entity
other knowledge to a plan or design for the production conferred by the entity on another party, under a share-
of new or substantially improved materials, devices, based payment arrangement.
products, processes, systems or services before the start of Equity instrument: Any contract that evidences a residual
commercial production or use. interest in the assets of an entity after deducting all of its
Direct non-controlling interest (DNCI): An NCI that liabilities.
holds shares directly in a subsidiary. Equity method: The method of accounting whereby
Discontinued operation: A component of an entity that the investment is initially recognised at cost and
either has been disposed of or is classified as held for subsequently adjusted for the post-acquisition change
sale and (a) represents a separate major line of business in the investor’s share of net assets of the associate. The
or geographical area of operations; (b) is part of a profit or loss of the investor includes the investor’s share
single coordinated plan to dispose of a separate major of the profit or loss of the investee.
line of business or geographical area of operations; or Equity-settled share-based payment transaction: A
(c) is a subsidiary acquired exclusively with a view share-based payment transaction in which the entity
to resale. receives goods or services as consideration for equity
Disposal group: A group of assets to be disposed of, instruments of the entity (including shares or share
by sale or otherwise, together as a group in a single options).
GLOSSARY 709
Errors: Omissions from or misstatements in the financial own equity instruments and is: (i) a non-derivative
statements. for which the entity is or may be obliged to deliver a
Exchange difference: The difference resulting from variable number of the entity’s own equity instruments,
translating a given number of units of one currency into or (ii) a derivative that will or may be settled other than
another currency at different exchange rates. by the exchange of a fixed amount of cash or another
Exchange rate: The ratio of exchange for two currencies. financial asset for a fixed number of the entity’s own
Executory contracts: Contracts under which neither party equity instruments (for this purpose the entity’s own
has performed any of its obligations or both parties equity instruments do not include instruments that are
have partially performed their obligations to an equal themselves contracts for the future receipt or delivery of
extent. the entity’s own equity instruments).
Executory costs: Operating amounts (including insurance, Financial position: The assets, liabilities, and residual
maintenance, consumable supplies, replacement parts and equity interest of an entity at a given point in time.
rates) that are paid by the lessor on behalf of the lessee. Financing activities: Those activities that result in changes
Exit price: The price that would be received to sell an asset in the size and composition of the equity capital and
or paid to transfer a liability. borrowings of the entity.
Expenses: Decreases in economic benefits during the Firm commitment: A binding agreement for the exchange
accounting period in the form of outflows or depletions of a specified quantity of resources at a specified price on
of assets or incurrences of liabilities that result in a specified future date or dates.
decreases in equity, other than those relating to First-in, first-out (FIFO): A method of allocating cost
distributions to equity participants. to inventory items that assumes that the items first
Fair value: The price that would be received to sell an asset purchased will be the items first sold.
or paid to transfer a liability in an orderly transaction FOB destination: A condition of sale under which the
between market participants at the measurement date seller pays all freight costs (FOB means ‘free on board’).
(IFRS 13 Fair Value Measurement). FOB shipping: A condition of sale under which freight
Fair value (of a leased asset): The amount for which an costs incurred from the point of shipment are paid by
asset could be exchanged or a liability settled between the buyer (FOB means ‘free on board’).
knowledgeable, willing parties in an arm’s length Forecast transaction: An uncommitted but anticipated
transaction. future transaction.
Faithful representation Foreign currency: A currency other than the functional
Final dividends currency of the entity.
Finance lease: A lease that transfers substantially all Foreign operation: An entity that is a subsidiary, associate,
the risks and benefits incidental to ownership of an asset; joint venture or branch of a reporting entity, the activities
title may or may not eventually be transferred. of which are based or conducted in a country or currency
Financial asset: Any asset that is: (a) cash; (b) an equity other than those of the reporting entity.
instrument of another entity; (c) a contractual right: (i) to Forfeited shares account: An account initially recording
receive cash or another financial asset from another entity, the amount of funds supplied by shareholders whose
or (ii) to exchange financial assets or financial liabilities shares were forfeited.
with another entity under conditions that are potentially Framework for the Preparation and Presentation of Financial
favourable to the entity; or (d) a contract that will or may Statements: The pronouncement of the International
be settled in the entity’s own equity instruments that is: (i) Accounting Standards Board that sets out the concepts
a non-derivative for which the entity is or may be obliged underlying the preparation and presentation of financial
to receive a variable number of the entity’s own equity statements for external users. This has been superseded by
instruments, or (ii) a derivative that will or may be settled the Conceptual Framework for Financial Reporting.
other than by the exchange of a fixed amount of cash or Functional currency: The currency of the primary
another financial asset for a fixed number of the entity’s economic environment in which the entity operates.
own equity instruments (for this purpose the entity’s own Gains
equity instruments do not include instruments that are General purpose financial statements: The financial
themselves contracts for the future receipt or delivery of statements that a business entity prepares and presents at
the entity’s own equity instruments). least annually to meet the common information needs
Financial assets at fair value through profit or loss: of a wide range of users external to the entity.
Financial assets held for trading and measured at fair Geographical segment: A distinguishable component
value with any gain or loss from a change in fair value of an entity that is engaged in providing products or
recognised in profit or loss, or financial assets that upon services within a particular economic environment
initial recognition are designated by the entity as at fair and that is subject to risks and returns that are different
value through profit or loss. from those of components operating in other economic
Financial instrument: Any contract that gives rise to a environments.
financial asset of one entity and a financial liability or Going concern: An entity that is expected to continue in
equity instrument of another. operation for the foreseeable future.
Financial liability: Any liability that is: (a) a contractual Goodwill: An asset representing the future economic
obligation: (i) to deliver cash or another financial asset benefits arising from other assets acquired in a business
to another entity, or (ii) to exchange financial assets or combination that are not individually identified and
financial liabilities with another entity under conditions separately recognised.
that are potentially unfavourable to the entity; or (b) Grant date: The date at which the entity and another party
a contract that will or may be settled in the entity’s (including an employee) agree to a share-based payment
710 GLOSSARY
arrangement, being when the entity and the counterparty determinable, the rate that (at the inception of the lease)
have a shared understanding of the terms and conditions the lessee would incur to borrow over a similar term, and
of the arrangement. At grant date the entity confers on with a similar security, the funds necessary to purchase
the counterparty the right to cash, other assets, or equity the asset.
instruments of the entity, provided the specified vesting Indirect non-controlling interest (INCI): An NCI that
conditions, if any, are met. If that agreement is subject to has an interest in a subsidiary as a result of having an
an approval process (e.g. by shareholders), grant date is interest in the parent of that subsidiary.
the date when that approval is obtained. Initial direct costs: Incremental costs that are directly
Gross investment: The aggregate of the minimum lease attributable to negotiating and arranging a lease,
payments receivable by the lessor under a finance lease except for such costs incurred by manufacturer or dealer
and any unguaranteed residual value accruing to the lessors.
lessor. Initial public offering
Group: A parent and its subsidiaries. Inputs: The assumptions that market participants would
Guaranteed residual value: That part of the residual value use when pricing the asset or liability, including
of the leased asset guaranteed by the lessee or a third assumptions about risk, such as the following: (a) the
party related to the lessee. risk inherent in a particular valuation technique used to
Hedge effectiveness: The degree to which changes in the measure fair value (such as a pricing model); and (b) the
fair value or cash flows of the hedged item that are risk inherent in the inputs to the valuation technique.
attributable to a hedged risk are offset by changes in the Inputs may be observable or unobservable.
fair value or cash flows of the hedging instrument. Intangible asset: An identifiable non-monetary asset
Hedged item: An asset, liability, firm commitment, highly without physical substance.
probable forecast transaction or net investment in a Interest rate implicit in the lease rate: The rate that,
foreign operation that (a) exposes the entity to risk of at the inception of the lease, causes the aggregate
changes in fair value or future cash flows and (b) is present value of the minimum lease payments and the
designated as being hedged. unguaranteed residual value to be equal to the sum of
Hedging instrument: A designated derivative or (for a the fair value of the leased asset and any initial direct
hedge of the risk of changes in foreign currency exchange costs of the lessor.
rates only) a designated non-derivative financial asset or Interim dividends
non-derivative financial liability whose fair value or cash Intrinsic value: The difference between the fair value of the
flows are expected to offset changes in the fair value or shares to which the counterparty has the (conditional
cash flows of a designated hedged item. or unconditional) right to subscribe or which it has the
Held-to-maturity investments: Investments that the right to receive, and the price (if any) the counterparty
entity has the positive intention and ability to hold to is (or will be) required to pay for those shares. For
maturity (e.g. debt instruments, such as debentures held example, a share option with an exercise price of CU15
in another entity or redeemable preference shares) other (currency units) on a share with a fair value of CU20,
than: (a) those that the entity upon initial recognition has an intrinsic value of CU5.
designates as at fair value through profit or loss; (b) those Inventories: Assets held for sale in the ordinary course of
that the entity designates as available for sale; and (c) those business, in the process of production for such sale, or in
that meet the definition of loans and receivables. the form of materials or supplies to be consumed in the
Highest and best use: The use of a non-financial asset production process or in the rendering of services.
by market participants that would maximise the value Investee: An entity in which funds have been invested.
of the asset or the group of assets and liabilities (e.g. a Investing activities: Those activities which relate to the
business) within which the asset would be used. acquisition and disposal of long-term assets and other
Highly probable: Significantly more likely than probable. investments not included in cash equivalents.
Impairment loss: The amount by which the carrying Investment property: Property (land or a building, or
amount of an asset or a cash-generating unit exceeds its part of a building, or both) held to earn rentals or for
recoverable amount (which is the higher of the asset’s capital appreciation or both, rather than for (a) use in
net selling price and its value in use). the production or supply of goods or services or for
Inception of the lease: The earlier of the date of the lease administrative purposes, or (b) sale in the ordinary
agreement and the date of commitment by the parties to course of business.
the principal provisions of the lease. Investor: An entity which invests funds in an investee.
Income: An increase in an asset or a decrease in a liability Joint control: The contractually agreed sharing of control
will result in income, unless the increase or decrease over an economic activity that exists only when the
results from an equity contribution (such as cash raised strategic financial and operating decisions relating to the
through share capital). Because of this broad definition, activity require the unanimous consent of the parties
income is further dissected into revenue and gains. sharing the control (the venturers).
Income approach: Valuation techniques that convert future Joint venture: A contractual arrangement whereby two
amounts (e.g. cash flows or income and expenses) to a or more parties undertake an economic activity that is
single current (i.e. discounted) amount; the fair value subject to joint control.
measurement is determined on the basis of the value Key management personnel: Those persons having
indicated by current market expectations about those authority and responsibility for planning, directing
future amounts. and controlling the activities of the entity, directly or
Incremental borrowing rate: The rate of interest the lessee indirectly, including any director (whether executive or
would have to pay on a similar lease or, if that is not otherwise) of that entity.
GLOSSARY 711
Lease: An agreement whereby the lessor conveys to the Measurement date: The date at which the fair value of the
lessee in return for a payment or series of payments the equity instruments granted is measured for the purposes
right to use an asset for an agreed period of time. of IFRS 2. For transactions with employees and others
Lease payments: The total amounts payable under the providing similar services, the measurement date is
lease agreement. the grant date. For transactions with parties other than
Lease term: The non-cancellable period for which the employees (and those providing similar services), the
lessee has contracted to lease the asset together with measurement date is the date the entity obtains the
any further terms for which the lessee has the option goods or the counterparty renders service.
to continue to lease the asset, with or without further Minimum lease payments: The payments over the lease
payment, when at the inception of the lease it is term that the lessee is or can be required to make,
reasonably certain that the lessee will exercise the option. excluding contingent rent, costs for services and taxes
Level 1 inputs: Quoted prices (unadjusted) in active to be paid by and reimbursed to the lessor, together
markets for identical assets or liabilities that the entity with (a) for a lessee, any amounts guaranteed by the
can access at the measurement date. lessee or by a party related to the lessee, and (b) for a
Level 2 inputs: Inputs other than quoted prices included lessor, any residual value guaranteed to the lessor.
within Level 1 that are observable for the asset or Monetary assets: Money held and assets to be received in
liability, either directly or indirectly. fixed or determinable amounts of money.
Level 3 inputs: Unobservable inputs for the asset or liability. Monetary items: Units of currency held and assets
Liability: A present obligation of the entity arising from and liabilities to be received or paid in a fixed or
past events, the settlement of which is expected to result determinable number of units of currency.
in an outflow from the entity of resources embodying Most advantageous market: The market that maximises
economic benefits. the amount that would be received to sell the asset or
Loans and receivables: Non-derivative financial assets with minimises the amount that would be paid to transfer the
fixed or determinable payments that are not quoted in liability, after taking into account transaction costs and
an active market and which the entity has no intention transport costs.
of trading, e.g. loan to a subsidiary. Net assets: Total assets minus total liabilities.
Market approach: A valuation technique that uses Net investment in a foreign operation: The amount of
prices and other relevant information generated by the reporting entity’s interest in the net assets of that
market transactions involving identical or comparable operation.
(i.e. similar) assets, liabilities or a group of assets and Net realisable value: The estimated selling price in the
liabilities, such as a business. ordinary course of business less the estimated costs of
Market condition: A condition upon which the exercise completion and the estimated costs necessary to make
price, vesting or exercisability of an equity instrument the sale.
depends that is related to the market price of the entity’s Non-adjusting event after the end of the reporting
equity instruments, such as attaining a specified share period: An event that is indicative of conditions that
price or a specified amount of intrinsic value of a share arose after the end of the reporting period.
option, or achieving a specified target that is based Non-cancellable lease: A lease that is cancellable only
on the market price of the entity’s equity instruments (a) upon the occurrence of some remote contingency,
relative to an index of market prices of equity (b) with the permission of the lessor, (c) if the lessee
instruments of other entities. enters into a new lease for the same or an equivalent
Market participants: Buyers and sellers in the principal asset with the same lessor, or (d) upon payment by the
(or most advantageous) market for the asset or liability lessee of an additional amount such that, at inception
that have all of the following characteristics: (a) they of the lease, continuation of the lease is reasonably
are independent of each other, i.e. they are not related certain.
parties as defined in IAS 24, although the price in a Non-controlling interest (NCI): The equity in a subsidiary
related party transaction may be used as an input to a not attributable, directly or indirectly, to a parent.
fair value measurement if the entity has evidence that the Non-performance risk: The risk that an entity will not
transaction was entered into at market terms; (b) they are fulfil an obligation. Non-performance risk includes, but
knowledgeable, having a reasonable understanding about may not be limited to, the entity’s own credit risk.
the asset or liability and the transaction using all available Non-sequential acquisition: Where a parent acquires its
information, including information that might be shares in a subsidiary after that subsidiary has acquired
obtained through due diligence efforts that are usual and shares in its subsidiary.
customary; (c) they are able to enter into a transaction for Notes: Notes are prepared in accordance with IAS 1
the asset or liability; (d) they are willing to enter into a and form part of a set of general purpose financial
transaction for the asset or liability, i.e. they are motivated statements. They contain information in addition to
but not forced or otherwise compelled to do so. that presented in the balance sheet, income statement,
Materiality: The notion of materiality guides the margin of statement of changes in equity and cash flow statement.
error acceptable, the degree of precision required and the They provide narrative descriptions of the basis of
extent of the disclosure required when preparing general preparation of the financial statements and accounting
purpose financial reports. policies adopted, as well as disaggregations of items
Measurement: The process of determining the monetary disclosed in the financial statements and information
amount at which an asset, liability, income or expense is about items that do not qualify for recognition in those
reported in the financial statements. statements.
712 GLOSSARY
Obligating event: An event that creates a legal or Private placement: An issue of shares usually to a large
constructive obligation that results in an entity having no institutional investor such as a finance company,
realistic alternative to settling that obligation. superannuation fund or life insurance company.
Observable inputs: Inputs that are developed using market Probable: More likely than not.
data, such as publicly available information about actual Property, plant and equipment: Tangible items that
events or transactions, and that reflect the assumptions (a) are held for use in the production or supply of goods
that market participants would use when pricing the or services, for rental to others, or for administrative
asset or liability. purposes, and (b) are expected to be used during more
Offsetting: Offsetting refers to the presentation of different than one period.
elements of financial statements on a net basis, such as Prospective application: Applying the change to
the offsetting of income and expense items to present transactions, events or other conditions occurring after
a net gain or loss, or the offsetting of liabilities and the date of the change and recognising the effect in the
assets, so as to report them as a single item, being a net current and future periods.
asset or a net liability. Protective rights: Rights designed to protect the interest of
Onerous contract: A contract in which the unavoidable the party holding those rights without giving that party
costs of meeting the obligations under the contract power over the entity to which those rights relate.
exceed the economic benefits expected to be received Provision: A liability of uncertain timing or amount.
under it. Public company: A company entitled to raise funds from
Operating activities: Those activities which relate to the public by lodging a disclosure document with ASIC
the main revenue-producing activities of the entity and have its shares or other ownership documents traded
and other activities that are not investing or financing on the stock exchange. It may be a limited company,
activities. unlimited company or no-liability company.
Operating lease: A lease other than a finance lease. Reciprocal shareholdings: Where two entities hold shares
Operating segment: An operating segment is defined as in each other.
a component of an entity: (a) that engages in business Recognition: The process of incorporating in the financial
activities from which it may earn revenues and incur statements an item that meets the definition of an asset,
expenses (including revenues and expenses relating to liability, income or expense.
transactions with other components of the same entity); Recoverable amount: For an asset or a cash-generating
(b) whose operating results are regularly reviewed by the unit, the higher of its fair value less costs of disposal and
entity’s chief operating decision maker to make decisions its value in use.
about resources to be allocated to the segment and assess Related party: A person or entity that is related to the
its performance; and (c) for which discrete financial entity that is preparing its financial statements.
information is available. Related party transaction: A transfer of resources, services
Ordinary shares or obligations between a reporting entity and a related
Orderly transaction: A transaction that assumes exposure party, regardless of whether a price is charged.
to the market for a period before the measurement Relevance: That quality of information that exists when
date to allow for marketing activities that are usual the information influences economic decisions made
and customary for transactions involving such assets by users.
or liabilities; it is not a forced transaction (e.g. a forced Relevant activities: For the purpose of IFRS 10, the activities
liquidation or distress sale). of the investee that significantly affect the investee’s
Parent: An entity that controls one or more entities. returns.
Participating: In relation to preference shares, shares that Reliability: Information has the quality of reliability
receive extra dividends above a fixed rate once a certain when it is free from material error and bias and can be
level of dividends has been paid on ordinary shares. depended on by users to represent faithfully that which
Performance: The ability of an entity to earn a profit on it either purports to represent or could reasonably be
the resources that have been invested in it. expected to represent.
Periodic method: A system of recording inventory whereby Reload feature: A feature that provides for an automatic
the value of inventory is determined and recorded on a grant of additional share options whenever the option
periodic basis (normally annually). holder exercises previously granted options using the
Perpetual method: A system of recording inventory entity’s shares, rather than cash, to satisfy the exercise
whereby inventory records are updated each time a price.
transaction involving inventory takes place. Reload option: A new share option granted when a share
Power: Existing rights that give the current ability to direct is used to satisfy the exercise price of a previous share
the relevant activities. option.
Pre-acquisition equity: The equity of the subsidiary at Remuneration: See compensation.
acquisition date. It is not just the equity recorded by the Reportable segment: A business segment or a geographical
subsidiary, but is determined by reference to the cost of segment identified based on the definitions for either a
the business combination. business segment or geographical segment.
Preference shares Reporting entity: An entity in respect of which it is
Presentation currency: The currency in which the financial reasonable to expect the existence of users who rely
report is presented. on the entity’s general purpose financial statements
Principal market: The market with the greatest volume and for information that will be useful to them for making
level of activity for the asset or liability. and evaluating decisions about the allocation of scarce
GLOSSARY 713
resources. A reporting entity can be a single entity or a with IAS 39 Financial Instruments: Recognition and
group comprising a parent and all of its subsidiaries. Measurement.
Research: Original and planned investigation undertaken Sequential acquisition: where a parent acquires its shares
with the prospect of gaining new scientific or technical in a subsidiary before or on the same date that the
knowledge and understanding. subsidiary acquires shares in its subsidiary.
Reserve: A category of equity that is not contributed Share buy-back: The repurchase of a company’s shares by
capital. the company from its shareholders.
Residual value: The estimated amount that an entity Share issue costs: Costs incurred on the issue of equity
would currently obtain from disposal of the asset, after instruments. These include underwriting costs, stamp
deducting the estimated costs of disposal, if the asset duties and taxes, professional advisers’ fees and
were already of the age and in the condition expected at brokerage.
the end of its useful life. Share option: A contract that gives the holder the right,
Retained earnings but not the obligation, to subscribe to the entity’s shares
Retrospective application: Means applying a new at a fixed or determinable price for a specified period of
accounting policy to transactions, other events and time.
conditions as if that policy had always been applied. Share split
Revaluation decrease (increase): The amount by which Share-based payment arrangement: An agreement
the revalued carrying amount of a non-current asset as between the entity and another party (including
at the revaluation date is less than (exceeds) its previous an employee) to enter into a share-based payment
carrying amount. transaction, which thereby entitles the other party to
Revenue: The gross inflow of economic benefits during the receive cash or other assets of the entity for amounts
period arising in the course of the ordinary activities of that are based on the price of the entity’s shares or other
an entity when those inflows result in increases in equity, equity instruments of the entity, or to receive equity
other than increases relating to contributions from instruments of the entity, provided the specified vesting
equity participants. conditions, if any, are met.
Reverse acquisition Share-based payment transaction: A transaction in which
Rights issue: An issue of new shares giving existing the entity receives goods or services as consideration for
shareholders the right to an additional number of shares equity instruments of the entity (including shares or
in proportion to their current shareholdings. share options), or acquires goods or services by incurring
Sale and leaseback liabilities to the supplier of those goods or services for
Scrip dividends amounts that are based on the price of the entity’s shares
Segment accounting policies: Accounting policies adopted or other equity instruments of the entity.
for preparing and presenting the financial statements Significant influence: The power to participate in the
of the consolidated group or entity as well as those financial and operating policies of the investee without
accounting policies that relate specifically to a segment. having control or joint control over those policies.
Segment assets: Operating assets that are employed by Specific identification: A method of allocating cost to
a segment in its operating activities and that either are inventory based on identifying and aggregating all costs
directly attributable to the segment or can be allocated to directly related to each individual inventory item.
the segment on a reasonable basis. Spot exchange rate: The exchange rate for immediate
Segment expense: Expense resulting from the operating delivery.
activities of a segment that is directly attributable to the Statement of changes in equity: A financial statement
segment and the relevant portion of an expense that prepared in accordance with IAS 1 for inclusion in
can be allocated on a reasonable basis to the segment, general purpose financial reports. The statement reports
including expenses relating to sales to external customers on the changes in the entity’s equity for the reporting
and expenses relating to transactions with other period. Changes in equity disclosed may include
segments of the same entity. movements in retained earnings for the period, items of
Segment liabilities: Operating liabilities that result from income and expense recognised directly in equity, and
the operating activities of a segment and that either are movements in each class of share and each reserve.
directly attributable to the segment or can be allocated to Statement of financial position: A financial statement that
the segment on a reasonable basis. presents assets, liabilities and equity of an entity at a
Segment result: Segment revenue less segment expense. given point in time.
Segment result is determined before any adjustments for Statement of profit or loss and other comprehensive
minority interest. income: A financial statement prepared in accordance
Segment revenue: Revenue reported in the entity’s income with the requirements of IAS 1 for inclusion in general
statement that is directly attributable to a segment purpose financial statements. The statement reports
and the relevant portion of entity revenue that can be the entity’s income, expenses, profit or loss, other
allocated on a reasonable basis to a segment, whether comprehensive income and total comprehensive income
from sales to external customers or from transactions for the reporting period.
with other segments of the same entity. Structured entity: An entity that has been designed so
Separate financial statements: Financial statements that voting or similar rights are not the dominant factor
presented by a parent (i.e. an investor with control of in deciding who controls the entity, such as when any
a subsidiary) or an investor with joint control of, or voting rights relate to administrative tasks only and the
significant influence over, an investee, in which the relevant activities are directed by means of contractual
investments are accounted for at cost or in accordance arrangements.
714 GLOSSARY
Subsidiary: An entity, including an unincorporated entity Unguaranteed residual value: That part of the residual
such as a partnership, that is controlled by another entity value of the leased asset, the realisation of which by the
(known as the parent). lessor is not assured or is guaranteed solely by a party
Substance over form: The accounts will reflect the related to the lessor.
underlying economic reality of transactions and not their Unit of account: The level at which an asset or a liability
legal form. is aggregated or disaggregated in an IFRS for recognition
Tax base: Of an asset or liability, the amount attributed to purposes.
that asset or liability for tax purposes. Unobservable inputs: Inputs for which market data are
Tax expense: The aggregate amount included in the not available and that are developed using the best
determination of profit or loss for the period in respect information available about the assumptions that
of current tax and deferred tax. market participants would use when pricing the asset
Taxable profit: The profit for a period, determined in or liability.
accordance with the rules established by the taxation Useful life: (a) The period over which an asset is expected
authorities, upon which income taxes are payable. to be available for use by an entity, or (b) the number of
Taxable temporary differences: Temporary differences that production or similar units expected to be obtained from
will result in taxable amounts in determining taxable the asset by an entity.
profit of future periods when the carrying amount of the Value in use: The present value of future cash flows expected
asset and liability is recovered or settled. to be derived from an asset or cash-generating unit.
Temporary difference: The difference between the carrying Venturer: A party to a joint venture that has joint control
amount of an asset or liability and the tax base of that over that joint venture.
asset or liability. Verifiability
Timeliness Vest: To become an entitlement. Under a share-based
Trade discount: A reduction in selling prices granted to payment arrangement, a counterparty’s right to receive
customers. cash, other assets or equity instruments of the entity
Transaction costs: The costs to sell an asset or transfer a vests when the counterparty’s entitlement is no longer
liability in the principal (or most advantageous) market conditional on the satisfaction of any vesting conditions.
for the asset or liability that are directly attributable to Vesting conditions: The conditions that must be satisfied
the disposal of the asset or the transfer of the liability for the counterparty to become entitled to receive
and meet both of the following criteria: (a) They result cash, other assets or equity instruments of the entity,
directly from and are essential to that transaction. under a share-based payment arrangement. Vesting
(b) They would not have been incurred by the entity had conditions include service conditions, which require the
the decision to sell the asset or transfer the liability not other party to complete a specified period of service,
been made (similar to costs to sell, as defined in IFRS 5). and performance conditions, which require specified
Transport costs: The costs that would be incurred to performance targets to be met (such as a specified
transport an asset from its current location to its increase in the entity’s profit over a specified period of
principal (or most advantageous) market. time).
Understandability: The ability of financial information Vesting period: The period during which all the specified
to be comprehended by financial statement users who vesting conditions of a share-based payment arrangement
have a reasonable knowledge of business and economic are to be satisfied.
activities and accounting, and a willingness to study the Warrants [or Share warrants]
information with reasonable diligence. Weighted average: A method of allocating cost to inventory
Underwriter: An entity which, for a fee, undertakes to items based on the weighted average of the cost of
subscribe for any shares not allotted to applicants as a similar items at the beginning of a period and the cost of
result of an undersubscription. similar items purchased or produced during the period.
GLOSSARY 715
INDEX
accounting book value compared with balance sheet see statement of financial business combination valuation reserve
market capitalisation 356 position (BCVR) 582
accounting estimates 468, 473 bank borrowings 486 business models 169–70
accounting policies 468 bank overdrafts 486 capital 14
retrospective application 469–72 banking industry capital returns 158
selecting and changing 468–73 consolidated assets 455 carry-forward tax losses, creating and
accounting profit employee benefits 246 recouping 132–3
difference from taxable profit 124–6 scrip dividends 35 cash 159, 486–7
permanent differences 124 bargain purchase 281, 326, 327 cash dividends 34
temporary differences 124–6, 133 business combination 391–2 cash equivalents 486–7
Accounting Standards Codification (ASC) bargain renewal 328 cash flow characteristics 170
820: 50 benefit/years of service method 256 cash flow hedge 183
accounts receivable inputs 59 best estimate measurement 100–1 of a firm commitment 185–7
accrual basis of accounting 451 bid prices, inputs based on 57 main requirements of 184
accruals 97 Black–Scholes–Merton formula 203 cash-generating units
accumulated depreciation 423 bonus issue 31 inputs 58, 59
accumulated profit or loss 34 borrowing cost 103, 281–2 reversal of impairment loss 432
acquisition method for business brands 364, 365 cash-settled share-based payments 201,
combination 381–3 broadcasting licence 366 209–12
active markets 58, 365 building held and used inputs 58 accounting 202, 209–10
actuarial gains and losses 260 business combination 385, 388–91 disclosure 212–13
actuaries 258, 263 accounting in records of acquiree 392–5 grant of shares with cash alternative
adjusted market assessment approach, accounting in records of acquirer 383 subsequently added 211
stand-alone selling price acquiree does not liquidate 392–3 transaction where counterparty has
determination 81 acquiree liquidates 393–5 settlement choice 210–11
adjusting event 474 acquirer buys only shares in transaction where entity has settlement
advantageous markets 54–5 acquiree 395 choice 212
agents 569 acquisition accounting method 381–3 combination goodwill 389
revenue from contracts with acquisition analysis by acquirer 390–1 commercial obsolescence 286–7
customers 87 acquisition analysis example 396–8 commercial substance 279–80
aggregation 451 acquisition-related costs 387–8 commodity contracts 158
airline industry cash and monetary assets 385 common stock 24
lease accounting policy consideration transferred 385–8 see also ordinary shares
disclosures 333–5 and consolidation 570–2 companies 22
reserves disclosure notes 37 contingent consideration 386–7 features of corporate
alcoholic beverages industry contingent liabilities 113–15 structure 23–4
statement of changes in equity note cost of issuing debt and equity for-profit 23
disclosures 39 instruments 386 limited liability 24
amortisation of contract costs 85 deferred tax arising from 143 ordinary share issue 24–5
amortised cost determining acquisition date 382–3 returns to shareholders 25
calculating 172–3 disclosure 398–400, 596–7 comparability of information 8–9
financial liabilities 174–5 equity instruments 386 compound financial instruments 163–4
intangible assets 366–7 gain on bargain purchase 391–2 measurement approaches 211
ancillary services 304 general forms of 381 compound securities 31
annual leave 246, 249, 250–1 goodwill 385 Conceptual Framework see Conceptual
ASC see Accounting Standards identifying 380 Framework for Financial Reporting
Codification identifying acquirer 381–2 Conceptual Framework for Financial
ask prices, inputs based on 57 intangible assets 384 Reporting 4
asset revaluation reserve 36 liabilities assumed 386 assets 10, 349
assets 11 measurement 385 assumptions of underlying financial
current 453, 454 nature of 380–1 statements 9
definition 10, 360 non-monetary assets 386 equity 11, 22
disposals of 301 recognition 383–4 expenses 12
identifiable concepts 358–9 subsequent adjustments to contingent expensing of outlays 278
physical and non-physical 359 consideration 395–6 income 11
recognition 12 subsequent adjustments to contingent liabilities 10, 96, 97, 349
significant parts approach 278 liabilities 395 measurement of elements 13
tax bases 134 subsequent adjustments to objective of general purpose financial
usefulness of definitions 360 goodwill 395 reporting 7
see also intangible assets worksheet entries subsequent to physical substance characteristic 359
assets held for sale 276 acquisition date 588–95 purpose of 6–7
Association of German Banks 519 business combination valuation entries qualitative characteristics of financial
automobile industry 578, 640 information 7–9
accounting policy notes and segment worksheet entries at acquisition date reporting entity 7
information 527–31 583–4 stewardship and prudence 14–15
INDEX 717
consideration paid or payable to a customer, partial goodwill method 648–50 contracts
transaction price determination 80–1 realisation of profits or losses 657–8 amortisation and impairment of costs 85
consignment inventories 229 realisation of profits or losses for assets 87
consolidated financial statements 569–70 intragroup transfer for services and combined 75–6
consolidation process 562–4 interest 657–8 costs 84–5, 89
income tax notes 146–7 realisation of profits or losses for inventory definition 75
multiple groups 564 657 disclosures 88–9
reasons for consolidation 563–4 consolidation for wholly owned subsidiaries identification 75–6
consolidation for business combination 578–98 liabilities 87
570–2 acquisition analysis 580–3 modifications 85–6
formation of new entity 570–1 acquisition analysis for parent with no own use 165, 188
reverse acquisitions 571–2 previously held equity interest in see also revenue from contracts with
consolidation for controlled entities 562–74 subsidiary 581–2 customers
ability to use power to affect returns 568 adjustments 578–9 contracts, rights and obligations
agents or principals 569 bonus share dividends 593 approach 165
business combination 570–2 business combination valuation entries contractual right 159
consolidated financial statements 562–4 588–91 contributed equity
disclosure 572–4 business combination valuation entries at share capital issue 26–8
exposure or rights to variable returns 568 acquisition date 583–4 subsequent movements in share capital
group of entities 563 consolidation process 578–9 28–32
level of share ownership 566–7 consolidation worksheets 579–80, 585–6 control criterion for consolidation 564–9
potential voting rights 567–8 contingent liability valuation subsequent controlled entities 564
power 565–8 to acquisition date 590–1 controlling entities 563
preparing consolidated financial disclosure 595–7 convertible bonds 163
statements 569–70 dividends paid/payable from subsidiary convertible notes 163–4
consolidation for foreign subsidiary equity 591–3 core goodwill 389, 398, 639
disclosure 700 equipment valuation entry subsequent to corporate accounting scandals 356
functional currency of parent entity 698–9 acquisition date 589 corporate assets 428–30
local currency is functional currency 691–8 gain on bargain purchase 587–8 corporate social responsibility 450
net investment in foreign operation goodwill valuation entry subsequent to cost approach valuation 56, 59, 289
699–700 acquisition date 591 cost model
consolidation for intragroup transactions information at acquisition date 581 factors influencing choice 299
606–25 inventory valuation entry subsequent to impaired asset 423, 424
dividends declared and paid in current acquisition date 590 intangible assets 365
period 615–16 land valuation entry subsequent to investment properties 304
dividends declared in current period but acquisition date 590 property, plant and equipment 283–8
not paid 614–15 parent has previously held equity interest cost of purchase
intragroup borrowings 616 in subsidiary 583 deferred payment terms 222
intragroup dividends 614–16 patent valuation entry subsequent to trade and cash discounts 221–2
intragroup services 613–14 acquisition date 589–90 transaction taxes 221
intragroup services realisation of profits or pre-acquisition entries 591 costs of conversion 222
losses 614 pre-acquisition entries at acquisition date credit default swaps 188
profits in ending inventory 608–11 584–5 credit-impaired financial assets 177
profits in opening inventory 611–13 pre-acquisition reserve transfers 593–5 credit risk 188, 189, 192
realisation of profit and loss 608 revaluations in records of the subsidiary at currency see functional currency; local
reasons for adjusting 606–7 acquisition date 595 currency; presentation currency
sales of inventory 607–8 subsidiary recorded dividends at currency risk 189
transfers of inventory 607–13 acquisition date 586–7 current cost measurement 13
consolidation for non-controlling interest transfers from retained earnings to other current tax 127–31
(NCI) 636–71 reserves 594 completed worksheet 130
calculating share of equity 636 transfers to retained earnings from other determining tax rates worksheet 128–30
comparing full goodwill and partial reserves 594–5 items recognised outside profit or loss 143
goodwill methods 642 worksheet entries at acquisition date offsetting 143
consolidated worksheet 643 583–8 recognition 131
effects of NCI on process 638–43 worksheet entries subsequent to current value system 14
full goodwill method 639–40 acquisition date 588–95 customer options for additional goods or
intragroup transactions 642 construction industry, financial statements services 77
partial goodwill method 640–2 499–506 cut-off procedures 227, 228
consolidation for non-controlling interest constructive obligation 97, 99, 106, 109, 246 debt instruments
(NCI) share of equity 644–55 contingent assets 111 amortised cost 168, 169, 178–9, 180
accounting at acquisition date 645–50 contingent liabilities 97–8 fair value through other comprehensive
accounting subsequent to acquisition date business combination 113–15 income 168, 169, 178, 179–80
651–5 comparisons between IFRS 3 and IAS 37: fair value through profit or loss 168,
adjusting for effects of intragroup 113–15 169, 180
transactions 656–8, 659–60 difference from provision 98 decommissioning liability 64
consolidation worksheet 655 disclosure 98, 99, 111 decommissioning provisions 107–8
full goodwill method 646–8 contingent rent 327, 331 deductible temporary differences 125, 126,
gain on bargain purchase 658–60 contingent settlement provisions 162–3 132
NCI share of recorded equity of subsidiary continuity assumption 9 deferred revenue 96
644–5 see also going-concern assumption deferred tax 133–9
718 INDEX
adjustments 138 share-based transactions 212–13 end-of-period accounting
from business combination 143 specific 38 control account/subsidiary ledger
calculating temporary differences 135–6 statement of changes in equity 38–9 reconciliations 229–30
determining carrying amounts 133 voluntary 518 inventories 227–30
determining tax bases for assets 133–5 disclosure notes 9 entity-specific value 280
determining tax bases for liabilities 134–5 discount rate entry price 51–2
excluded differences 136–7 impairment of assets 422–3 equity 11
initial recognition of asset or liability 137 lease 327–8 equity distributions classification 164
items recognised outside profit or loss 143 long-service leave 264, 265 equity instruments 159
recognition 291 provision 101–2 business combination 386
recognition of adjustments 141 discussion papers 284–5, 336, 348 definition 157, 162
worksheet 137–9 dividends 34–5 difference from financial liabilities 160–3
deferred tax asset cash 34 disclosure 213
amendments 142–3 consolidation worksheets 586–7 fair value through other comprehensive
calculating 136 declared and paid in current period income 168, 169, 180
recognition 139–41 615–16 fair value through profit or loss 168, 169,
deferred tax liability declared in current period but not paid 180
amendments 142–3 614–15 intrinsic value 207
calculating 136 final 35–6 modifications to terms and conditions
recognition 139–40 interim 35–6 208–9
defined benefit plans 253 intragroup 614–16 subsequent measurement 172
accounting for 255–63 preference 545 equity investments 486
alternative approaches to 255 scrip 34–5 equity method of accounting
amount of asset/liability 258 wholly owned subsidiaries 593 accounting for 202–4
modifications to 259–60 earnings per share 543–53 transactions in which services are received
present value using projected unit credit basic earnings per share 545–8 203
method 256–7 bonus issues and share splits 547 transactions measured by reference to fair
recognised amounts in profit or loss calculation to include tax expense and value of equity instruments granted
258–60 preference dividends 545 203–4
remeasurements of liability/asset to be contingently issuable shares 547 equity-settled share-based payments 201
recognised in other comprehensive determining weighted average number of errors 468, 473
income 260–3 shares 547 correction of 473
worksheet 262–3 diluted 549–52 cut-off 228
defined contribution plans 253, 254 diluted warrants 550 estimation, reliable 99
depreciation dilutive contingently issuable shares 551 European Financial Reporting Advisory
leased assets 342 dilutive convertible securities 551 Group (EFRAG) 519
methods of 285–6 dilutive options 550–1 European opinion about IFRS 8: 519
process of allocation 284–5 dilutive potential of contracts 551–2 executive remuneration
property, plant and equipment 284–8 dilutive potential ordinary shares 550 related party disclosures 542–3
revalued assets 298–9 dilutive shares 550–2 use of earnings per share 544
significant parts 288 disclosure 553 executory contracts 323
subsequent measurement 331 earnings 545 executory costs 327, 331
derivatives 158, 163, 166–8 repurchases and conversion of preference exit price 51–2, 61
embedded 167–8 shares 545–6 expected cost plus margin approach, stand-
fair value through profit or loss 168, retrospective adjustments 553 alone selling price determination 81
169, 180 rights issues 548 expected credit loss model 176, 177–80
required characteristics 167 share consolidation 546–7 expected value approach, variable
detailed formal plans 106, 107 share repurchase 546–7 consideration estimation 78, 79–80
development costs, criteria for capital shares 546 expenses
classification 362–3 weighted average number when one classification 164
diminishing-balance method of depreciation than one issue of potentially dilutive definition 12
285–6 securities 552 recognition 13
direct method 489, 492–6 earnings per share ratio 543–4 exposure drafts 7, 14, 50, 115, 336, 348,
directly attributable costs effective interest method 172 518–19
acquisition for zero or nominal cost 282 effective interest rate 172 extraordinary items 459
business combination 387 embedded derivatives 167–8 fair value
costs not to be included 282 employee benefits 246 definitions 50, 51–3
costs to be included 281–2 bonus plans 252–3 differences 37
income earned 282 definitions 246 fair value hedge 183
directors' reports 450 non-monetary benefits 246 main requirements 184
disclosure payroll 247 simple 184–5
consolidation for wholly owned profit-sharing arrangements 252–3 fair value measurement
subsidiaries 595–7 relationships between employer, pension appropriate valuation techniques 56–7
contingent liabilities 98, 99 plan and employees 253 blockage factors 54
finance lease by lessees 333–6 short-term 246–53 calculating less costs of disposal 421
foreign subsidiaries 700 short-term paid absences 249–52 criticisms about 156
income tax 144–7 termination benefits 266–7 disclosure 65–7
intangible assets 357–8, 367–70 see also long-term employee benefits; post- equity application 65
revenue from contracts with customers employment benefits equity instruments granted 203–4
87–9 employee retirement plans 253 fair value definitions 51–3
INDEX 719
fair value measurement (continued) subsequent measurement 172–3 liabilities recognition 12
financial instruments with offsetting financial capital 14 liquidation basis 451
positions application 65 Financial Crisis Advisory Group report about measurement of elements 13–14
framework 53–9 accounting for financial instruments non-adjusting events after reporting
how transaction and transport costs are during GFC 156–7 period 474–5
used 53 financial guarantee contracts 165, 174 financial statements notes 466–7
incremental 208 financial information characteristics 7–8 accounting policies and sources of
inputs 57–9 financial instruments estimation uncertainty 467
key principles in determining assets or categories 168–71 disclosure 466, 467
liabilities 53–4 classification of liability and equity information about capital 467
lease assets 326 components 163–4 financing activities 487, 488, 498–9
liabilities applications 62–4 common 159 finished goods inventory at retail outlet 58
market participants 55–6 definition 158 finite useful life 366, 367
non-financial assets applications 59–62 disclosure 188–93 firm commitment 182
prioritising inputs 57–8 disclosure of risk 191–3 first-in, first-out (FIFO) cost formula 231,
property, plant and equipment 279–80 gains and losses 175–6 232–3, 234
recurring 66 hybrid 167 food and beverage industry, earnings per
fair value model, investment properties 304 initial measurement 171–2 share 545
faithful representation of financial measurements 171–80 forecast transaction 182, 183
information 8 other disclosures 191 foreign currency hedge 183
FASB/IASB joint projects see IASB/FASB joint reclassification 175 foreign currency translation differences 36–7
projects recognition criteria 171 foreign subsidiaries
finance lease 323, 324 risks pertaining to 188–93 acquisition analysis 692
classification guidance 324, 325, 326, 328, settlement options 163 business combination valuation entries
329, 330 subsequent measurement 172–5 692–3
sale and leaseback transactions 346–7 transfers of financial assets 193 consolidating functional currency is that
finance lease by lessees 330–6 financial liabilities of parent entity 698–9
disclosure 333–6 amortised cost 170, 174–5 consolidating where local currency is
initial recognition of 330 categories 170–1 functional currency 691–8
lease payment schedules 331–3 definition 159 elimination of investment 693
reimbursement of lessor costs and difference from equity instruments 160–3 intragroup transactions 693–4
contingent rent 331 fair value through profit or loss 170, 171 non-controlling interest (NCI) 693
subsequent measurement for assets 331 IFRS 9 requirements 164–5 translating statements of 680
subsequent measurement for liability 331 measurement rules 180 formal agreements 246
finance lease by lessors 336–41 offsetting 65, 181 for-profit companies 23
disclosure 340–1 scope 164–5 forward contracts 171, 186
executory cost and contingent rent 337–9 subsequent measurement 174–5 forward derivatives 167
initial direct costs (IDC) 339–40 financial liabilities versus equity instruments Framework for the Preparation and
initial recognition of 336–7 equity/liability test for ordinary shares Presentation of Financial Statements
lease receipts schedule 338–9 160–1 (the Framework) 6
subsequent measurement 337–9 equity/liability test for preference fringe benefits 246
finance lease by manufacturer/dealer shares 161 full goodwill method 639–40
lessors 341 equity/liability test for settlement in compared with partial goodwill 642
calculating and recognising profit on sale entity’s own equity instruments 162 consolidation worksheet at acquisition
with initial direct costs 341 financial reporting date 646–8
Financial Accounting Standards Board cost constraints of 9 functional currency
(FASB) 5 objective of 7 changing 689
fair value 50, 60 by segments 518 identifying 683–4
FAS 158 Defined Benefit Pension and other financial statements rationale behind using 680–2
Post-retirement Pension Plans 256 adjusting after reporting period 474 statement of financial position 685
functional currency indicators 683 assets definition 10 statement of profit or loss and other
SFAS No. 52 Foreign Currency assets recognition 12 comprehensive income 685
Translation 680 assumption underlying 9 translating into 684–8
SFAS No. 131 Disclosures about Segments of common types of 158 translation from local currency into 686–8
an Enterprise and Related Information 519 components of 450 future cash flow, measuring 422
SFAS No. 133 Accounting for Derivative consistency of presentation 452 futures derivatives 167
Instruments and Hedging Activities 157 disclosure of comparative information 452 gain on bargain purchase
financial assets disclosure of risk 191–3 consolidation worksheets 587–8
amortised cost 168, 169 equity definition 11 NCI 658–60
categories 168–70 expenses definition 12 gains 12
credit-impaired 177 expenses recognition 13 expected disposal of assets 102
definition 159 fair presentation and compliance 451 general price level accounting system 14
fair value through other comprehensive frequency of reporting 452 generally accepted accounting principles
income 168, 169 general principles 451–2 (GAAP) see US GAAP
fair value through profit or loss 168, 169 going-concern assumption 451 global financial crisis (GFC)
IFRS 9 requirements 164–5 income definition 11–12 impact on IAS 39: 156, 162
impaired and uncollectable 176–80 income recognition 13 report on financial instruments during
measurement rules 180 items outside scope of 158 156–7
offsetting 65, 181 key users of 7 going-concern assumption 9–10
scope 164–5 liabilities definition 10–11 financial statements 451
720 INDEX
going-concern goodwill 389 disclosure 433–4 interest-free loan 172
goods in transit 228–9 discount rate 422–3 initial public offering (IPO) 26
goodwill 385, 388–91 other issues relating to goodwill 431–2 input methods, revenue recognition 83
accounting for 390–1 scope of 418 inputs
acquisition analysis 581–2 when to undertake impairment test bid and ask prices 57
allocation to cash-generating units 427 418–20 disclosure 65, 66
cash-generating units 427, 430–2 write-downs 423, 431 level 1: 58, 289
components 389 impairment of assets (cash-generating units level 2: 58, 59, 289
deferred tax liability 136–7 and goodwill) 430–2 level 3: 59, 67, 289
difference from identifiable net assets 390 impairment test 430–2 prioritising 57–8
disclosure of unallocated 434 reversal of previous impairment loss selecting 57
foreign subsidiaries 692 432–3 intangible assets 10, 360
impairment test 419, 430–2 impairment of assets (cash-generating units acquisition as part of business
internally generated 364 excluding goodwill) 426–30 combination 361–2
reversal of impairment loss 432–3 cash flows and individual assets 426 acquisition by way of government grant
guaranteed residual value 328 identifying 426–7 362, 369
hedge accounting 181–8 impairment of contract costs 85 amortisation 366–7
alternatives 188 impairment test 363, 418 business combination 384
conditions for application 182–7 representation diagram 420 cost model 365
discontinuing 187–8 sources of information 419–20 differences between physical and non-
effectiveness 183, 187 timing 431 physical 359
fair value and cash flow hedges 184–7 when to undertake 418–20 disclosures 357–8, 367–70
hedge ratio 187–8 impairment test for individual asset 420–6 finite useful life 366, 367
hedged item 182 calculating fair value less costs of disposal group classifications 367
hedging instrument 182 421 identifiable characteristics 358–9, 389
rebalancing 187–8 calculating value in use 421–3 impairment test 419, 421
types of hedging relationships 182–7 calculating value in use for discount rate indefinite useful life 366, 367
highest and best use of a non-financial asset 422 internally generated 362–3
60, 61–2 calculating value in use for future cash internally generated goodwill 364
hire purchase agreements 322 flows 422 lack of physical substance characteristic
historical cost measurement 13 recognition and measurement of loss 359
hold to collect and sell business model 169 423–6 measurement subsequent to initial
hold to collect business model 169 reversal of loss 432 recognition 364–7
IAS® standards see International Accounting impairment test of goodwill 419, 430–2 monetary assets 358
Standards carrying amount exceeds recoverable nature of 358–60
IASB® see International Accounting Standards amount 431 non-recognised internally generated 363–4
Board recoverable amount exceeds carrying probability test 361
IASB and IFRS Interpretations Committee Due amount 430–1 recognising expense 364
Process Handbook 5 in-combination valuation premise 60–1 recognition and initial measurement
IASB and the IASC Foundation: Who We Are income criteria 360–3
and What We Do 4 definition 11–12 research and development disclosure 369
IASB®/FASB joint projects recognition 13 retirements and disposals 367
on leasing 322, 348 income approach valuation 56, 57, 59, 289 revaluation model 365
on post-employment benefits 256 non-financial assets 56 separability tests 358–9
on revenue recognition 74 income tax 124 separate acquisition 361
IFRIC® 4–5, 6 acknowledging current and future subsequent expenditures 365
IFRIC® Interpretations consequences of items 126 intellectual property, licences from 86–7
IFRIC 1 Changes in Existing amended prior year tax figures 142–3 interest rate
Decommissioning, Restoration and Similar annual payment 131 hedge 183
Liabilities 108 classification in statement of cash flows risk 189
IFRIC 4 Determining whether an 488–9 risk-free 204
Arrangement contains a Lease 322–3 disclosure 144–7 International Accounting Standards (IAS®) 4
IFRIC 13 Customer Loyalty Programmes 74 payment by instalment 131–2 Application Guidance (AG) 157
IFRIC 15 Agreements for the Construction of payment options for 131–2 Basis for Conclusions 7, 8
Real Estate 74 presentation in financial statements 143–4 IAS 1 Presentation of Financial Statements
IFRIC 18 Transfers of Assets from tax losses 132–3 10, 34, 38, 89, 143, 220, 279, 300,
Customers 74 see also current tax; deferred tax 450–75, 636–7
IFRIC 21 Levies 108–9 incremental fair value 208 IAS 2 Inventories 84, 220–37
IFRS® see International Financial Reporting incurred loss model 176 IAS 7 Statement of Cash Flows 486–509
Standards indefinite useful life 366, 367 IAS 8 Accounting Policies, Changes in
IFRS® Advisory Council 5, 6 impairment test for intangible asset 421 Accounting Estimates and Errors 6, 9, 83,
IFRS® Foundation Trustees 5 indirect method 489, 490, 497, 499 234, 283, 304, 468–73
IFRS® Interpretations Committee information IAS 10 Events after the Reporting Period 35,
4–5, 6, 222 disclosure 467 136, 467, 473–5
impairment loss 418 relevancy and reliability 8 IAS 11 Construction Contracts 74
corporate assets 428–30 segment 518 IAS 12 Income Taxes 124–48, 607
reversal 432–3 use in selecting accounting policies 468 IAS 14 Segment Reporting 518
impairment of assets initial direct costs (IDC) 339–40, 341, 342 IAS 16 Property, Plant and Equipment 36,
cash-generating units reversal of initial measurement 50, 84, 220, 276–312, 433, 458
impairment 432 financial instruments 171–2 IAS 17 Leases 74, 322–49
INDEX 721
International Accounting Standards IFRS 3 Business Combinations 53, 96, 105, ancillary services 304
(IAS®) (continued) 113–15, 361, 380–406, 581, 638–9 definition and classification 303
IAS 18 Revenue 11, 13, 74 IFRS 4 Insurance Contracts 74 disclosure 304–5
IAS 19 Employee Benefits 97, 102, 246–68 IFRS 5 Non-current Assets Held for Sale and joint use 303–4
IAS 20 Accounting for Government Grants and Discontinued Operations 220, 545 measurement of 304
Disclosure of Government Assistance 362 IFRS 7 Financial Instruments: Disclosures transfers in and out of 303
IAS 21 The Effects of Changes in Foreign 157, 188–93 joint use properties 303–4
Exchange Rates 680–700 IFRS 8 Operating Segments 427, 434, journal entries
IAS 23 Borrowing Costs 222 518–32 acquiree on liquidation after sale of net
IAS 24 Related Party Disclosures 538–43 reasons for controversy 519 assets 393–4
IAS 27 Consolidated and Separate Financial IFRS 9 Financial Instruments 37, 74, 87, acquiree on sale of business 393
Statements 74, 164–5, 573–4, 591 156, 164, 168–71, 172–3, 176–88 acquisition of machinery 279
IAS 27 Separate Financial Statements 592–3 IFRS 10 Consolidated Financial Statements adjusting to net realisable value 236
IAS 28 Investments in Associates and Joint 74, 164–5, 381, 562–74, 580, 581, bonus issue 31
Ventures 74, 164–5 606–8, 636 business combination 388
IAS 30 Disclosures in the Financial IFRS 11 Joint Arrangements 74 business combination by acquirer 397–8
Statements of Banks and Similar Financial IFRS 12 Disclosure of Interests in Other change of tax rate 142
Institutions 157 Entities 572–4, 596, 638 consolidation for wholly owned
IAS 32 Financial Instruments: Presentation IFRS 13 Fair Value Measurement 50–68, subsidiaries 583, 585–6
26, 33, 65, 157–66, 181, 190, 194 80, 362 convertible notes 164
IAS 33 Earnings per Share 543–53 IFRS 15 Revenue from Contracts with depreciation 285
IAS 36 Impairment of Assets 53, 61, 418–38, Customers 74–89, 96 depreciation of revalued assets 298, 299
593 IFRS 16 Leases 336, 349 dividends 35, 36
IAS 37 Provisions, Contingent Liabilities and International Organization of Securities end-of-period adjustments 230
Contingent Assets 50, 96–115, 384 Commissions (IOSCO) 5 finance lease by lessees 330, 332–3
IAS 38 Intangible Assets 50, 84, 356–72 intragroup borrowings 616 gain on bargain purchase 392
IAS 39 Financial Instruments: Recognition intragroup dividends 614–16 impairment loss 423–4, 428
and Measurement 38, 50, 74, 87, 156–7, intragroup services 613–14 income tax owing 131, 132
176, 181, 183 realisation of profit or losses 657–8 liquidation of acquiree 394–5
IAS 40 Investment Property 50 intragroup transactions 578, 656–8 options 30
IAS 41 Agriculture 50 foreign subsidiaries 693–4 options lapse 30
International Financial Reporting intrinsic value method 207 payroll 248
Interpretations Committee (IFRIC) inventories 232–3 placement of shares 29
4–5, 6 accounting methods 224–7 recognition of goodwill at acquisition
International Accounting Standards Board applying cost formulas 232–4 date 391
(IASB®) 4–6, 50 applying net realisable value rule 236 recouping tax losses 133
advisory bodies 6 assigning cost to inventory items revaluation decrease 294
corporate responses to exposure drafts sold 231–4 revaluation decrease reversing previous
51–2, 56 choice of cost formula 234 increase 294, 295
discussion paper Leases — Preliminary consignment 229 revaluation increases 290
Views 322 consistency in applying costing revaluation with associated tax effect
discussion paper Measurement of Tangible methods 234 291, 292
Fixed Assets 284–5 cost of agricultural produce harvested from rights issues 29
Exposure Draft ED/2010/2 Conceptual biological assets 238 share-based transactions 202
Framework for Financial Reporting — The cost of service providers 222–4 tax effect on gain 291
Reporting Entity 7 costs of conversion 222 tax losses 132
exposure draft Fair Value Measurement 50 costs of purchase 221–2 treasury share cancellation 33
formation of 4 cut-off procedures 228 treasury share reissue 33
highest and best use 60 definition 220–1 write-downs to net realisable value 235
IASB and IFRS Interpretations Committee disclosure 236–7, 457 judgement and use in best estimate
Due Process Handbook 5 end-of-period accounting 227–30 assessments 101
IASB Update 6 excluded costs 222 lease
post-implementation review of IFRS 8: first-in, first-out (FIFO) cost formula 231, bargain purchase option 326, 327
531–2 232–3, 234 bargain renewal 328
standard-setting structure 4–6 goods in transit 228–9 cancellability 324–5
International Accounting Standards initial recognition of 221 changes to standards for 348–9
Committee (IASC) 4, 6, 96 moving average method 231, 232, 233 classification 323–4
Framework for the Preparation and net realisable value 234–6 classification guidance 324–30
Presentation of Financial Statements (the other costs 222 definitions 322–3, 348
Framework) 6 periodic method 224–5 discount rate 327–8
International Accounting Standards perpetual method 225 extent of asset’s economic life transferred
Committee Foundation 4 physical count 227–8 to lessee 326
International Financial Reporting Standards realisation of profits or losses 657 gains/losses from fair value fluctuation
(IFRS®) recognition as expense 236 328
applying professional judgement 4 settlement discounts 222 guaranteed residual value 327
bundle of assets 280–1 techniques for measuring cost 224 incremental borrowing rate 328
compliance 466 transfers of 607–13 initial direct costs (IDC) 327
due process for issuing 5–6 write-downs to net realisable value 235–6 minimum lease payments 327
fair presentation and compliance 451 investing activities 487, 496–8 present value of minimum lease
IFRS 2 Share-based Payment 200–14 investment properties 303 payments 327
722 INDEX
residual value risk 328 non-controlling interest (NCI) 383, 565 results of post-implementation review of
rewards of ownership 323–4 disclosure 572–3, 636–8 IFRS 8: 531–2
risk of ownership 323–4 foreign subsidiaries 693 segment managers 520
sale and leaseback disclosure 348 nature of 636 vertically integrated businesses 522
sale and leaseback transactions 346–8 see also consolidation for non-controlling option contracts 166, 167
specialised asset 328 interest (NCI) option-pricing models 203–4, 213
substantial transfer 328 non-current assets held for sale 66 options 29–30, 550–1
term 324–6 non-derivative financial instruments 163 orderly transactions 52
legal obligation 99, 109 non-monetary assets ordinary shares 24–5, 158
levies 108–9 fair value measurement 59–62 dilutive potential 550
liabilities highest and best use 60 equity/liability test 160–1
current 453, 454 translating into functional currency other comprehensive income (OCI) 34
decommissioning 64 684–5, 698 revaluation increases 290
definition 10–11 non-performance risk liabilities 62–3 see also statement of profit or loss and
fair value measurement 62–4 non-tradeable rights 29 other comprehensive income
held as assets 63–4 obligating event 99, 110 output methods, revenue recognition 83
non-performance risk 62–3 obligation 97 owners 23, 24, 29, 31, 566–7
recognition 12 constructive 97, 99, 106, 109 owners' equity 22
settlement versus transfer 62 legal 99, 109 parent entities 564, 569
tax bases 134–5 possible 97–8 partial capitalisation methods 255
licences from intellectual property 86–7 present 97–8, 99, 106 partial goodwill method 640–2
limited by guarantee 23 observable inputs 57, 421 compared with full goodwill 642
limited liability companies 24 off balance sheet 255, 256, 322 consolidation worksheet at acquisition
liquidity risk 189, 192–3 offsetting date 648–50
listed companies 23 financial assets and liabilities 65, 181, 452 partnerships 22
local currency, translating into functional hedge accounting 182 patents 55
currency 686–8 manufactured 181 payroll 247
long service leave obligations 263–6 tax assets and liabilities 143 accounting 247–8
long-term employee benefits 263–6 onerous contracts 104–5, 110 accrual of wages and salaries 248–9
loss see impairment loss operating activities 487, 488 pension plans 253
market approach valuation 56, 57, 59, 289 operating cycle 220, 454–5 accounting for defined benefit 255
market capitalisation compared with operating lease 323, 342–6 determining deficit or surplus 256–8
accounting book value 356 accounting for 342–3 modifications to defined benefit 259–60
market participants 55–6 accounting for lease incentives 345–6 performance obligations
market risk 189, 193 accounting for lessees 342 disclosure 89
mark-to-market accounting 156 accounting for lessors 342 identification 76–7
materiality 8, 451 classification guidance 324, 325, 329 satisfaction 82–4
materials and measures of net realisable depreciation of leased assets 342 separate 76–7
value 235 disclosure for lessees 344 periodic method 224–5
measurement bases for financial statements disclosure for lessors 344–5 compared with perpetual method 225–7
13–14 initial direct costs (IDC) 341 cost of inventory items 231
mining industry provision requirements 110 cut-off procedures 228
cash and cash equivalents sale and leaseback transactions 347–8 physical count 227–8
disclosures 507 operating segments 518–32 periodic returns 158
cash flows from operating activities 488 75% threshold 522 perpetual method 225
current and non-current assets and aggregation criteria 522–3 compared with periodic method 225–7
liabilities 454 applying definition of reportable cost of inventory items 231
disclosures 456, 457 segments 524 cut-off procedures 228
executive remuneration 252 applying disclosures in practice 527–31 end-of-period adjustments 229–30
non-cash investing and financing automobile industry 527–31 physical count 227–8
activities 508 basic criteria 522 pharmaceutical industry
statement of changes in equity 464–5 chief operating decision maker disclosure 111–13
monetary assets, translating into functional (CODM) 520 intangible assets 369–70
currency 684 comparative information disclosure 527 physical capital 14
most likely amount approach, variable disclosure 524–7 plant, foreign subsidiaries 692–3
consideration estimation 78, 80 entity-wide disclosures 526–7 possible obligation 97–8
moving average method 231, 232, 233 four steps in identifying segments 521 post-employment benefits 253–4
multi-employer plans 253 general information disclosure 525 defined benefit plans 253, 255–63
NCI see non-controlling interest (NCI) identifying 520–2 defined contribution plans 253, 254
net capitalisation 263 identifying reportable segments 522–3 potential voting rights
pension plan 255, 256 identifying segments using matrix convertible debt instruments 568
net realisable value 234–6, 418 structure 521–2 exercisable options 568
estimating 235 maximum number of reportable pre-acquisition entries 578
reasons for falling below cost 235 segments 523 gain on bargain purchase at acquisition
no-liability companies 23 measurement disclosure 525–6 date 588
non-adjusting events 474–5 non-reportable segments 522 worksheet entries at acquisition date
non-cancellable lease 324–5, 345 profit or loss, assets and liabilities 584–5
non-cancellable service agreements 323 disclosure 525 pre-emptive rights 23
non-cash consideration, transaction price quantitative thresholds 522, 524 preference shares 25–6, 161, 163, 545–6
determination 80 reconciliations disclosure 526 present obligation 97–8, 99, 106
INDEX 723
present value measurement 14 difference from contingent liability 98 restructuring provisions 96, 105–7
decommissioning liability 64 disclosure 111–13 retail cost method 222
expected cash flow approach 422 distinguishing from other liabilities 97 retail industry
provision 101–2 expected disposal of assets 102 disclosures 213, 398–400, 540–1
presentation currency 680 future events 102 executive remuneration 544
statement of financial position 689–90 future operating losses 104 key management personnel 540–1
statement of profit or loss and other legal obligation 109 key management personnel compensation
comprehensive income 690–1 levies 108–9 543
translating into 689–91 offshore oilfields 109 potential dilutive ordinary shares 549
principal markets 54–5 onerous contracts 110 property, plant and equipment 276–7
principals 569 present value measurement 101–2 transactions with directors and key
revenue from contracts with customers 87 qualifying costs 107 management personnel 543
probability 99 recognition criteria 98–100 retained earnings 34–6
probability test 361 recording restructuring provisions 106–7 revaluation model 291
product warranties 99 reimbursements 102–3 asset-by-asset basis accounting 289–93
projected unit credit method 256–7, 263, repairs and maintenance 111 class-by-class basis 297
264–6 restructuring 96, 105–7 cost associated with 299
property, plant and equipment risk-adjusted rate 101–2 decrease reversing previous increase 294–5
accounting for depreciable 291–2 risk and uncertainties 101 depreciation of revalued assets 298–9
acquisition date 280 smoke filters 110 impaired asset 423–4
acquisition for zero or nominal cost 282 warranties 109, 112 intangible assets 365
acquisition of multiple assets 280–1 public companies net revaluation increase reversing previous
capitalisation of outlays 284 initial public offering (IPO) 26 decrease 295–6
choosing between cost and revaluation no-par shares issue 26–7 property, plant and equipment 283,
models 299–300 oversubscription 27–8 289–99
costs not to be included 281–2 par value shares issue 24, 27 reasons for adopting 299–300
costs of dismantling, removal or purchase price measurement 279–81 revaluation decrease 293–6
restoration 282–3 acquisition date 280 revaluation decrease worksheet 295
costs to be included 281–2 put option 167 revaluation increase reversing previous
definitions 276 puttable instruments 161 decrease 293
depreciation 284–8 see also financial liabilities revaluation increases 289–93
derecognition reasons 300–1 quantitative disclosures 467 revaluation increases and depreciable
directly attributable costs 281–2 realisable or settlement value assets 291–2
disclosure 301–2, 304–5 measurement 14 revaluation increases and tax-effect
disposals of assets 301 reclassification adjustments 462–3 worksheet 292–3
division into classes 276, 289 reimbursements 102–3 transferring surplus to retained
effects of accounting on asset-by-asset related party relationship 538–43 earnings 297
basis 296–7 close family members with control or revenue, classification of 164
expensing of outlays 278 significant influence 540 revenue from contracts with customers 74
generation of future benefits 278 definitions 538, 539 contract costs 84–5
income earned 282 exemption from disclosure for contract identification 75–6
initial measurement of 278–83 government-related entities 543 contract modifications 85–6
initial recognition of 277–8 identifying a joint venture 542 licences of intellectual property 86–7
investment properties 303–5 identifying associate of entity 541 performance obligations identification
measurement subsequent to initial identifying close member of family 538 76–7
recognition 283 identifying control, joint control and performance obligations
purchase price measurement 279–81 significant influence 539–40 satisfaction 82–4
recording at cost 281 identifying key management personnel presentation and disclosures 87–9
residual value 287–8 540–1 principal versus agent considerations 87
revaluation by asset or class of asset 297 identifying post-employment benefit scope 74
revaluation model 289–99 plans 542 transaction price allocation 81–2
significant parts approach to asset key management personnel transaction price determination 78–81
recognition 278 remuneration 543 reverse acquisitions in business combination
useful life 284, 286–7 non-related relationships 542 571–2
prospectus 26 related party transactions and related party rights see protective rights; substantive rights
protective rights 565 relationships disclosures 542–3 rights issues 29
provision 96 relative stand-alone selling price method 81 adjustment factor containing a bonus
accounting where discounting is applied application 82 element 548
103–4 relevancy of financial information 8 theoretical ex-rights value per share 548
binding sales agreements 107 reporting entity 7 royalties on licences of intellectual
changes and use of 103–4 research costs 135, 362 property 87
contaminated land 109 reserves 22, 34–8 sales-based royalties on licences of
contaminated land and constructive disclosure notes 37 intellectual property 87
obligation 109 transfers 37–8 scrip dividends 34–5
costs that do not qualify as residual approach, stand-alone selling price service agreements 323
restructuring 107 determination 81 settlement 134, 162–3
decision tree for 100 residual value of property, plant and versus transfer 62
decommissioning 107–8 equipment 287–8 share-based transactions 32, 200–1, 213
definitions 97 residual value risk 328 form and features of 201
724 INDEX
grant of equity instruments that are changes in ownership interest of statement of profit or loss and other
repriced 208–9 subsidiaries and other businesses 506–8 comprehensive income 457–63
grant of equity instruments where exercise classifying cash flow activities 487–9 additional line items and labelling 459–60
price varies 206 classifying interest and dividends received functional currency translation 685
grant where number of equity instruments and paid 488 information required for presentation
expected varies 204–5 classifying taxes on income 488–9 458–63
grant with market condition 206 components of cash and cash equivalents items of comprehensive income 458
grant with performance condition linked disclosure 506 limitations 457
to earnings 205 depreciation of plant and impairment of NCI disclosure 637
modifications to terms and conditions intangibles explanation 504 presentation currency translation 690–1
208–9 determining cash paid to suppliers and revaluation increases 290
recognition criteria 201–2 employees 493–5 tax expense 144
repurchases 209 determining cash receipts from customers stock dividend 31
treatment of non-vesting conditions 207 492–3 straight-line method of depreciation
treatment of reload features 207–8 determining income tax paid 495–6 285, 301
treatment of vesting conditions 204–7 determining interest paid 495 structured entities 573
share capital 23 determining interest recovered 493 subsequent measurement
authorisation to increase 28 disclosures that are encouraged but not exceptions to rule 174
issue of 26–8 required 509 finance lease by lessors 337–9
subsequent decreases 32–4 explanations for reconciling adjustments financial instruments 172–5
subsequent movements 28–32 in worksheet 503–5 lease liability 331
share investments 159 financial statements 499 leased assets 331
share options financial statements and additional subsidiaries 564
accounting for repriced 208–9 accounting information 491–2 see also controlled entities; foreign
disclosure 212–13 gain on sale of plant explanation 504 subsidiaries; wholly-owned subsidiaries
recognition as services are rendered across income tax paid explanation 504 subsidiary ledgers 225
vesting period 203 increase in cash and short-term deposits substantive rights 565
reload features 207–8 explanation 505 superannuation see pension plans
share split 31–2 increase in net accounts receivable supermarket industry
share warrants 31 explanation 503 option pricing models 204
shareholders see owners interest expense explanation 504 owners‘ equity 22
shares interest income explanation 504 sustainability reports 450
buy-back 32, 34 inventory increase explanation 503 swap contracts 167
cost of issuing 26 non-cash transaction disclosures 508–9 swaps, credit default 188
issued at discount 27 preparing 491–506 tangible assets 276
issued at premium 27 prepayments explanation 503 tax expense 124, 144
level of ownership 566–7 proceeds from borrowings tax rates
oversubscription 27–8 explanation 505 calculating deferred tax 136
placement of 28–9 proceeds from share issue and payment of change in 142
returns to shareholders 25 cash dividends explanation 505 taxable profit
rights issues 29 profit before tax adjustments circumstances for 125–6
see also public companies explanation 503 difference from accounting profit 124–6
short-term paid absences 249–52 purchase of land and plant permanent differences 124
SIC® see Standing Interpretations Committee explanation 505 temporary differences 124–6, 133
sick leave 246, 249, 251–2 purpose of 486 taxable temporary differences 135, 140
significant financing component, transaction reporting from investing and financing tax-effect worksheets 292–3, 295
price determination 80 activities 490 technical obsolescence 286–7
significant judgements 89 reporting from operating activities telecommunications industry 23
significant parts depreciation 288 489–90 calculating fair value less costs of
sole proprietors 22 reporting on net basis 490 disposal 421
solely payments of principal and interest share of profits of associate explanation impairment of assets 420, 424–6
(SPPI) test 170 503–4 inventories 221
stand-alone selling prices 81–2 summarising cash flows from operating share capital 24–5
stand-alone valuation premise 60 activities 496 treasury shares 34
standard cost methods 222 worksheet 501–2 time value of money 177–8
Standards Advisory Council (SAC) 4 worksheet approach 499–506 timeliness of information 8–9
Standing Interpretations Committee (SIC®) statement of changes in equity 38–9, 463–5 trade payables 97
SIC Interpretation 15 Operating Leases — information for presentation 463–5 tradeable rights 29
Incentives 345, 346 NCI disclosure 637 trademarks 55, 59, 60, 366, 367
SIC Interpretation 31 Revenue — Barter statement of financial position 452–7 transaction and transport costs 52–3, 54–5
Transaction Involving Advertising asset revaluation surplus disclosure 291 transaction price
Services 74 classifications 453–5 allocation 81–2
statement of cash flows disclosure 189–90, 638 determination 78–81
accounts payable explanation 503 functional currency translation 685 transfer versus settlement 62
accrued liabilities explanation 503 information required for notes 456–7 treasury shares 546
cash and cash equivalents 486–7 information required for presentation cancelled 33–4
cash flows from financing activities 498–9 455–7 kept in the company 32
cash flows from investing activities 496–8 limitations 453 reissued 33
cash flows from operating activities 492–6 presentation currency translation 689–90 UK Accounting Standards Board 284–5
INDEX 725
understandability of information 8–9 usage-based royalties on licences of estimating 78, 79
unit holder funds 161 intellectual property 87 verifiability of information 8–9
unit of account 53 useful life 284, 286–7, 331 vesting conditions
unit trusts 161 assessment of 287 distinguishing between non-vesting and
units-of-production method 286 finite and indefinite 366, 367 207
unlimited companies 23 intangible assets 366–7 share-based transactions 204–7
unlisted companies 23 valid expectation test 107 warrants 31, 550
unobservable inputs 57, 59, 421 valuation premise 60–2 weighted average cost formula 231–4
disclosure 67 valuation techniques disclosure 66 weighted average exercise prices 212–13
unrealised profits 608, 657 value in use 61 wholly-owned subsidiaries 578–98
US GAAP 50, 74, 299, 324, 348, 519 variable consideration 78–80 write-downs 235–6, 423, 431
726 INDEX
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A P P LY I N G

LEO VAN DER TAS

Leo van der Tas

PART 3 PRESENTATION AND DISCLOSURES 447

PART 4 ECONOMIC ENTITIES 559

What’s new in this edition?

ABOUT THE AUTHORS xi

Leo van der Tas

xii ABOUT THE AUTHORS

LEARNING After studying this chapter, you should be able to:

CHAPTER 1 The IASB and its Conceptual Framework 3

LO1 1.1 THE INTERNATIONAL ACCOUNTING STANDARDS

1.1.1 Formation of the IASB

1.1.2 The standard-setting structure of the IASB

4 PART 1 Conceptual Framework

appoints, monitors report to

Trustees of the IFRS Foundation

appoint inform oversee, review effectiveness,

IFRS Advisory Council Standard setting

International Accounting Standards Board (IASB)

IFRS Interpretations Committee

FIGURE 1.1 Institutional structure of international standard setting

CHAPTER 1 The IASB and its Conceptual Framework 5

1.1.3 IFRS Interpretations Committee

1.1.4 Advisory bodies

LO2 1.2 THE PURPOSE OF A CONCEPTUAL FRAMEWORK

6 PART 1 Conceptual Framework

1.2.1 The objective of financial reporting

1.2.2 The reporting entity

LO3 1.3 QUALITATIVE CHARACTERISTICS OF USEFUL

1.3.1 Fundamental qualitative characteristics

CHAPTER 1 The IASB and its Conceptual Framework 7

1.3.2 Enhancing qualitative characteristics

8 PART 1 Conceptual Framework

1.3.3 Cost constraint on useful financial reporting

LO4 1.4 GOING CONCERN ASSUMPTION

CHAPTER 1 The IASB and its Conceptual Framework 9

LO5 1.5 DEFINITION OF ELEMENTS IN FINANCIAL

10 PART 1 Conceptual Framework

CHAPTER 1 The IASB and its Conceptual Framework 11

LO6 1.6 RECOGNITION OF ELEMENTS OF FINANCIAL

1.6.1 Asset recognition

1.6.2 Liability recognition

12 PART 1 Conceptual Framework

1.6.4 Expense recognition

LO7 1.7 MEASUREMENT OF THE ELEMENTS OF FINANCIAL

CHAPTER 1 The IASB and its Conceptual Framework 13

LO8 1.8 CONCEPTS OF CAPITAL

LO9 1.9 FUTURE DEVELOPMENTS

14 PART 1 Conceptual Framework

Exercises STAR RATING ★ BASIC ★★ MODER ATE ★★★ DIFFICULT

Exercise 1.1 MEASURING INVENTORIES OF GOLD AND SILVER

CHAPTER 1 The IASB and its Conceptual Framework 15

Exercise 1.3 NEED FOR THE CONCEPTUAL FRAMEWORK VS. INTERPRETATIONS

Exercise 1.4 ASSESSING PROBABILITIES IN ACCOUNTING RECOGNITION

Exercise 1.5 PURCHASE ORDERS

Exercise 1.6 DEFINITIONS OF ELEMENTS AND RECOGNITION CRITERIA

Exercise 1.7 ASSETS

Exercise 1.8 ASSET DEFINITION AND RECOGNITION

16 PART 1 Conceptual Framework