Corporate Reporting Manual Part 2 - Up To 2018

CHAPTER 16
Financial instruments:
recognition and
measurement
Introduction
Topic List
1 Introduction and overview of earlier studies
2 Recognition and derecognition
3 Measurement and impairment
4 Application of IFRS 13 to financial instruments
5 Derivatives
6 Embedded derivatives
7 IFRS 9 Financial Instruments and current developments
Summary and Self-test
Technical reference
Answers to Interactive questions
Answers to Self-test
733
Introduction
Learning objectives Tick off
 Determine and calculate how different bases for recognising, measuring and classifying
financial assets and financial liabilities can impact upon reported performance and position
 Evaluate the impact of accounting policies and choice in respect of financing decisions for
example hedge accounting and fair values
 Explain and appraise accounting standards that relate to an entity's financing activities
which include: financial instruments; leasing; cash flows; borrowing costs; and
government grants
 Identify and explain current and emerging issues in corporate reporting
Specific syllabus references for this chapter are: 1(e), 4(a), 4(c), 4(d)
734 Corporate Reporting

1 Introduction and overview of earlier studies C
H
A
Section overview P
T
 This section gives a chapter overview and summarises the material covered at Professional Level in E
order to consolidate student knowledge before more advanced issues are covered. R
 IAS 39 Financial Instruments: Recognition and Measurement

– A financial instrument should initially be measured at fair value, usually including transaction 16
costs.
– Subsequent remeasurement depends on how the financial asset or financial liability is
classified.
– Financial assets and liabilities should be measured either at fair value or at amortised cost.
– IAS 39 contains detailed requirements regarding the derecognition of financial instruments.
– Financial assets (other than assets recognised at fair value through profit or loss, and fair
value can be measured reliably) should be reviewed at each reporting date for objective
evidence of impairment.
 IFRS 9 Financial Instruments
– Simplifies the requirements of IAS 39.
– Issued in 2014, but IAS 39 remains the main examinable standard on recognition and
measurement of financial instruments. However, it is important to have an awareness of IFRS 9,
particularly in terms of how future accounting periods may be affected.
1.1 Introduction
The purpose of this chapter is to provide thorough coverage of the accounting treatment of financial
instruments. The main presentation and disclosure requirements as detailed in IAS 32 Financial
Instruments: Presentation and IFRS 7 Financial Instruments: Disclosures together with certain aspects of
recognition and measurement of IAS 39 Financial Instruments: Recognition and Measurement have already
been covered at Professional Level. This chapter extends the coverage of recognition and derecognition
of financial assets and liabilities, and their initial and subsequent measurement and impairment, and
finally discusses particular issues relating to the definition of derivatives and the accounting treatment of
derivatives and embedded derivatives.
1.2 Summary of material covered at Professional Level

The accounting treatment of financial instruments is covered at Professional Level. The emphasis at that
level is on presentation and disclosure and less on recognition and measurement. The main points
covered at Professional Level can be summarised as follows:
(a) A financial instrument is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity.
(b) An equity instrument is any contract that evidences a residual interest in the assets of another
entity after deducting all of its liabilities.
(c) A financial asset is any asset that is cash, an equity instrument of another entity, a contract that
(subject to certain conditions) will or may be settled in the entity's own equity instruments or a
contractual right:
(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.
Financial instruments: recognition and measurement 735

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

Interactive question 1: Classification of equity instruments
C
Are there circumstances in which an investment in equity should be classified as a held-to-maturity H
investment? A
P
See Answer at the end of this chapter. T
E
R
Interactive question 2: Classification

16
During the financial year ended 28 February 20X5, Dennis issued the two financial instruments
described below.
Requirement
For each of the instruments, identify whether it should be classified as a financial liability or as part of
equity, explaining the reason for your choice.
(a) Redeemable preference shares with a coupon rate of 8%. The shares are redeemable on
28 February 20X9 at a premium of 10%.
(b) A grant of share options to senior executives. The options may be exercised from 28 February 20X8.
See Answer at the end of this chapter.
Interactive question 3: Transactions covered by IAS 39

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

IAS 39 follows a mixed measurement model under which some financial instruments are carried at fair
value while others are carried at amortised cost, and some gains or losses are recognised in profit or loss
and others in other comprehensive income.
The following two tables summarise the accounting treatment of each category of financial asset and
financial liability under IAS 39, provided they have not been designated as hedged items. The
accounting treatment of hedged items follows different rules and these are discussed in the next
chapter.
Summary of accounting treatment of assets
Measurement
Asset after initial Gains
category Description recognition and losses
Financial assets at Any financial asset which is held for the Fair value In profit or loss
fair value through purpose of selling in the short term (held for
profit or loss trading) or, in limited circumstances, is
designated under this heading.

Measurement
Asset after initial Gains
Available-for-sale Non-derivative financial assets designated as Fair value In other

financial assets available for sale or not classified under any of comprehensive
the other three headings. income, except
that investment
income,
impairment losses
and foreign
exchange gains
and losses are in
profit or loss
Loans and Non-derivative financial assets with fixed or Amortised cost In profit or loss
receivables determinable payments that are:
 Not quoted in an active market
 Not designated as at fair value through
profit or loss
 Not held for trading or designated as
available for sale
(ie, loans and receivables are none of the
above)
Held-to-maturity Non-derivative financial assets with fixed or Amortised cost In profit or loss
investments determinable payments and fixed maturity that
an entity has the positive intention and ability
to hold to maturity and are not
designated/classified under any of the other
three headings.
Note: These categories are simplified under IFRS 9 (see section 7). It is important to have an awareness
of IFRS 9, but IAS 39 remains the main examinable standard, so the IAS 39 categories should be used in
questions unless asked specifically for the IFRS 9 ones.
Interactive question 4: Convertible bonds

RP issued £4 million 5% convertible bonds on 1 October 20X8 for £3.9 million. The bonds have a four
year term and are redeemable at par. At the time the bonds were issued the prevailing market rate for
similar debt without conversion rights was 7%. The effective interest rate associated with the bonds is
7% and the liability is measured, in accordance with IAS 39 Financial Instruments: Recognition and
Measurement, at amortised cost. The interest due was paid and recorded within finance costs during the
year.
Requirement
Prepare the accounting entries to record the issue of the convertible bonds and to record the
adjustment required in respect of the interest expense on the bonds for the year ended
30 September 20X9.

Interactive question 5: Classification and measurement
C
Financial instrument (a) H
A
DG acquired 500,000 shares in HJ, a listed entity, for £3.50 per share on 28 May 20X9. The costs P
associated with the purchase were £15,000 and were included in the cost of the investment. The T
directors plan to realise this investment before the end of 20X9. The investment was designated on E
acquisition as held for trading. There has been no further adjustment made to the investment since the R
date of purchase. The shares were trading at £3.65 each on 30 June 20X9.
Financial instrument (b) 16
DG purchased a bond with a par value of £5 million on 1 July 20X8. The bond carries a 5% coupon, payable
annually in arrears and is redeemable on 30 June 20Y3 at £5.8 million. DG fully intends to hold the bond
until the redemption date. The bond was purchased at a 10% discount. The effective interest rate on the
bond is 10.26%. The interest due for the year was received and credited to investment income in the
statement of profit or loss.
Requirement
Explain how financial instruments (a) and (b) should be classified, initially measured and subsequently
measured. Prepare any journal entries required to correct the accounting treatment for the year to
30 June 20X9.
Interactive question 6: Recording and measurement

(a) MNB acquired an investment in a debt instrument on 1 January 20X0 at its par value of £3 million.
Transaction costs relating to the acquisition were £200,000. The investment earns a fixed annual
return of 6%, which is received in arrears. The principal amount will be repaid to MNB in four
years' time at a premium of £400,000. The investment has been correctly classified as held to
maturity. The investment has an effective interest rate of approximately 7.05%.
Requirement
(i) Explain how this financial instrument will be initially recorded and subsequently measured in
the financial statements of MNB, in accordance with IAS 39 Financial Instruments: Recognition
and Measurement.
(ii) Calculate the amounts that would be included in MNB's financial statements for the year to
31 December 20X0 in respect of this financial instrument.
(b) MNB acquired 100,000 shares in AB on 25 October 20X0 for £3 per share. The investment resulted
in MNB holding 5% of the equity shares of AB. The related transaction costs were £12,000. AB's
shares were trading at £3.40 on 31 December 20X0. The investment has been classified as held for
trading.
Requirement
Prepare the journal entries to record the initial and subsequent measurement of this financial
instrument in the financial statements of MNB for the year to 31 December 20X0.

Interactive question 7: Bonds and shares
(a) QWE issued 10 million 5% five-year convertible £1 bonds on 1 January 20X0. The proceeds of
£10 million were credited to non-current liabilities and debited to bank. The 5% interest paid has
been charged to finance costs in the year to 31 December 20X0.
The market rate of interest for a similar bond with a five-year term but no conversion terms is 7%.
Requirement
Explain and demonstrate how this convertible instrument would be initially measured in
accordance with IAS 32 Financial Instruments: Presentation and subsequently measured in
accordance with IAS 39 Financial Instruments: Recognition and Measurement in the financial
statements for the year ended 31 December 20X0.
(b) The directors of QWE want to avoid increasing the gearing of the entity. They plan to issue
5 million 6% cumulative redeemable £1 preference shares in 20X1.
Requirement
Explain how the preference shares would be classified in accordance with IAS 32 Financial
Instruments: Presentation, and the impact that this issue will have on the gearing of QWE.
Interactive question 8: Bonds

The Myntech Company issued 100,000, £1,000 par value bonds to the market at par on 1 July 20X0.
The bonds pay a semi-annual rate of interest of 3% based on nominal value. Interest payments are
made on 31 December and 30 June.
The financial institution that organised the placement charged £80,000 and there were other associated
fees that amounted to £20,000.
The effective semi-annual return on the bonds, taking into account the issue costs, has been calculated
at 3.0117%.
The bonds are quoted on a public stock exchange and, due to a persistent rise in market interest rates,
were quoted at £996.40 on 31 December 20X0 and £989.50 on 31 December 20X1.
Requirement
Calculate the carrying amount of the bonds in the financial statements of Myntech as at
31 December 20X1. Present your answer to the nearest £1,000.
Summary of accounting treatment of liabilities
Measurement
Liability after initial Gains
Financial liabilities Any financial liability which is held for the Fair value In profit or loss
at fair value purpose of selling in the short term (held for
through profit or trading) or, in limited circumstances, is
loss designated under this heading.
Other liabilities Financial liabilities that are not classified as at Amortised cost In profit or loss
fair value through profit or loss.

2 Recognition and derecognition C
H
A
Section overview P
T
This section deals with certain aspects of recognition and derecognition and includes the guidelines of E
the standard. R
2.1 Introduction 16
IAS 39 requires that a financial asset or a financial liability should be recognised by an entity in its
statement of financial position when the entity becomes a party to the contractual provisions of the
financial asset or financial liability.
IAS 39 also requires that a financial asset or financial liability should be derecognised; that is, removed,
from an entity's statement of financial position, when the entity ceases to be a party to the financial
instrument's contractual provisions.
The recognition of financial instruments is in general more straightforward than derecognition and
IAS 39 pays more attention to establishing rules for the latter.
2.2 Initial recognition

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

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

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

An entity entered into a contractual commitment on 27 December 20X4 to purchase a financial asset
for £1,000. On 31 December 20X4, the entity's reporting date, the fair value was £1,005. The
transaction was settled on 5 January 20X5 when the fair value was £1,007. The entity has classified the
asset as at fair value through profit or loss.
Requirement
How should the transactions be accounted for under trade date accounting and settlement date
accounting?
Solution
Trade date accounting
 On 27 December 20X4, the entity should recognise the financial asset and the liability to the
counterparty at £1,000.
 At 31 December 20X4, the financial asset should be remeasured to £1,005 and a gain of £5
recognised in profit or loss.
 On 5 January 20X5, the liability to the counterparty of £1,000 will be paid in cash. The fair value of
the financial asset should be remeasured to £1,007 and a further gain of £2 recognised in profit or
loss.
Settlement date accounting
 No transaction should be recognised on 27 December 20X4.
 On 31 December 20X4, a receivable of £5 should be recognised (equal to the fair value movement
since the trade date) and the gain recognised in profit or loss.
 On 5 January 20X5, the financial asset should be recognised at its fair value of £1,007. The
receivable should be derecognised, the payment of cash to the counterparty recognised and the
further gain of £2 recognised in profit or loss.
Interactive question 9: Regular way sale of a financial asset

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

2.4 Derecognition of financial assets
C
2.4.1 Criteria for derecognition H
A
Derecognition is the removal of a previously recognised financial instrument from an entity's statement P
of financial position. T
E
An entity should derecognise a financial asset when: R
(a) the contractual rights to the cash flows from the financial asset expire; or
(b) the entity transfers substantially all the risks and rewards of ownership of the financial asset to 16
another party.
Derecognition of a financial asset is often straightforward, as the above criteria can be implemented
easily. For example, a trade receivable should be derecognised when an entity collects payment. The
collection of payment signifies the end of any exposure to risks or any continuing involvement.
However, more complex transactions may involve the transfer of legal title to another entity but only a
partial transfer of risks and rewards, so that the original owner of the asset is still exposed to some of the
risks and rewards of owning the asset. This is discussed further below.
Worked example: Risks and rewards

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

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

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

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

a part or all of an asset (or group of similar assets)
Have the rights to the Yes

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

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

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

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

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

Derecognise the asset
control of the asset?
Yes
Continue to recognise the asset to the extent of the entity’s continued

involvement
Figure 16.1: Derecognition

The following points relate to this flowchart:
C
(a) If the contractual rights to receive the cash flows from the asset have expired or have been wholly H
transferred, the whole of the asset should be derecognised. This is also the case if the contractual A
rights have been retained by the entity but it has assumed a contractual obligation to pay the cash P
flows to one or more recipients. Such an obligation is only assumed if: T
E
(i) there is no obligation to pay unless amounts are actually collected; R
(ii) the entity is forbidden to sell or pledge the original asset other than to the recipient of the
cash flows; and
16
(iii) the entity must remit the cash flows collected without material delay.
(b) If an entity has sold just a portion of the cash flows arising from an asset, only part of the asset
should be derecognised.
(c) If substantially all the risks and rewards of ownership have been transferred, the financial asset
should be derecognised; if they have not, it should not.
(d) If the entity has neither retained nor transferred all the risks and rewards of ownership, it should
determine whether it has retained control of the financial asset. If it has, it continues to recognise
the asset to the extent of its continuing involvement.
Some common transactions, such as repurchase agreements, factoring and securitisations, that are
employed in order to try to remove assets from the statement of financial position are discussed below.
Remember always to apply the principle of substance over form.
2.4.4 Repurchase agreements

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

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

Illustration: Factoring without recourse
Entity A carries in its statement of financial position receivables measured at £10 million. It sells the
receivables in a factoring transaction without recourse to Entity B for £8.5 million of cash.
Entity A should derecognise the receivables, as it has transferred the risks and rewards to Entity B. The
loss of £1.5 million should be recognised in profit or loss.
Illustration: Factoring with full recourse

Entity A carries in its statement of financial position receivables measured at £10 million. It sells the
receivables in a factoring transaction with full recourse to Entity B for £8.5 million of cash. Entity A
guarantees to reimburse Entity B in cash if the receivables realise less than £8.5 million.
In this example Entity A has transferred the right to receive the receivables to Entity B but it has not
transferred all the risks. The asset should not be derecognised. The cash received should be credited to a
liability account (in essence a loan from the factor).
2.4.6 Securitisations
Securitisation is the process whereby an originator packages pools of, for instance, loans, receivables or
the rights to future income streams that it owns and then sells the packages. Investors buy the
repackaged assets by providing finance in the form of securities or loans which are secured on the
underlying pool and its associated income stream. Securitisation thereby converts the originator's illiquid
assets into liquid assets.
Illustration: Securitisation
Some football clubs have needed to raise cash quickly to buy players. They have therefore obtained
immediate cash which has been securitised to the lender by the rights to the income from the first
tranche of future season ticket sales.
Another example is a bank that has extended mortgages to individuals. It will receive cash flows in
future in the form of interest payments. However, it cannot demand early repayment of the mortgages.
If, however, it sells the rights to the interest cash flows from the mortgages to a third party, it could
convert the income stream into an immediate lump sum (therefore, receiving today the present value of
a future cash flow).
Securitisation often involves the use of a structured entity (SE) to acquire the originator's receivables or
loans. The SE issues debt to third parties to raise the finance to repay the originator.
Illustration: Structured entities

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

A key aspect of whether risk is transferred would be whether the originator retains the risk of bad debts.
Thus if the originator sells 90% of a package to the SE and retains 10%, then it is arguable that C
substantially all risks and rewards of ownership have been transferred. If, however, the originator H
A
transfers the 90% package but agrees to retain all the bad debt risk of the entire portfolio, then risks and
P
rewards have not been transferred and the loan package should not be derecognised. T
E
The derecognition criteria will be met if the SE is not under the control of the originator and there are
R
no guarantees provided by the originator. In this case the derecognition takes the package of loans out
of the group accounts and the group recognises cash received instead. The benefit then is that it
improves the credit rating of the originator, as cash is a better asset than the package of mortgages.
16
Securitisation has had a bad name since 2008, when the repackaging of sub-prime loans was partly
responsible for the crises in some US banks.
2.5 Derecognition of financial liabilities

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

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

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

Interactive question 10: Sale of cash flows debt instrument
During the year ended 31 December 20X0, Jones sold to a third party the right to receive the interest
cash flows on a fixed maturity debt instrument it holds and will continue to legally own up to the date
of maturity. The debt instrument is quoted in an active stock market. The entity has no obligation to
compensate the third party for any cash flows not received.
Requirement
Discuss whether the debt instrument should be derecognised.
Interactive question 11: Derecognition of financial assets and liabilities

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

If a new loan is agreed between a borrower and a lender, or the two parties agree revised terms for an
existing loan, the accounting depends on whether the original liability should be derecognised and a
new liability recognised, or whether the original liability should be treated as modified.
A new liability should be recognised if the new terms are substantially different from the old terms. The
terms are substantially different if the present value of the cash flows under the new terms, including
any fees payable/receivable, discounted at the original effective interest rate, is 10% or more different
from the present value of the remaining cash flows under the original terms. There is said to be an
'extinguishment' of the old liability. In these circumstances:
 The difference between the carrying amount extinguished and the consideration paid should be
 The fees payable/receivable should be recognised as part of that gain or loss.
If the difference between the two present values is below this cut-off point, there is said to be a
modification of the terms. In these circumstances:
 The existing liability is not derecognised.
 Its carrying amount is adjusted by the fees payable/receivable and amortised over the remaining
term of the modified liability.

3 Measurement and impairment C
H
A
Section overview P
T
This section deals with certain aspects of initial and subsequent measurement of financial instruments, E
especially the treatment of transaction costs and of valuation methods when fair values are not R
available.
16
3.1 Introduction
It was noted earlier that financial assets and financial liabilities should initially be measured at fair
value (cost). Subsequently:
 Financial assets should be remeasured to fair value, unless they are loans and receivables, held-to-
maturity investments or financial assets whose value cannot be reliably measured.
 Financial liabilities should be remeasured to amortised cost unless they are at fair value through
profit or loss.
Note: IFRS 9 modifies the rules (see section 7) but IAS 39 remains the extant standard, so you need to
know the IAS 39 rules.
3.2 Initial measurement

Financial instruments should initially be measured at the fair value of the consideration given or
received (ie, cost) plus (in most cases) transaction costs that are directly attributable to the
acquisition or issue of the financial instrument.
The exception to this rule is where a financial instrument is at fair value through profit or loss. In this
case transaction costs are immediately recognised in profit or loss.
The fair value of the consideration is normally the transaction price or market prices. If market prices are
not reliable, the fair value may be estimated using a valuation technique (for example, by discounting
cash flows).
The categories for financial instruments are important because they determine how a particular
instrument should be measured subsequent to initial recognition. The definitions given in section 1 of
this chapter are now set in fuller detail.
Definitions
A financial asset or liability at fair value through profit or loss is one which meets either of the
following conditions:
(a) It is classified as held for trading. A financial asset or liability is classified as held for trading if it is:
(i) acquired or incurred principally for the purpose of selling or repurchasing it in the near term;
(ii) part of a portfolio of identified financial instruments that are managed together and for which
there is evidence of a recent actual pattern of short-term profit-taking; or
(iii) a derivative (unless it is a designated and effective hedging instrument – see the next
chapter).
(b) Upon initial recognition it is designated by the entity as at fair value through profit or loss. An
entity may only use this designation in severely restricted circumstances ie,:
(i) where it eliminates or significantly reduces a measurement or recognition inconsistency
('accounting mismatch') that would otherwise arise; and
(ii) where a group of financial assets/liabilities is managed and its performance is evaluated on
a fair value basis.

Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments
and fixed maturity that an entity has the positive intent and ability to hold to maturity other than:
(a) those that the entity upon initial recognition designates as at fair value through profit or loss;
(b) those that the entity designates as available for sale; or
(c) those that meet the definition of loans and receivables.
Loans and receivables are non-derivative financial assets with fixed or determinable payments that are
not quoted in an active market, other than:
(a) those that the entity intends to sell immediately or in the near term, which should be classified as
held for trading and those that the entity upon initial recognition designates as at fair value
through profit or loss;
(b) those that the entity upon initial recognition designates as available for sale; or
(c) those for which the holder may not recover substantially all of the initial investment, other than
because of credit deterioration, which shall be classified as available for sale.
An interest acquired in a pool of assets that are not loans or receivables (for example, an interest in a
mutual fund or a similar fund) is not a loan or a receivable.
Available-for-sale financial assets are those non-derivative financial assets that are designated as
available for sale or are not classified as:
(a) loans and receivables;
(b) held-to-maturity investments; or
(c) financial assets at fair value through profit or loss. (IAS 39)
Worked example: Fair value of interest-free loan

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

Transaction costs are defined as the incremental costs that are directly attributable to the acquisition,
issue or disposal of a financial asset or liability. Transaction costs should be added to the initial fair value
except for financial assets and financial liabilities classified as at fair value through profit or loss where
they should be recognised in profit or loss. The detailed requirements of IAS 39 are set out below:
 For financial instruments that are measured at fair value through profit or loss, transaction costs
should not be added to the fair value measurement at initial recognition. They are expensed when
incurred.
 For other financial assets, transaction costs, for example fees and commissions, should be added to
the amount initially recognised.
 For other financial liabilities, directly related costs of issuing debt should be deducted from the
amount of debt initially recognised.

 For financial instruments that are carried at amortised cost (such as held-to-maturity
investments, loans and receivables, and financial liabilities that are not at fair value through C
profit or loss) transaction costs should be included in the calculation of amortised cost using the H
A
effective interest method and amortised through profit or loss over the life of the instrument. In
P
practice, many entities write off the transaction costs on a straight-line method. While not in T
accordance with IAS 39, they claim that the difference is immaterial. E
R
 For available-for-sale financial assets, transaction costs should be recognised in other
comprehensive income as part of a change in fair value at the next remeasurement. If an available-
for-sale financial asset does not have fixed or determinable payments and has an indefinite life, the
16
transaction costs are reclassified to profit or loss when the asset is derecognised or becomes
impaired. If an available-for-sale financial asset has fixed or determinable payments and does not
have an indefinite life, the transaction costs are amortised to profit or loss using the effective
interest method.
Transaction costs expected to be incurred on transfer or disposal of a financial instrument should not be
included in the remeasurement of the financial instrument to fair value.
It is not uncommon for explicit transaction costs to be immaterial and for market traders to trade
financial instruments by offering bid and offer/ask prices. In such circumstances the transaction costs are
effectively within the bid-ask price spread.
Worked example: Transaction costs 1

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

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

After initial recognition loans and receivables and held-to-maturity (HTM) investments should be
remeasured at amortised cost using the effective interest method.
Certain investments in equity instruments should be measured at cost. These are equity investments
that do not have a quoted market price in an active market and whose fair value cannot be reliably

measured, together with derivatives that are linked to and must be settled by delivery of such unquoted
equity instruments.
All other financial assets should be remeasured to fair value, without any deduction for transaction
costs that may be incurred on sale or other disposal.
Definitions
The amortised cost of a financial asset or financial liability is the amount at which the financial asset or
liability is measured at initial recognition minus principal repayments, plus or minus the cumulative
amortisation using the effective interest method of any difference between that initial amount and the
maturity amount, and minus any write down (directly or through the use of an allowance account) for
impairment or uncollectability.
Effective interest method: A method of calculating the amortised cost of a financial instrument and of
allocating the interest income or interest expense over the relevant period.
Effective interest rate: The rate that exactly discounts estimated future cash payments or receipts
through the expected life of the financial instrument to the net carrying amount of the financial asset or
liability.
Gains and losses on remeasurement should be recognised as follows:

(a) Changes in the carrying amount of financial assets at fair value through profit or loss should be
(b) Changes in the carrying amount of loans and receivables and HTM investments should be
recognised in profit or loss. Changes arise when these financial assets are derecognised or impaired
and through the amortisation process.
(c) In respect of AFS financial assets:
(i) Impairment losses and foreign exchange differences should be recognised in profit or loss.
(ii) Interest on an interest-bearing asset should be calculated using the effective interest method
and recognised in profit or loss.
(iii) All other gains and losses should be recognised in other comprehensive income and held in a
separate component in equity. On derecognition, either through sale or impairment, gains
and losses previously recognised in other comprehensive income should be reclassified to
profit or loss, becoming part of the gain or loss on derecognition.
Note: IFRS 9 simplifies the categories (see section 7). While IAS 39 remains the extant standard, some
knowledge of IFRS 9 is required, and it may be examinable.
Worked example: Financial liability

In the year ended 31 December 20X0, Smith entered into a contractual commitment to make a variable
rate loan to a customer beginning on 1 January 20X1 for a fixed period at 1% less than the rate at
which the entity (not the customer) can borrow money.
Requirement
Explain the accounting treatment for the above transaction in accordance with IAS 39.
Solution
The commitment to provide a loan to the customer appears to have been entered into at less than
market interest rates, given that the rate is lower than that at which the entity can borrow money on the
market. A commitment to provide a loan at less than market interest rates represents a financial liability.
This is because the entity has an obligation to pay more interest on financing the loan than it will receive
from the customer.
The commitment was entered into during 20X0 and is initially measured at its fair value. Interest income
is recognised on this amount using the effective interest method under IAS 18 Revenue.

At the year end, the liability is increased to its IAS 37 provision valuation ('the best estimate of the
expenditure required to settle the present obligation') if this amount exceeds the amount of the initial C
fair value recognised less amounts already amortised to profit or loss using the effective interest rate. H
A
Any difference is charged to profit or loss. P
T
E
Interactive question 12: IAS 39 R
Which of the following can be held at amortised cost under IAS 39?
(1) A trade receivable 16
(2) 6% debentures issued by the reporting company on 1 January 20X1 and repayable at a premium
of 20% after three years
(3) An interest rate option
(4) Investment in the redeemable preference shares of another company
A (1) and (2) only
B (2) and (4) only
C (2), (3) and (4) only
D (1), (2) and (4) only
Worked example: Measurement of HTM asset

On 1 January 20X4 an entity subscribed for a £20,000 5% bond, interest being payable annually in
arrears. The bond was issued at a discount of 5% and was redeemed at a premium of 5% on
31 December 20X6. The effective interest rate of the financial instrument was calculated as 8.49%. As a
result in changes in general interest rates, the fair value of the bond was £19,400 at 31 December 20X4
and £20,400 at 31 December 20X5.
Requirements
Calculate the amounts to be recognised in the entity's financial statements for each of the three years
ended 31 December 20X6 if:
(a) The asset was classified as HTM
(b) The asset was classified as AFS
Solution
(a) A HTM investment should be measured at amortised cost using the effective interest method. The
amounts in the financial statements should be determined as follows.
Statement of Interest at Cash received Statement of
financial 8.49% effective at 5% of financial
position carrying rate recognised £20,000 position carrying
Year amount b/f in profit or loss nominal value amount c/f
£ £ £ £
20X4 19,000 1,613 (1,000) 19,613
20X5 19,613 1,665 (1,000) 20,278
20X6 20,278 1,722 (22,000)* 0
* Includes redemption of £20,000 × 105% = £21,000.
(b) The interest on an AFS financial asset should be recognised in profit or loss using the effective
interest method. The carrying amount should then be remeasured to fair value with changes being
recognised in other comprehensive income.

Carrying Carrying
amount Interest as Cash flow Fair value amount
Year b/f before as before change (bal fig) c/f
£ £ £ £ £
20X4 19,000 1,613 (1,000) (213) 19,400
20X5 19,400 1,665 (1,000) 335 20,400
20X6 20,400 1,722 (22,000) (122) 0
Included in other comprehensive income is a debit of £213 in 20X4 for the loss in fair value, a credit of
£335 in 20X5 for the gain in fair value and a debit in 20X6 as the cumulative gain is removed.
When shares ('old shares') classified as AFS are exchanged for other shares ('new shares'), perhaps as a
result of a takeover, any gains or losses on the old shares previously recognised in other comprehensive
income should be reclassified from other comprehensive income to profit or loss and the new shares
should be measured at their fair value.
Worked example: Exchange of shares

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

3.5.1 Classification
Financial assets and financial liabilities should be classified at the time of their initial recognition.
For a financial asset to be classified as a held-to-maturity investment it must meet the specified narrow
criteria. The entity must have a positive intent and a demonstrated ability to hold the investment to
maturity. These conditions are not met in the following circumstances:
(a) The entity intends to hold the financial asset for an undefined period.
(b) The entity stands ready to sell the financial asset in response to changes in interest rates or risks,
liquidity needs and similar factors (unless these situations could not possibly have been reasonably
anticipated).
(c) The issuer has the right to settle the financial asset at an amount significantly below its amortised
cost (because this right will almost certainly be exercised).
(d) The entity does not have the financial resources available to continue to finance the investment
until maturity.
(e) The entity is subject to an existing legal or other constraint that could frustrate its intention to hold
the financial asset to maturity.
An equity instrument cannot meet the criteria for classification as held to maturity, because it has no
fixed maturity.
Any financial asset may be designated as available for sale.

3.5.2 Reclassification
C
Reclassification into another category is not allowed for assets or liabilities at fair value through profit or H
loss (but see the amended rules in the next paragraph). A
P
Other financial assets may be reclassified if circumstances change. For example, if in respect of held-to- T
maturity investments there is a change of intention or ability to hold to maturity, it is no longer E
appropriate for such investments to continue in the same category. They should instead be reclassified R
as available for sale and measured at their then fair value. Any gain or loss on reclassification should be
16
There is a penalty for reclassifying (or indeed selling) a held-to-maturity investment:
(a) All remaining held-to-maturity investments should also be classified as available for sale and
remeasured to fair value.
(b) No investment may be classified as held to maturity if there has been a reclassification or sale
during the current financial year or during the two preceding financial years. The held-to-maturity
classification is said to be tainted.
This penalty is applied unless:
(a) the amount reclassified/sold is insignificant compared to the total amount of held-to-maturity
investments; or
(b) the reclassification or sale was within three months of maturity, or after the entity has collected
substantially all the amounts of the original principal, or was the result of an event beyond the
entity's control and which could not reasonably have been anticipated.
Worked example: Reclassifying financial assets

On 1 January 20X4, an entity classifies a portfolio of 10 six-year bonds as HTM investments. On
30 June 20X5, the entity sells six of the assets for their fair value of £16 each. At that date the amortised
cost of each financial asset using the effective interest method was £12. On 1 January 20X8, the fair
value of each financial asset was £21. The entity has a 31 December reporting date.
Requirement
How should the above be accounted for?
Solution
The HTM category is tainted on 30 June 20X5 when the entity sells more than an insignificant amount
(in this case 60%) of the HTM financial assets. At that date, the remaining financial assets should be
reclassified as AFS. They should be measured at £64 (4 × £16) and the gain of £16 (4 × (£16 – £12))
The category of HTM investments is unavailable for classification for the remainder of the 20X5 financial
year and the two following financial years. The financial assets may be reclassified as HTM on
1 January 20X8 when the classification is cleansed. On that date, the fair value of £84 (4 × £21)
becomes the new amortised cost and the total gain of £36 (4 × (£21 – £12)) recognised in other
comprehensive income should be amortised to profit or loss over the remaining two-year term to
maturity, using the effective interest rate method.
3.6 Amended reclassification rules

Changes introduced in 2008 permit entities to reclassify non-derivative financial assets out of the 'fair
value through profit or loss' and 'AFS' categories in limited circumstances. Additional disclosures are
required.
In 2008, the IASB published amendments to IAS 39 Financial Instruments: Recognition and Measurement
and IFRS 7 Financial Instruments: Disclosures. The IASB had come under pressure to bring the
reclassification of financial assets into line with US GAAP, thus creating a 'level playing field'. The
amendments are effective retrospectively from 1 July 2008.

3.6.1 Scope
The amendment only applies to reclassification of some non-derivative financial assets recognised in
accordance with IAS 39. Reclassification is not permitted for financial liabilities, derivatives and financial
assets that are designated as at fair value through profit or loss (FVTPL) on initial recognition under the
'fair value option'.
The amendments therefore only permit reclassification of debt and equity financial assets subject to
meeting specified criteria. They do not permit reclassification into FVTPL.
3.6.2 Criteria for reclassification out of fair value through profit or loss and available for sale
The criteria vary depending on whether the asset would have met the definition of 'loans and
receivables' if it had not been classified as FVTPL or AFS on initial recognition.
(a) If a debt instrument would have met the definition of loans and receivables, had it not been
required to be classified as held for trading at initial recognition, it may be reclassified out of FVTPL
provided the entity has the intention and ability to hold the asset for the foreseeable future
or until maturity.
(b) If a debt instrument was classified as AFS, but would have met the definition of loans and
receivables if it had not been designated as AFS, it may be reclassified to the loans and receivables
category provided the entity has the intention and ability to hold the asset for the
foreseeable future or until maturity.
(c) Other debt instruments or any equity instruments may be reclassified from FVTPL to AFS or, in the
case of debt instruments only, from FVTPL to HTM if the asset is no longer held for selling in the
short term.
3.6.3 Measurement at the reclassification date

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

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

One of the first companies to take advantage of the change was Deutsche Bank. For illustrative
purposes, here is the relevant extract from the Annual Report for the year ended 31 December 2008:

Following the amendments to IAS 39 and IFRS 7, the Group reclassified certain trading assets and
financial assets available for sale to loans and receivables. The Group identified assets, eligible under the C
amendments, for which at the reclassification date it had a clear change of intent and ability to hold for H
A
the foreseeable future rather than to exit or trade in the short term. The disclosures below detail the
P
impact of the reclassifications to the Group. T
E
In the third quarter of 2008, reclassifications were made with effect from 1 July 2008 at fair value at that
R
date. As the consolidated financial statements for the year ended 31 December 2008 were prepared,
adjustments relating to the reclassified assets as disclosed previously in the Group's interim report as of
30 September 2008 were made to correct immaterial errors. Disclosure within this note has been
16
adjusted for the impact of these items.
The following table shows carrying values and fair values of the assets reclassified at 1 July 2008.
1 July 2008 31 December 2008
Carrying value Carrying value Fair value
€m €m €m
Trading assets reclassified to loans 12,677 12,865 11,059
Financial assets AFS reclassified to loans 11,354 10,787 8,628
Note: IFRS 9 restricts reclassification further (see section 7). While IAS 39 remains the extant standard,
some knowledge of IFRS 9 is required, and it may be examinable.
3.7 Subsequent measurement of financial liabilities

Financial liabilities at FVTPL should be remeasured at fair value, excluding disposal costs, and any
change in fair value should be recognised in profit or loss.
All other financial liabilities should be remeasured at amortised cost using the effective interest method.
Where a liability is carried at amortised cost, a gain or loss is recognised in profit or loss when the
financial liability is derecognised or through the amortisation process.
Any difference is charged to profit or loss.
Interactive question 13: Financial liability

Chipping Co is preparing its financial statements for the year ended 30 September 20X5.
Chipping raised a loan with Norton bank of £40 million on 1 October 20X4. The market interest rate of
8% per annum is to be paid annually in arrears and the principal is to be repaid in 10 years' time. The
terms of the loan allow Chipping to redeem the loan after seven years by paying the interest to be
charged over the seven year period, plus a penalty of £4 million and the principal of £40 million. The
effective interest rate of the repayment option is 9.1%. The directors of Chipping are currently
restructuring the funding of the company and are in initial discussions with the bank about the
possibility of repaying the loan within the next financial year.
The directors of Chipping are uncertain about the accounting treatment for the current loan agreement
and whether the loan can be shown as a current liability because of the discussions with the bank and as
yet it has not been accounted for. How will profit be affected if it is expected that the loan is repaid
early?
Requirement
Show the appropriate treatment of the loan, together with workings showing how the figures are
derived, and stating any effect on profit for the year if the treatment needs to be corrected.

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

Financial asset 10,000 –
WORKINGS
£'000
Cash – 1.1.20X5 10,000
Effective interest at 8% (same as nominal, as no discount or premium to be 800
amortised)
Coupon received (nominal interest 8%  10m) (800)
At 31.12.20X5 10,000
Effective interest at 8% 800
Coupon and capital received ((8%  10m) + 10m) (10,800)
At 31.12.20X6 0
Interactive question 14: Financial instruments – valuation of bonds

(a) Graben Co purchases a bond for £441,014 on 1 January 20X1. It will be redeemed on
31 December 20X4 for £600,000. The bond will be HTM and carries no coupon.
Requirement
Using the table below, calculate the measurement of the bond for the statement of financial position
as at 31 December 20X1 and the finance income to be recognised in profit or loss for that year.
n
Compound sum of £1: (1 + r)
Year 2% 4% 6% 8% 10% 12% 14%
1 1.0200 1.0400 1.0600 1.0800 1.1000 1.1200 1.1400
2 1.0404 1.0816 1.1236 1.1664 1.2100 1.2544 1.2996
3 1.0612 1.1249 1.1910 1.2597 1.3310 1.4049 1.4815
4 1.0824 1.1699 1.2625 1.3605 1.4641 1.5735 1.6890
5 1.1041 1.2167 1.3382 1.4693 1.6105 1.7623 1.9254
(b) Baldie Co issues 4,000 convertible bonds on 1 January 20X2 at par. Each bond is redeemable three
years later at its par value of £500 per bond, which is its nominal value.
The bonds pay interest annually in arrears at an interest rate (based on nominal value) of 5%. Each
bond can be converted at the maturity date into 30 £1 shares.
The prevailing market interest rate for three-year bonds that have no right of conversion is 9%.
Cumulative three-year annuity factors:
5% 2.723
9% 2.531
Requirement
Calculate the amounts to be recognised at 1 January 20X2.

Worked example: Debt instrument with fixed rate
C
An entity issues irredeemable debt instruments at their par value of £5 million with an 8% coupon, the H
market rate for such instruments. A
P
Requirement T
E
Explain how these instruments should be measured on initial recognition and subsequently.
R
Solution
These instruments should initially be measured at their fair value of £5 million. 16
There is no evidence that these instruments were issued for trading purposes, so they should
subsequently be measured at amortised cost. Because they are irredeemable, there is no maturity
amount to be compared with the amount initially recognised, so there is no difference to be amortised
to profit or loss. They should always be carried at £5 million.
Worked example: Perpetual debt instrument with decreasing interest rate

Requirement
If the stated interest rate on a perpetual debt instrument decreases over time, would amortised cost
equal the principal amount in each period?
Solution
No. From an economic perspective, the interest payments are repayments of the principal amount. For
example, the interest rate may be stated as 16% for the first 10 years and as 0% in subsequent periods.
In that case the initial recognised amount is amortised to 0 over the first 10 years.
3.8 Fair value measurement issues

The definition and determination of fair value is crucial, given its importance as a measurement principle
for certain financial instruments. The definition of fair value in IAS 39 is consistent with that in IFRS 13
Fair Value Measurement (see Chapter 2, section 4): it is the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction between market participants at the measurement
date.
The application of IFRS 13 to financial instruments is covered in section 4.
IAS 39 provides a hierarchy of approaches for the determination of the fair value based on the following:
 The quoted price of an instrument that trades in an active market
 Valuation techniques for instruments that do not trade in active markets
Unquoted equity instruments and their derivatives which cannot be measured reliably at fair value
should be measured at cost.
For instruments that trade in active markets, dealers often quote two prices, such as 315p – 317p. The
315p price is the price at which the dealers will buy (the bid price) and the 317p price is the price at
which they will sell (the offer or ask price).
IAS 39 specifies that the quoted price that should be used for measurement purposes is as follows:
Instrument held Instrument to be acquired
Financial asset Bid Ask (but adjust for transaction costs)
Financial liability Ask Bid

Worked example: Measurement of financial asset
An entity purchases 10,000 units of a financial asset which is quoted at 198p – 200p and pays
commission totalling 3p per unit. At the entity's first subsequent year end, the market quotes the
financial asset at 218p – 220p and it would cost 6p per unit to dispose of it.
Requirements
Explain how this financial asset should be measured on initial recognition and at the subsequent year
end assuming it is classified as:
(a) A financial asset at fair value through profit or loss
(b) An available-for-sale financial asset
(c) A held-to-maturity investment
Solution
(a) A financial asset at fair value through profit or loss
On initial recognition the asset should be measured at fair value. For financial assets treated as at
FVTPL, IAS 39 regards the bid price as the fair value. The bid-offer spread is considered as a
transaction cost and, along with any other transaction costs, is recognised as an expense in profit
or loss. So the asset should be measured at £19,800 (10,000 × 198p bid price) and the £500
(10,000 × 5p) transaction costs recognised as an expense. (Transaction costs comprise both
commission of 3p per unit and the bid-offer spread of 2p per unit.)
At the year end no account should be taken of the potential disposal costs, so the asset should be
remeasured at the 218p bid price, so £21,800, with the £2,000 gain in fair value being recognised
in profit or loss.
(b) An available-for-sale financial asset
For an available-for-sale financial asset the bid-offer spread is considered as a transaction cost, but
(along with other transaction costs) is added to the fair value (bid price) of the financial asset
(rather than being treated as an expense as for FVTPL assets). On initial recognition the asset
should therefore be measured at fair value with the addition of the transaction costs. So the asset
should be measured at £20,300 (10,000 × (198p bid price + 5p transaction costs)).
At the year end no account should be taken of the potential disposal costs, so the asset should be
remeasured at the 218p bid price, so £21,800, with the £1,500 gain in fair value being recognised
in other comprehensive income.
(c) A held-to-maturity investment
On initial recognition the asset should be measured in the same way as if it was an available-for-
sale financial asset, so it is recognised at £20,300.
It should subsequently be remeasured at amortised cost (there is insufficient information to be able
to calculate this).
Interactive question 15: Pompeii

On 1 January 20X6 The Pompeii Company purchased 7% bonds at par with nominal value of £500,000,
classifying them as at fair value through profit or loss.
The fair values of Pompeii's holding of the bonds (before the sale referred to below) have been:
At 1 January 20X6 £500,000
At 31 December 20X6 £560,000
At 31 December 20X7 £600,000
Interest on the bonds is payable on 31 December each year.
On 31 December 20X7 Pompeii sold one quarter of its holding of the bonds ex-interest for £150,000.
Transaction costs incurred on the sale were £6,000.

Requirement
C
Calculate the total amount to be recognised in profit or loss in respect of this financial asset in Pompeii's H
financial statements for the year ending 31 December 20X7. A
P
See Answer at the end of this chapter. T
E
R
Interactive question 16: Forstar
On 1 January 20X6, The Forstar Company purchased 500,000 ordinary shares in The Pokurukuru 16
Company, a company quoted on an active market, designating them as available-for-sale financial
assets.
The fair values of Forstar's holding of the shares (before the sale referred to below) have been:
At 1 January 20X6 £500,000
At 31 December 20X6 £560,000
At 31 December 20X7 £600,000
Pokurukuru does not pay any dividends.
On 31 December 20X7 Forstar sold one quarter of its holding of the shares for £150,000. Transaction
costs incurred on the sale were £4,000.
Requirement
Calculate the total amounts to be recognised in profit or loss and in other comprehensive income in
respect of this financial asset in Forstar's financial statements for the year ending 31 December 20X7.
Interactive question 17: Greentree

Greentree Co had the following transactions in financial instruments in the year ended 31 December 20X2:
(a) Purchased 4% debentures in MT Co on 1 January 20X2 (their issue date) for £100,000 as an
investment. Greentree decided to hold them until their redemption after six years at a premium of 17%.
Transaction costs of £2,000 were incurred on purchase. The internal rate of return of the bond is 6%.
(b) Entered into a speculative interest rate option costing £7,000 on 1 September 20X2 to borrow
£5,000,000 from GF Bank commencing 31 March 20X3 for six months at 5.5%. Value of the
option at 31 December 20X2 was £13,750.
(c) Purchased 25,000 shares in EG Co in 20X1 for £2.00 each as an available-for-sale financial asset.
Transaction costs on purchase or sale are 1% of the purchase/sale price. The share price on
31 December 20X1 was quoted at £2.25 – £2.28. Greentree sold the shares on 20 December 20X2
for £2.62 each.
(d) Sold some shares in BW Co 'short' (ie, sold shares that were not yet owned) on 22 December 20X2
for £24,000 (the market price of the shares on that date) to be delivered on 10 January 20X3. The
market price of the shares at 31 December 20X2 was £28,000.
Requirement
Show the accounting treatment of these transactions and relevant extracts from the financial statements
for the year ended 31 December 20X2.
Use of mid-market prices

The standard does not permit the use of mid-market prices (average of bid and offer prices) for
valuation purposes. The reason is that to do so would be to recognise early the gains or losses between
the bid/offer price and mid-market price.
The only case where mid-market prices can be used is when an entity holds assets and liabilities with
offsetting market risks. In those circumstances the entity may use mid-market prices as a basis for

establishing fair values for the offsetting risk positions and apply the bid or ask price to the net open
position as appropriate. The IASB believes that use of the mid-market price is appropriate because the
entity has locked in its cash flows from the asset and liability and potentially could sell the matched
position without incurring the bid-ask spread. It is presumed that such matching positions would be
settled within a similar time period.
Unavailability of published prices

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

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

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

If there is no active market for a particular financial instrument, fair value should be determined using a
valuation technique. The aim of the technique is to obtain an estimate of the price that would be
obtained in a market transaction. Such techniques could include recent market transactions,
transactions in other shares or securities that are substantially the same, discounted cash flow models
and option pricing models. The inputs to such models should be market based and not entity specific;
that is, they should incorporate data which market participants would use to value the asset but should
not take account of factors which are only relevant to the owner of the asset (such as strategic
importance to it).
Appropriate techniques for valuing financial instruments should include observable data about the
market conditions that are likely to affect the fair value of an instrument. IAS 39 includes the time value
of money, credit risk, exchange rates, volatility, equity prices, prepayment risk and servicing costs as
examples of factors to be considered.
Recognition where no reliable fair value is available
In the limited circumstances where no active market exists and no reliable fair value is available, equity
investments, such as unquoted equity, and their related derivatives should be measured at cost less
impairment. This exclusion only applies where the range of reasonable fair value estimates is significant
and the probabilities of various estimates cannot be reasonably assessed. The exclusion is only

appropriate for financial instruments linked to unquoted equity investments. IAS 39 requires all other
equity instruments to be measured at fair value. C
H
A
3.9 Impairment P
T
A summary of the impairment process is as follows. E
R
At each year end, an entity should assess whether there is any objective evidence that a financial asset or
group of assets is impaired.
16
The following are indications that a financial asset or group of assets may be impaired.
(a) Significant financial difficulty of the issuer
(b) A breach of contract, such as a default in interest or principal payments
(c) The lender granting a concession to the borrower that the lender would not otherwise consider,
for reasons relating to the borrower's financial difficulty
(d) It becomes probable that the borrower will enter bankruptcy
(e) The disappearance of an active market for that financial asset because of financial difficulties
(f) An adverse change in the payment status of borrowers in a group of financial assets
(g) Economic conditions that correlate with defaults on the assets in a group of financial assets
Where there is objective evidence of impairment, the entity should determine the amount of any
impairment loss.
3.9.1 Financial assets at fair value through profit or loss

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

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

An entity has a 7% loan receivable of £1,000. Interest is payable annually in arrears and the principal is
repayable in three years' time. The amortised cost of the loan is £1,000. The original effective rate of
interest was 7% and the current effective interest rate is 8%.
The borrower is in financial difficulty and the entity has granted a concession in that no annual interest
is payable and the principal will be repaid in four years' time at a premium of 10%.
Requirement
Explain how the carrying amount of the loan should be calculated.
Solution
The financial difficulty of, and the granting of a concession to, the issuer are both objective evidence of
impairment. The recoverable amount should be calculated as £839 by discounting the £1,100 agreed
repayment at the original effective interest rate of 7% over a four-year period.

In Year 1, interest income of £59 (7%  £839) should be recognised and the carrying amount of the
loan increased to £898. This process should be repeated through Years 2–4, at which point the loan will
be carried at £1,100 immediately before repayment.
Interactive question 18: Restructuring

Because of Customer B's financial difficulties, Entity A is concerned that Customer B will not be able to make
all principal and interest payments due on a loan in a timely manner. It negotiates a restructuring of the loan.
Entity A expects that Customer B will be able to meet its obligations under the restructured terms.
Requirement
In which of the following cases should Entity A recognise an impairment loss?
(a) Customer B will pay the full principal amount of the original loan five years after the original due
date, but none of the interest due under the original terms.
(b) Customer B will pay the full principal amount of the original loan on the original due date, but
none of the interest due under the original terms.
(c) Customer B will pay the full principal amount of the original loan on the original due date, with
interest only at a lower interest rate than the interest rate inherent in the original loan.
(d) Customer B will pay the full principal amount of the original loan five years after the original due
date and all interest accrued during the original loan term, but no interest for the extended term.
(e) Customer B will pay the full principal amount of the original loan five years after the original due date
and all interest, including interest for both the original term of the loan and the extended term.
Interactive question 19: Impairment of financial asset

Broadfield Co purchased 5% debentures in A Co on 1 January 20X3 (their issue date) at par for
£100,000. The term of the debentures was five years and the maturity value is £130,525. The effective
rate of interest on the debentures is 10% and Broadfield classified them as a held-to-maturity
investment.
At the end of 20X4 A Co went into liquidation. All interest had been paid until that date. On
31 December 20X4 the liquidator of A Co announced that no further interest would be paid and only
80% of the maturity value would be repaid, on the original repayment date.
The market interest rate on similar bonds is 8% on 31 December 20X4.
Requirements
(a) What should the carrying amount of the debentures be at 31 December 20X4 before the
impairment became apparent?
(b) What should the carrying amount be at that date after impairment?
(c) How should the impairment be recognised in the financial statements for the year ended
31 December 20X4?
If the impairment loss decreases at a later date (and the decrease relates to an event occurring after the
impairment was recognised) the reversal should be recognised in profit or loss. The carrying amount of
the asset should not exceed what the amortised cost would have been if no impairment had been
recognised.
3.9.3 Financial assets carried at cost

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

Illustration: Banks in the credit crunch
C
Impairment losses have been a topical issue in the credit crunch of 2008, continuing to the present day, H
particularly for the banks. For example, the interim accounts of HSBC, for the period ending A
30 June 2009, state: P
T
'Loan impairments increased by £1,223 million to £1,795 million as deterioration in credit quality E
was experienced across all customer groups as the European economies weakened.' R
In the same period, Barclays saw its impairment charges increase by 86% to £4,556 million. These came
from credit market exposure, corporate failures and in failures from consumer lending. 16
3.9.4 Available-for-sale financial assets

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

An equity instrument was acquired for £2,000 a number of years ago and was classified as available for
sale. At 31 December 20X4, the cumulative loss recognised in other comprehensive income was £100
and the financial asset was carried at fair value of £1,900.
At 31 December 20X5, the equity issuer was in severe financial difficulty and the fair value had fallen to
£1,600.
As a result of a takeover of the issuer, the fair value increased during 20X6 to £2,200.
Requirement
How should the equity instrument be accounted for in 20X5 and 20X6?
Solution
In 20X5 an impairment loss of £400 should be recognised in profit or loss and £100 credited to other
comprehensive income in respect of the loss previously recognised there.
In 20X6 a gain of £600 (£2,200 – £1,600) should be recognised in other comprehensive income,
because impairment losses on available for sale equity instruments should not be reversed through profit
or loss.

The following table summarises the impairment requirements for debt, equity and derivative
instruments.
Financial asset Classification Measurement basis Impairment test
FVTPL Fair value No
Debt HTM Amortised cost Yes
Loans and receivables Amortised cost Yes
AFS Fair value Yes
FVTPL Fair value No
FVTPL Cost when the fair

value cannot be
Yes
measured reliably
AFS Fair value Yes

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

than hedging instruments)
Equity derivatives FVTPL Cost when the fair

value cannot be
Yes
measured reliably
3.9.5 More detail on impairment

A financial asset or a group of financial assets is impaired if and only if a past event or series of past
events provides evidence of a reduction in the future cash flows that can be measured reliably. IAS 39
does not require that an entity be able to identify a single, distinct past causal event to conclude that it
is probable that an impairment loss on a financial asset has been incurred. It may not be possible to
identify a single, discrete event that caused the impairment. Rather, the combined effect of several
events may have caused the impairment. Other factors that an entity considers in determining whether
it has objective evidence that an impairment loss has been incurred include:
 information about the debtors' or issuers' liquidity, solvency and business and financial risk
exposures;
 levels of and trends in delinquencies for similar financial assets;
 national and local economic trends and conditions; and
 the fair value of collateral and guarantees.
These and other factors may, either individually or taken together, provide sufficient objective evidence
that an impairment loss has been incurred in a financial asset or group of financial assets.
Although a significant credit downgrade is not considered by itself to be an indication that an
impairment has occurred, it may be objective evidence when considered with other evidence.
The decline in fair value to below cost is not necessarily evidence of impairment. As an example, the fair
value of fixed rate debt classified as an available-for-sale financial asset will fall if the risk-free rate of
interest rises. But this rise may be reversed over a relatively short time period, resulting in the debt's fair
value increasing. It is to cover such circumstances that a debit balance on the separate component of
equity in relation to available-for-sale financial assets is permitted. For equity investments, however, a
significant or prolonged decline in fair value is objective evidence of impairment. No further guidance is
provided on what constitutes a significant or prolonged decline and therefore an entity should exercise

judgement in making this assessment, but the standard includes a number of indicators showing that
the equity investment costs may not be recovered. These indicators include: C
H
 technological changes that change the industry permanently; A
P
 competitive changes in the industry as a result of the industry being exposed for example to T
foreign competition; E
R
 permanent fall in the demand for the products of the company; and
 changes in the political or legal environment.
16
Future losses
Losses expected as a result of future events, however likely, should not be recognised. For
example, it would not be appropriate for a lender which over time has experienced an average default
rate of 2% to recognise an immediate impairment of £200 at the time of advancing a loan of £10,000;
the reason is that at the time of making the loan there cannot have been a past event to cause an
impairment loss.
Collateral
Many loans and receivables are collateralised. This may involve the security from a mortgage of
property, for example. In determining the impairment loss on such a financial asset, the assessment of
impairment should include the cash flows from obtaining and disposing of the collateral, regardless of
whether foreclosure is probable. This may involve obtaining estimates of the realisable value of property,
using appropriately qualified valuers.
Evaluation of impairment on a portfolio basis

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

An entity has a portfolio of 100 small loans made to individuals. Each loan is for £100 and carries a fixed
interest rate of 8%. Each debtor belongs to the same credit group in the same geographical area.
Adverse economic conditions have increased the group's unemployment rate. One borrower has
notified the entity that he has become unemployed and the entity has rescheduled his payments. It has
allowed him an interest-free payment holiday.
Requirement
How should the assessment for impairment be made?
Solution
The individual balance relating to the unemployed person should be assessed separately for impairment.
The remaining 99 loans should be assessed collectively for impairment.

4 Application of IFRS 13 to financial instruments
Section overview
The use of fair value accounting is permitted or required in some instances by both IAS 39 and IFRS 9.
Additional guidance is provided in IFRS 13 on how the standard is applied to financial assets and
liabilities and own equity instruments
4.1 Introduction
IFRS 13 Fair Value Measurement gives extensive guidance on how the fair value of assets and liabilities
should be established. It sets out to:
 define fair value
 set out in a single IFRS a framework for measuring fair value
 require disclosures about fair value measurements
IFRS 13 was covered in Chapter 2. This section is concerned with its application to financial instruments.
Below is a reminder of the definition of fair value and the three-level valuation hierarchy.
Definition
Fair value: 'The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date'.
IFRS 13 states that valuation techniques must be those which are appropriate and for which sufficient
data are available. Entities should maximise the use of relevant observable inputs and minimise the use
of unobservable inputs.
The standard establishes a three-level hierarchy for the inputs that valuation techniques use to measure
fair value:
Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting
entity can access at the measurement date.
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly, eg, quoted prices for similar assets in active markets or for
identical or similar assets in non-active markets or use of quoted interest rates for valuation
purposes.
Level 3 Unobservable inputs for the asset or liability, ie, using the entity's own assumptions about
market exit value.
4.2 Financial assets

The following should be considered where a financial asset is being fair valued:
(a) If a quoted item has a bid price (the price that buyers are willing to pay) and an ask price (the price
that sellers are willing to achieve), the price within the bid-ask spread that is most representative of
fair value is used to measure fair value. The use of bid prices for financial assets and the use of ask
prices for financial liabilities is permitted but not required. IFRS 13 does not preclude the use of
mid-market pricing.
(b) In the case of equity shares, a control premium is considered when measuring the fair value of a
controlling interest. Similarly, any non-controlling interest discount is considered where measuring
a non-controlling interest.
(c) If an entity holds a position in a single asset or liability (including a position comprising a large
number of identical assets or liabilities, such as a holding of financial instruments) and the asset or
liability is traded in an active market, the fair value of the asset or liability shall be measured within
Level 1 as the product of the quoted price for the individual asset or liability and the quantity held

by the entity. That is the case even if a market's normal daily trading volume is not sufficient to
absorb the quantity held and placing orders to sell the position in a single transaction might affect C
the quoted price. H
A
(d) An exposure draft is currently in issue that proposes that a subsidiary, associate or joint venture P
investment in quoted equity shares is always measured as a multiple of the share price, with no T
E
adjustment for a premium associated with influence or control.
R
(e) The valuation of unlisted equity investments involves significant judgment and different valuation
techniques are likely to result in different fair values, however this does not mean that any of the
techniques are incorrect. Certain techniques are better suited to particular types of business, for 16
example an asset based approach is relevant to property companies whilst an income approach is
more relevant to service businesses. It is likely that valuation will be based on some unobservable
inputs and as a result the overall fair value will be classified as a level 3 measurement.
4.3 Liabilities and own equity instruments

Liabilities and own equity instruments must be measured on the assumption that the liability or equity is
transferred to a market participant at the measurement date and therefore:
 a liability would remain outstanding and the market participant would be required to fulfil the
obligation; and
 an entity's own equity instrument would remain outstanding and the market participant would
take on the rights and responsibilities associated with the instrument.
This differs (sometimes significantly so) from a measurement that is based on the assumption of
settlement of a liability or cancellation of an entity's own equity instrument.
IFRS 13 further requires that the fair value of a liability must factor in non-performance risk. Anything
that could influence the likelihood of an obligation being fulfilled is considered a non-performance risk,
including an entity's own credit risk.
Worked example: Fair value of liabilities

Crossley Co has a bank loan with a nominal value of £1 million that attracts a market rate of interest.
Due to market concern regarding non-performance risk of Crossley Co, the market value of the loan to
the bank is just £800,000. The bank will not agree to discount the amount paid by Crossley Co to
extinguish the loan.
Miller Co is seeking similar financing to the bank loan and has a similar credit profile to Crossley Co.
Miller Co is indifferent to obtaining a new bank loan or assuming Crossley Co's bank loan.
Requirement
What is the fair value (transfer value) of Crossley Co's bank loan?
Solution
As Miller Co has the same credit profile as Crossley Co, if it were to take out a bank loan, the bank
would lend only £800,000 (the market value of Crossley Co's loan) in return for the same cash flows as
are outstanding in respect of Crossley Co's loan. This is because the bank would require a higher rate of
interest to compensate for the increased credit risk.
Therefore the transfer value (fair value) of Crossley Co's loan is £800,000.
Interactive question 20: Fair value of liability

Morden Co and Merton Co individually enter into legal obligations to each pay £200,000 to Wallington
Co in seven years in exchange for some goods.
Morden Co has a very good credit rating and can borrow at 4%. Merton Co's credit rating is lower and
it can borrow at 8%.

Requirement
What is the fair value of the legal obligation that Morden Co and that Merton Co must record in their
financial statements?
4.4 Liabilities and own equity instruments

The specific approach to fair value liabilities and an entity's own equity instruments sometimes differs
from the concepts to fair value an asset and is summarised in the following flowchart:
Is there a quoted price for the Yes

transfer of an identical or a Use quoted
similar liability or entity’s own price
equity instrument?
No
Yes Is there an identical item held No

by another entity as an asset?
Measure fair value of the Measure the fair value of the

liability or equity instrument liability or equity instrument
from the perspective of market using a valuation technique
participant that holds the from the perspective of a
identical item as an asset at the market participant that owes
measurement date. the liability or has issued the
equity.
Figure 16.2: Fair Value of Liabilities
5 Derivatives
Section overview
This section covers aspects relating to financial derivatives not covered at Professional Level.
5.1 Definition of a derivative – further examples

The definition of derivative was set out earlier in the summary of the material covered at Professional
Level. A quick reminder – it is a financial instrument:
 whose value changes in response to the change in price of an underlying security,
commodity, currency, index or other financial instrument(s);
 where the initial net investment is zero or is small in relation to the value of the underlying
security or index; and
 that is settled at a future date.
A derivative normally has a notional amount, such as a number of shares or other quantity specified in
the contract. For example, a forward currency contract has a quoted amount of currency even though

neither the holder nor writer is required to invest or receive this amount at the inception of the contract.
However, this is not a requirement and a derivative could require a fixed payment or a variable payment C
based on the outcome of some future event that is unrelated to the notional amount. For example, a H
A
contract that requires the fixed payment of £1,000 if a commodity price increases by 5% or more is a
P
derivative. T
E
Common types of derivatives include the following:
R
 Swaps
 Purchased or written options (call and put)
 Futures 16
 Forwards
Underlying variables
Examples of underlying variables attaching to the derivatives include the following:
 Interest rates
 Currency rates
 Commodity prices
 Equity prices
 Credit-related variables
In determining whether a derivative exists, the substance of the transaction should be considered. Non-
derivative transactions should be aggregated and treated as derivatives when the transactions result, in
substance, in derivatives. For example, if Entity A grants a fixed rate loan to Entity B and in return
Entity B grants a variable rate loan of the same amount and maturity, both entities should treat the
arrangement as an interest rate swap and account for it as a derivative.
(a) A defining characteristic of a derivative is that it requires either no initial investment or an initial
net investment smaller than would be required for other types of contracts that would be
expected to have a similar response to changes in market factors. A purchased call option contract,
for example, meets this definition because the premium is less than the investment that would be
required to obtain the underlying financial instrument to which the option is linked.
(b) An interest rate swap in which the parties settle on a net basis qualifies as a derivative instrument.
This is because the definition of a derivative makes reference to future settlement, but not to the
method of settlement.
(c) If a party prepays its obligation under a pay-fixed, receive-variable interest rate swap at
inception, the swap should be classified as a derivative.
(d) However, if the fixed rate payment obligation is prepaid subsequent to initial recognition this
would be regarded as a termination of the old swap and an origination of a new instrument.
(e) A prepaid pay-variable, receive-fixed interest rate swap is not a derivative if it is prepaid at
inception and it is no longer a derivative if it is prepaid after inception because it provides a return
on the prepaid (invested) amount comparable to the return on a debt instrument with fixed cash
flows. The prepaid amount fails the 'no initial net investment or an initial net investment that is
smaller than would be required for other types of contracts that would be expected to have a
similar response to changes in market factors' criterion of a derivative.
(f) An option which is expected not to be exercised, for example because it is 'out of the money',
still qualifies as a derivative. This is because an option is settled upon exercise or at its maturity.
Expiry at maturity is a form of settlement even though there is no additional exchange of
consideration.
(g) Many derivative instruments, such as futures contracts and exchange-traded written options,
require margin accounts. The margin account is not part of the initial net investment in a
derivative instrument. Margin accounts are a form of collateral for the counterparty or clearing
house and may take the form of cash, securities or other specified assets, typically liquid assets.
Margin accounts are separate assets that are accounted for separately.
(h) A derivative may have more than one underlying variable.

(i) A contract to buy or sell a non-financial asset is a derivative if:
 it can be settled net in cash or by exchanging another financial instrument; and
 the contract was not entered for the purpose of receipt or delivery of the non-financial item to
meet the entity's expected purchase, sale or usage requirements.
An example would be a gas supply contract in the UK (where there is an active market) where the
supplier or purchaser has the right to refuse delivery or receipt of the gas for financial reasons, for
example because they can get a better price in the market. However, if the right to refuse delivery
on the part of the seller can only be invoked for operational reasons (ie, they do not have the gas
available to supply), this does not on its own make the contract a derivative.
5.1.1 Currency swaps

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

Two entities enter into a 10-year fixed currency swap of € and £. Current interest rates relating to € and
£ are 4% and 6% respectively. At inception of the contract the current rate of exchange is €2 per £. The
contract requires the initial exchange of €2,000 and £1,000.
Annual interest payments are made between the parties without netting of €80 (4%  €2,000) and £60
(6%  £1,000). After 10 years, the swap terminates and the original principal amounts are returned.
Requirement
Does the instrument fit the definition of a derivative?
Solution
The currency swap meets the definition of a derivative, as the exchange of the initial fair values means
there is zero initial investment, its value changes in response to a specified exchange rate and it is settled
at a future date.
Interactive question 21: Loan agreement as derivatives

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

SML, a tools manufacturer, entered into a contract to buy 50 tonnes of steel in 12 months' time, in
accordance with its expected use requirements. The contract permits SML to take physical delivery of
the steel or to pay or receive a net settlement in cash based on the change in the market price of steel.
Requirement
Is the contract a derivative?

Solution
C
The contract meets some of the criteria of a derivative; that is, no initial investment and it is to be settled H
at a future date. However, because the underlying is a non-financial asset, classification as a derivative A
will depend on whether the contract was entered into in order to benefit from short-term price P
fluctuations by selling it. If SML intends to take delivery of the steel and use it as an input in its T
E
production process, then the contract is not a derivative. R
5.2 Accounting for derivatives 16
As noted previously, derivatives are classified as held for trading (unless they are hedging instruments –
see the next chapter), so they should be measured at fair value and changes in fair value should be
recognised in profit or loss. The following example highlights the accounting treatment of derivatives.
Illustration: Accounting treatment of purchased option

On 31 December 20X0 Entity Theta purchases put options over 100,000 shares in Omega which expire
on 31 December 20X2. The exercise price of the option is £2, the market price on 31 December 20X0,
and the premium paid is £11,100.
The intrinsic value of the option (ie, the exercise price less the price per share, times the number of
shares specified in the option contract) is zero at acquisition. The cost of £11,100 reflects the time value
of the option which depends on the time to expiration, the price of the stock and its volatility.
If the stock price falls below £2 the put becomes in the money by the amount below the £2 strike price
times the number of option shares. For instance, if the price of Omega stock fell to £1.90, the intrinsic
value gain on the put option is £0.10 per share. If the stock price rises and stays above £2 for the term
of the contract, the put option expires worthless to the buyer because it is out of the money. The
purchaser of the put option loses the premium which is kept by the seller (writer).
Economic assumptions
The value of the shares in Omega and the put options is shown in the table below. The value of the put
option increases as the stock price decreases.
31.12.20X0 30.6.20X1 31.12.20X1
Omega shares
Price per share (£) 2.00 1.90 1.85
Value of put option (£) 11,100 13,500 15,000
On 31 December 20X1, Theta sells the option.
Solution
Accounting entries under IAS 39:
Debit Credit
£ £
31 December 20X0
Financial asset – put option 11,100
Cash 11,100
(To record the purchase of the put option)
30 June 20X1
Financial asset – put option (13,500 – 11,100) 2,400
Profit or loss – gain on put option 2,400
(To record the increase in the fair value of the put option)
31 December 20X1
Financial asset – put option (15,000 – 13,500) 1,500
Profit or loss – gain on put option 1,500
(To record the increase in the fair value of the put option)
Cash 15,000
Financial asset – put option 15,000
(To record the sale of the put option on 31.12.20X1)

6 Embedded derivatives
Section overview
This section deals with the definition and accounting treatment of embedded derivatives.
6.1 Introduction
Certain contracts that are not themselves derivatives (and may not be financial instruments) include
derivative contracts that are 'embedded' within them.
Definition
Embedded derivative: A component of a hybrid (combined) instrument that also includes a non-
derivative host contract – with the effect that some of the cash flows of the combined instrument vary
in a way similar to a stand-alone derivative.
6.2 The basics

Below we look at some basic examples and their treatment. Then we will look in detail at more complex
issues.
Examples of host contracts
Possible examples include:
(a) A lease
(b) A debt or equity instrument
(c) An insurance contract
(d) A sale or purchase contract
(e) A construction contract
Examples of embedded derivatives
Possible examples include:
(a) A bond which is redeemable in five years' time with part of the redemption price being based on
the increase in the FTSE 100 Index:
'Host' Accounted for as normal ie, amortised

Bond
contract cost
Treat as derivative ie, remeasured to fair

Embedded Option on value with changes recognised in profit or
derivative equities loss
(b) A construction contract priced in a foreign currency. The construction contract is a non-derivative
contract, but the changes in foreign exchange rate is the embedded derivative.
Accounting treatment of embedded derivatives
The basic rule for accounting for an embedded derivative is that it should be separated from its host
contract and accounted for as a derivative. The purpose is to ensure that the embedded derivative is
measured at fair value and changes in its fair value are recognised in profit or loss. But this separation
should only be made when the following conditions are met.
(a) The economic characteristics and risks of the embedded derivative are not closely related to the
economic characteristics and risks of the host contract.
(b) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative.

(c) The hybrid (combined) instrument is not measured at fair value with changes in fair value
recognised in profit or loss (if changes in the fair value of the total hybrid instrument are C
recognised in profit or loss, then the embedded derivative is already accounted for on this basis, so H
A
there is no benefit in separating it out).
P
The meanings of 'closely related' and 'not closely related' are dealt with in more detail below, but a T
E
simple example may help. A lease of retail premises may provide for the amounts payable to the lessor
R
to include contingent rentals based on the lessee's sales from the leased premises. The variable nature of
the contingent rentals makes them fall within the definition of an embedded derivative. But these
contingent rentals are considered to be 'closely related' to the lease host contract, so this embedded
16
derivative should not be separated out for accounting purposes.
Note that an entity may, subject to conditions, designate any hybrid contract as at fair value through
profit or loss, thereby avoiding the need to measure the fair value of the embedded derivative separately
from that of the host contract.
Illustration: Embedded forward contract

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

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

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

The diagram shows how these three conditions should be tested for.
Is the hybrid
instrument Yes Do not separate
measured at fair out the embedded
value through derivative
profit or loss?
No
Would it be
a derivative No
Do not separate
if it was a out the embedded
separate derivative
instrument?
Yes
Are its Yes

characteristics/ Do not separate
risks closely out the embedded
related to those of derivative
the host contract?
No
Account separately
for the embedded
derivative
Figure 16.3: Embedded Derivatives

Where an entity is unable to measure an embedded derivative that is required to be separated from its
host, either on acquisition or subsequently, the entire hybrid contract should be designated as at fair
value through profit or loss.
If the fair value of the embedded derivative cannot be determined due to the complexity of its terms
and conditions, but the value of the hybrid and the host can be determined, then the value of the
embedded derivative should be determined as the difference between the value of the hybrid and the
value of the host contract.
6.5 Identification of embedded derivatives

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

Identification of embedded derivatives requires the entity to consider all financial assets and liabilities
that are carried at amortised cost or classified as available for sale and all executory contracts such as C
operating leases, purchases and sales contracts and commitments. H
A
Although the identification of the host instrument does not present a serious problem, the identification P
of the embedded derivative is more problematic. Going back to the definition of a derivative, we can T
E
use the main characteristics of a derivative in order to identify embedded derivatives. For example, an
R
embedded derivative may be identified if contracts contain the following:
 Rights or obligations to exchange at some time in the future
16
 Rights or obligations to buy or sell
 Provisions for adjusting the cash flows according to some interest rate, price index or specific time
period
 Options which permit either party to do something not closely related to the contract
 Unusual pricing terms (eg, a bond which pays interest at rates linked to the FTSE 100 yield contains
an embedded swap)
Finally, a comparison of the terms of a contract such as maturity, cancellation or payment provisions
with the terms of another similar non-complex contract may indicate the existence, or not, of an
embedded derivative.
6.6 Examples of closely related embedded derivatives

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

 A derivative embedded in an insurance contract is closely related to the host insurance contract if
the embedded derivative and host insurance contract are so interdependent that an entity cannot
measure the embedded derivative separately (ie, without considering the host contract).
6.7 Examples of not closely related embedded derivatives

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

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

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

Interactive question 22: Embedded derivatives
C
The Sebacoyl Company operates in the construction industry and is based in Ermania. Its functional H
currency is the £. In the ordinary course of business it entered into the following contracts. A
P
Contract (1) On 31 March 20X7 Sebacoyl made a contract with The Lenny Company, which T
manufactures plant and machinery in Okastan. The functional currency of Lenny is the E
R£. Under the contract Sebacoyl will purchase a very large excavating machine for R
R£700,000, payable on 1 February 20X8.
Contract (2) On 30 October 20X7 Sebacoyl made a contract with Pettrill Company, which operates in 16
Aslan and whose functional currency is the L£. Under the contract Sebacoyl will build a
major runway installation in Aslan for a fixed price of N£9 million and Sebacoyl is due to
receive N£1.5 million on 30 June and 31 December in each of 20X8, 20X9 and 20Y0.
The N£ is infrequently used as the measure of contract prices in Ermania or Aslan.
Neither contract is measured at fair value through profit or loss.
Requirement
Explain in respect of each contract whether there is an embedded derivative and, if so, whether it should
be recognised separately in the financial statements of Sebacoyl for the year to 31 December 20X7.
6.9 IFRIC 9 Reassessment of Embedded Derivatives

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

IFRS 9 changes the rules for embedded derivatives that are financial assets (see section 7). While IAS 39
remains the extant standard, some knowledge of IFRS 9 is required, and it may be examinable
7 IFRS 9 Financial Instruments and current developments
Section overview
IFRS 9 Financial Instruments, issued in final form in 2014, replaces IAS 39. The standard covers
recognition and measurement, impairment, derecognition and general hedge accounting.
7.1 Background
It has been the IASB's intention to replace IAS 39 with a principles-based standard for some time, due to
criticism of the complexity of IAS 39, which is difficult to understand, apply and interpret.
The replacement of IAS 39 became more urgent after the financial crisis. The IASB and US FASB set up a
Financial Crisis Advisory Group (FCAG) to advise on how improvements in financial reporting could help
enhance investor confidence in financial markets.

IFRS 9 was published in stages: new classification and measurement models (2009 and 2010) and a new
hedge accounting model (2013). The version of IFRS 9 issued in 2014 supersedes all previous versions
and completes the IASB's project to replace IAS 39. It covers recognition and measurement, impairment,
derecognition and general hedge accounting. It does not cover portfolio fair value hedge accounting for
interest rate risk ('macro hedge accounting'), which is a separate IASB project, currently at the discussion
paper stage.
7.2 Implementation dates and significance for your exam

The mandatory effective date for IFRS 9 is 1 January 2018. Earlier adoption has been permitted. From
February 2015 if an entity applies IFRS 9 it must be the version issued in July 2014. Those entities must
therefore apply the rules on classification and measurement, impairment and hedge accounting. They
may, however, elect to continue to apply the IAS 39 rules on hedge accounting. A further exception is
that an entity can apply the 'own credit' changes (see below) at any time in isolation without adopting
the other new requirements.
7.2.1 Your exam

While IAS 39 remains the extant standard, some knowledge of IFRS 9 is required and may be
examinable, particularly in relation to how future accounting periods may be affected.
7.3 Definitions and scope

The scope of IFRS 9 is the same as that of IAS 39, and the IFRS 9 definitions relating to financial
instruments are the same as those in IAS 39.
7.4 Recognition of financial instruments

A financial asset or financial liability must be recognised in an entity's statement of financial position
when the entity becomes party to the contractual provisions of the instrument.
These recognition criteria are unchanged from IAS 39.
7.5 Derecognition of financial instruments

Derecognition is the removal of a previously recognised financial instrument from an entity's statement
of financial position.
An entity should derecognise a financial asset when:

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

IFRS 9 replaces the rule-based, complex classification rules in IAS 39 with a principles-based classification
based on business model and nature of cash flows.
On recognition, IFRS 9 requires that financial assets are classified as measured at either:
 amortised cost; or
 fair value.
This classification is made on the basis of both:
(a) the entity's business model for managing the financial assets; and
(b) the contractual cash flow characteristics of the financial asset.

A financial asset is classified as measured at amortised cost where:
C
(a) the objective of the business model within which the asset is held is to hold assets in order to H
collect contractual cash flows; and A
P
(b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely
T
payments of principal and interest on the principal amount outstanding. E
A financial asset must be classified as measured at fair value through other comprehensive income R
(unless the asset is designated at fair value through profit or loss under the fair value option) if it meets
both the following criteria:
16
(a) the financial asset is held within a business model whose objective is achieved by both collecting
contractual cash flows and selling financial assets; and
(b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely
payments of principal and interest on the principal amount outstanding.
This business model was new to the July 2014 version of IFRS 9.
All other debt instruments must be measured at fair value through profit or loss.
Even if an instrument meets the above criteria for measurement at amortised cost or fair value through
other comprehensive income, IFRS 9 allows such financial assets to be designated at initial recognition,
as being measured at fair value through profit or loss if an 'accounting mismatch' would otherwise arise
from measuring assets or liabilities or recognising the gains and losses on them on different bases.
Equity instruments
Investments in equity instruments may not be classified as measured at amortised cost and must be
measured at fair value. This is because contractual cash flows on specified dates are not a characteristic
of equity instruments. However, if an equity investment is not held for trading, an entity can make an
irrevocable election at initial recognition to measure it at FVTOCI with only dividend income recognised
in profit or loss. This is different from the treatment of debt instruments, where the fair value through
other comprehensive income classification is mandatory for assets meeting the criteria, unless the fair
value through profit or loss option is chosen.
Derivatives
All derivatives are measured at fair value.
Note that the IFRS 9 requirement to classify financial assets on recognition as one of two types is a
significant simplification of the previous IAS 39 rules. These required financial assets to be classified as
one of four types:
 At fair value through profit or loss
 Held to maturity
 Available for sale
 Loans and receivables
7.7 Reclassification of financial assets

Although on initial recognition financial instruments must be classified in accordance with the
requirements of IFRS 9, in some cases they may be subsequently reclassified. IFRS 9 requires that when
an entity changes its business model for managing financial assets, it should reclassify all affected
financial assets. This is expected to be a rare event.
The reclassification applies only to debt instruments, as equity instruments must be classified as
measured at fair value.
When financial instruments are reclassified, disclosures are required under IFRS 7.
7.8 Classification of financial liabilities

On recognition, IFRS 9 requires that financial liabilities are classified as measured either:
(a) at fair value through profit or loss, or
(b) financial liabilities at amortised cost.

A financial liability is classified at fair value through profit or loss if:
(a) it is held for trading; or
(b) upon initial recognition it is designated at fair value through profit or loss.
Derivatives are always measured at fair value through profit or loss.
These classification rules are unchanged from those previously contained within IAS 39.
7.9 Initial measurement: financial assets

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

Financial assets are subsequently measured at:
 fair value with changes in value normally recognised in profit or loss;
 fair value with changes in value recognised in other comprehensive income for debt instruments
meeting the criteria;
 fair value with changes in value recognised in other comprehensive income for equity instruments
where the election has been made; or
 amortised cost with interest recognised in profit or loss.
7.10.1 Financial assets measured at fair value

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

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

IFRS 9 does not define amortised cost, but it refers to the definition of this and other relevant terms in
IAS 39.

Worked example: Promissory note
C
Big Bank issues promissory notes to customers at more favourable rates than standard deposit accounts. H
A
On 26 August 20X2, PJF Systems, a client of the bank, purchased promissory notes with a nominal value P
of £30,000 at a discount for £29,474.31. The notes mature on 28 February 20X3 and PJF intends to T
classify them as part of a group of assets that will be held until the maturity date in order to receive the E
full return. No interest is paid during the term of the promissory notes. The effective annual interest rate R
on the notes is 3.53%. Interest is credited daily, based on a 365-day year.
Requirement 16
Explain, working to the nearest penny, how the promissory notes would be accounted for in PJF
Systems's financial statements for the year ended 31 December 20X2, showing relevant financial
statement extracts. (Notes to the financial statements are not required.)
Solution
The promissory notes are a financial asset. As PJF Systems intends to hold them as part of a group of
assets to be held until they mature, the notes meet the two IFRS 9 criteria to be held at amortised cost:
(a) The asset is held within a business model whose objective is to hold assets in order to collect
contractual cash flows.
(b) The contractual terms of the financial asset give rise on specific dates to cash flows that are solely
payments of principal and interest on the principal amount outstanding.
In this case there are no cash payments of interest during the term. All of the return is received in the
final receipt on maturity. PJF needs to accrue this interest based on the effective return which is 3.53%.
– 1)  100% = 0.0095049% per day.
1/365
The daily return is therefore (1.0353
Interest is accrued as follows:
£
Amount initially recognised at 26 August 20X2 29,474.31
Interest accrued (balance) 357.93
c/d at 31 December 20X2 (29,474.31  1.000095049 )
127
29,832.24
Profit or loss:
£
Finance income 357.93
Statement of financial position:
£
Current assets
Promissory notes held at amortised cost 29,832.24
Interactive question 23: IFRS 9 and derecognition

During 20X1, The Purple Company invested in 80,000 shares in a stock market quoted company. The
shares were purchased at £4.54 per share. The broker collected a commission of 1% on the transaction.
Purple elected to measure these shares at fair value through other comprehensive income.
The quoted share price at 31 December 20X1 was £4.22 – £4.26.
Purple decided to 'bed and breakfast' the shares to realise a tax loss and therefore sold the shares at
market price on 31 December 20X1, and bought the same quantity back the following day. The market
price did not change on 1 January 20X2. The broker collected a 1% commission on both the
transactions.

Requirement
Explain the IFRS 9 accounting treatment of the above shares in the financial statements of Purple for the
year ended 31 December 20X1 including relevant calculations.
7.11 Initial measurement: financial liabilities

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

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

IFRS 9 requires that financial liabilities which are designated as measured at fair value through profit
or loss are treated differently. In this case the gain or loss in a period must be classified into:
 gain or loss resulting from credit risk; and
 other gain or loss.
This change to IFRS 9 was made in response to an anomaly regarding changes in the credit risk of a
financial liability.
Changes in a financial liability's credit risk affect the fair value of that financial liability. This means
that when an entity's creditworthiness deteriorates, the fair value of its issued debt will decrease (and
vice versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to
be recognised in profit or loss for the year. For example:
Statement of profit or loss and other comprehensive income (extract)
Profit or loss for the year
Liabilities at fair value (except derivatives and liabilities held for trading) $'000
Change in fair value 100
Profit (loss) for the year 100
Many users of financial statements found this result to be counter-intuitive and confusing. Accordingly,
IFRS 9 requires the gain or loss as a result of credit risk to be recognised in other comprehensive income
(unless it creates or enlarges an accounting mismatch, in which case it is recognised in profit or loss).
The other gain or loss (not the result of credit risk) is recognised in profit or loss.
On derecognition any gains or losses recognised in other comprehensive income are not transferred to
profit or loss, although the cumulative gain or loss may be transferred within equity.
IFRS 9 presentation
Statement of profit or loss and other comprehensive income (extract)
Profit or loss for the year
Liabilities at fair value (except derivatives and liabilities held for trading) $'000
Change in fair value from own credit 90
Profit (loss) for the year 90

Other comprehensive income (not reclassified to profit or loss)
C
$'000
H
Fair value gain on financial liability attributable to change in credit risk 10 A
Total comprehensive income 100 P
T
7.14 Embedded derivatives E
R
7.14.1 Financial asset host contracts
Where the host contract is a financial asset within the scope of the standard, the classification and
16
measurement rules of the standard are applied to the entire hybrid contract.
This is a simplification of the IAS 39 rules, which required that an embedded derivative be separated
from its host contract and accounted for as a derivative under certain conditions.
7.14.2 Other host contracts

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

IAS 39 currently uses an 'incurred loss' model for the impairment of financial assets. This model
assumes that all loans will be repaid until evidence to the contrary. Only at this point is the impaired
loan written down to a lower value.
The impairment model in IFRS 9 is based on the premise of providing for expected losses. The financial
statements should reflect the general pattern of deterioration or improvement in the credit quality of
financial instruments within the scope of IFRS 9.
7.15.1 On initial recognition

The entity will create a credit loss allowance/provision equal to 12 months' expected credit losses.
This is calculated by multiplying the probability of a default occurring in the next 12 months by the total
lifetime expected credit losses that would result from that default. (This is not the same as the expected
cash shortfalls over the next 12 months.)
7.15.2 Subsequent years

If the credit risk increases significantly since initial recognition this amount will be replaced by lifetime
expected credit losses. If the credit quality subsequently improves and the lifetime expected credit
losses criterion is no longer met, the 12-month expected credit loss basis is reinstated.
Certain financial instruments have a low credit risk and would not, therefore, meet the lifetime expected
credit losses criterion. Entities do not recognise lifetime expected credit losses for financial instruments
that are equivalent to 'investment grade', which means that the asset has a low risk of default. The
model requires that there is a rebuttable presumption that lifetime expected losses should be provided
for if contractual cash flows are 30 days overdue.
7.15.3 Amount of impairment

The amount of the impairment to be recognised on these financial instruments depends on whether or
not they have significantly deteriorated since their initial recognition.

Change in credit quality since initial recognition
Expected credit losses recognised
12-month expected Lifetime expected credit Lifetime expected credit

credit losses losses losses
Interest revenue recognised
Gross basis Gross basis Net basis
Stage 1 Stage 2 Stage 3
(IFRS 9)
Figure 16.4: The impact of deterioration in credit quality
Stage 1 Financial instruments whose credit quality has not significantly deteriorated since their
initial recognition
Stage 2 Financial instruments whose credit quality has significantly deteriorated since their initial
recognition
Stage 3 Financial instruments for which there is objective evidence of an impairment as at the
reporting date
For Stage 1 financial instruments, the impairment represents the present value of expected credit losses
that will result if a default occurs in the 12 months after the reporting date (12 months' expected
credit losses).
For financial instruments classified as Stage 2 or 3, an impairment is recognised at the present value of
expected credit shortfalls over their remaining life (lifetime expected credit loss). Entities are required
to reduce the gross carrying amount of a financial asset in the period in which they no longer have a
reasonable expectation of recovery.
7.15.4 Interest
For Stage 1 and 2 instruments interest revenue will be calculated on their gross carrying amounts,
whereas interest revenue for Stage 3 financial instruments would be recognised on a net basis (ie, after
deducting expected credit losses from their carrying amount).
7.15.5 IFRS 9 financial assets classification and impairment

Financial assets are classified as follows in IFRS 9:
 Amortised cost – debt instruments held to collect contractual cash flows
 Fair value through other comprehensive income – debt held to collect contractual cash flows and
to be sold, and equity instruments not held for trading and classified as such through an
irrevocable option exercised on origination
 Fair value through profit or loss – held for trading debt and equity instruments, debt instruments
designated as such to reduce accounting mismatches, financial assets managed on a fair value
basis, derivatives (except certain hedging derivatives) and hybrid contracts with IFRS 9 financial
host
The IFRS 9 impairment assessment is required only for debt instruments at amortised cost and fair value
through other comprehensive income. In both these classifications, the impairment on debt instruments
is recognised in profit or loss.
Equity instruments at fair value through other comprehensive income are not required to be tested for
impairment as gains and losses are never recycled to profit or loss.

7.15.6 Loan commitments and financial guarantee contracts
C
The date that the entity becomes a party to the irrevocable commitment shall be considered to be the H
date of initial recognition for the purposes of applying the impairment requirements. A
P
For undrawn loan commitments, a credit loss is the present value of the difference between: T
E
(a) the contractual cash flows that are due to the entity if the holder of the loan commitment draws R
down the loan; and
(b) the cash flows that the entity expects to receive if the loan is drawn down.
16
For a financial guarantee contract, the entity is required to make payments only in the event of a
default by the debtor in accordance with the terms of the instrument that is guaranteed. Cash shortfalls
are the expected payments to reimburse the holder for a credit loss it incurs less any amounts that the
entity expects to receive from the holder, debtor or any other party.
A provision may be made for a loss allowance on undrawn loan commitments or financial guarantee
contracts since the asset is not recognised in the statement of financial position.
Worked example: Expected credit losses

Zed Bank originates a five-year loan of £100,000 to a customer on 1 October 20X8. The bank estimates
that the loan at initial recognition has a probability of default of 0.5% over the next 12 months. This
estimation is based on the expectations for instruments with similar credit risk, the credit risk of the
borrower and economic outlook for the next 12 months. Based on this estimation and loss given default
of 25% of gross carrying amount, the expected credit loss allowance on origination is
£(100,000  25%  0.5%) = £125.
At the 31 December 20X8 reporting date, the bank assesses that the probability of default over the next
12 months has increased to 0.75% but this is not considered significant change in the credit risk – ie,
the risk of a default occurring – since initial recognition. Based on this revised probability of default and
loss given default of 25% of gross carrying amount, the bank estimates the loan loss allowance based on
12-month expected credit losses to be £(100,000  25%  0.75%) = £187.50. This increase of
£(187.50 – 125) = £62.50 in loss allowance is recognised in profit or loss.
A year later, at 31 December 20X9, the bank assesses the credit risk over the life of the loan based on
credit risk of the borrower and relevant forecast conditions over the remaining life of the loan. While the
loan is currently performing, the bank determines that the credit risk on the loan – the likelihood of it
defaulting – has increased significantly. The bank estimates that at 31 December 20X9 the lifetime
expected credit losses for the loan are £2,500. The loss allowance is increased by
£(2,500 – 187.50) = £2,312.50 in 20X9 which reflects the significant increase in credit risk.
The IAS 39 impairment model recognises an impairment loss only after the default event has occurred.
The significant increases in credit risk until the default event happens are not considered in the
measurement of credit loss allowance. IFRS 9 requires expected credit losses to be recognised and this
will have a significant impact, in particular for banks, on transition from IAS 39.
Worked example: Impairment loss

Dexter Lee Company advanced an interest-bearing loan to a supplier on 1 January 20X5.
The following information relates to this loan at 1 January and 31 December 20X5:
1 January 20X5 31 December 20X5

£ £
Present value of contractual cash flows 8,000,000 7,650,000

Present value of expected cash flows and 8,000,000 – 95% 7,650,000 – 85%
associated probability of default within 12 months
7,750,000 – 5% 5,500,000 – 8%
1,000,000 – 7%

Requirement
What is the impairment loss at each date, assuming that credit risk has not increased significantly since
initial recognition?
Solution
1 January 20X5
Possible outcomes
£'000 £'000
Present value of principal and interest cash flows that are contractually due 8,000 8,000
to the entity
Present value of cash flows the entity expects to receive 8,000 7,750
Credit loss 0 250
Probability 95% 5%
Weighted credit loss 0 12.5
Therefore an impairment loss of £12,500 (0 + £12,500) is recognised.

31 December 20X5
Possible outcomes
£'000 £'000 £'000
Present value of principal and interest cash flows that are 7,650 7,650 7,650
contractually due to the entity
Present value of cash flows the entity expects to receive 7,650 5,500 1,000
Credit loss 0 2,150 6,650
Probability 85% 8% 7%
Weighted credit loss 0 172 465.5
Therefore an impairment loss of £637,500 (0 + £172,000 + £465,500) is recognised.
Worked example: Interest

On 1 January 20X4 Mayhew Smith acquired an investment in £600,000 8% loan stock. The investment
is measured at amortised cost.
At 1 January 20X4 there is a 6% probability that the borrower will default on the loan during 20X4
resulting in a 100% loss.
At 31 December 20X4 there is a 1% probability that the borrower will default on the loan before
31 December 20X5 resulting in a 100% loss.
At 31 December 20X5 the borrower is expected to breach its covenants as a result of cash flow
problems. There is a 40% probability of the loan defaulting over the remainder of its term.
At 31 December 20X6 the borrower breached its covenants and there is a 70% probability of default
over the remainder of the loan term.
Requirement
What impairment loss and interest revenue are recognised at initial recognition and in each of the years
ended 31 December 20X4, 20X5 and 20X6?
Solution
Impairment allowance Interest revenue
1 January 20X4 6%  £600,000 = £36,000 –
(Initial recognition)
31 December 20X4 1%  £600,000 = £6,000 £600,000  8% = £48,000
(Stage 1)
31 December 20X5 40%  £600,000 = £240,000 £600,000  8% = £48,000
(Stage 2)
31 December 20X6 70%  £600,000 = £420,000 (£600,000 – £420,000)  8% = £14,400
(Stage 3)

An impairment loss on a financial asset at amortised cost is recognised in profit or loss, with a
corresponding entry to an allowance account, which is offset against the carrying amount of the C
financial asset in the statement of financial position. H
A
1 January 20X4 £ £ P
DEBIT Profit or loss 36,000 T
E
CREDIT Impairment allowance 36,000
R
31 December 20X4 £ £
DEBIT Impairment allowance (36,000 – 6,000) 30,000
16
CREDIT Profit or loss 30,000
DEBIT Profit or loss (240,000 – 6,000) 234,000
DEBIT Profit or loss (420,000 – 240,000) 180,000
7.15.7 Simplified approach for trade and lease receivables

For trade receivables that do not have an IAS 18/ IFRS 15 financing element, the loss allowance is
measured at the lifetime expected credit losses, from initial recognition.
For other trade receivables and for lease receivables, the entity can choose (as a separate accounting
policy for trade receivables and for lease receivables) to apply the three-Stage approach or to recognise
an allowance for lifetime expected credit losses from initial recognition.
Worked example: Trade receivable provision matrix

On 1 June 20X4, Kredco sold goods on credit to Detco for £200,000. Detco has a credit limit with
Kredco of 60 days. Kredco applies IFRS 9, and uses a pre-determined matrix for the calculation of
allowances for receivables as follows.
Expected loss
Days overdue provision
Nil 1%
311 to 1 to 30 5%
31 to 60 15%
61 to 90 20%
90 + 25%
Detco had not paid by 31 July 20X4, and so failed to comply with its credit term, and Kredco learned
that Detco was having serious cash flow difficulties due to a loss of a key customer. The finance
controller of Detco has informed Kredco that they will receive payment.
Ignore sales tax.
Requirement
Show the accounting entries on 1 June 20X4 and 31 July 20X4 to record the above, in accordance with
the expected credit loss model in IFRS 9.
Solution
On 1 June 20X4
The entries in the books of Kredco will be:
DEBIT Trade receivables £200,000
CREDIT Revenue £200,000

Being initial recognition of sales
An expected credit loss allowance, based on the matrix above, would be calculated as follows:
DEBIT Expected credit losses £2,000
CREDIT Allowance for receivables £2,000
Being expected credit loss: £200,000 × 1%
On 31 July 20X4
Applying Kredco's matrix, Detco has moved into the 5% bracket, because it has exhausted its 60-day
credit limit (note that this does not equate to being 60 days overdue!). Despite assurances that Kredco
will receive payment, the company should still increase its credit loss allowance to reflect the increased
credit risk. Kredco will therefore record the following entries on 31 July 20X4:
DEBIT Expected credit losses £8,000
CREDIT Allowance for receivables £8,000
Being expected credit loss: £200,000 × 5% – £2,000
Worked example: Impairment of trade receivable

Included in Timpson's trade receivables at 31 October 20X8 is an amount due from its customer
Thompson of £51,542,000. This relates to a sale which took place on 31 October 20X6, payable in
three annual instalments of £20,000,000 commencing 31 October 20X7 discounted at a market rate of
interest adjusted to reflect the risks of Thompson of 8%. Based on previous sales where consideration
has been received in annual instalments, the directors of Timpson estimate a lifetime expected credit
loss in relation to this receivable of £14.4 million. The probability of default over the next 12 months is
estimated at 25%. For trade receivables containing a significant financing component, Timpson chooses
to follow the three stage approach for impairments (rather than always measuring the loss allowance at
an amount equal to lifetime credit losses). No loss allowance has yet been recognised in relation to this
receivable.
Requirement
How should the receivable be treated in the financial statements?
Solution
A loss allowance for the trade receivable should be recognised at an amount equal to 12-month
expected credit losses. Although IFRS 9 offers an option for the loss allowance for trade receivables with
a financing component to always be measured at the lifetime expected losses, Timpson has chosen
instead to follow the three-Stage approach of IFRS 9.
The 12-month expected credit losses are calculated by multiplying the probability of default in the next
12 months by the lifetime expected credit losses that would result from the default. Here this amounts
to £3.6 million (£14.4m × 25%).
Adjustment:
DEBIT Expected credit loss £3.6m
CREDIT Allowance for receivables (this is offset against trade receivables) £3.6m
Worked example: Portfolio of mortgages and personal loans

Credito Bank operates in South Zone, a region in which clothing manufacture is a significant industry.
The bank provides personal loans and mortgages in the region. The average loan to value ratio for all its
mortgage loans is 75%.
All loan applicants are required to provide information regarding the industry in which they are
employed. If the application is for a mortgage, the customer must provide the postcode of the property
which is to serve as collateral for the mortgage loan.

Credito Bank applies the expected credit loss impairment model in IFRS 9 Financial Instruments. The
bank tracks the probability of customer default by reference to overdue status records. In addition, it is C
required to consider forward-looking information as far as that information is available. H
A
Credito Bank has become aware that a number of clothing manufacturers are losing revenue and profits P
as a result of competition from abroad, and that several are expected to close. T
E
Requirement R
How should Credito Bank apply IFRS 9 to its portfolio of mortgages in the light of the changing situation
in the clothing industry?
16
Solution
Credito Bank should segment the mortgage portfolio to identify borrowers who are employed by
clothing manufacturers and suppliers and service providers to the clothing manufacturers. This segment
of the portfolio may be regarded as being 'in Stage 2', that is having a significant increase in credit risk.
Lifetime credit losses must be recognised.
In estimating lifetime credit losses for the mortgage loans portfolio, Credito Bank will take into account
amounts that will be recovered from the sale of the property used as collateral. This may mean that the
lifetime credit losses on the mortgages are very small even though the loans are in Stage 2.
Interactive question 24: Particular defaults identified

Later in the year, more information emerged, and Credito Bank was able to identify the particular loans
that defaulted or were about to default.
Requirement
How should Credito Bank treat these loans?
Interactive question 25: Mortgage loans

A bank makes mortgage loans to clients. Interest charged to these clients is LIBOR (London Interbank
Offered Rate) + 1%, reset monthly.
The bank recognises that in its portfolio of clients there will be some clients who will experience financial
difficulties in the future and will not be able to keep up mortgage payments.
Under the mortgage agreement, the bank takes first legal charge over the mortgaged property and, in
the event of a default where payments cannot be rescheduled, the property would be sold to cover
unpaid debts.
Requirement
Discuss how revenue relating to the above would be accounted for under IAS 39 and under the revised
approach to amortised cost and impairment in IFRS 9.
Interactive question 26: Expected credit loss

Marland Co is preparing its financial statements for the year ended 30 April 20X5. Included in Marland's
trade receivables is an amount due from its customer, Metcalfe, of £128.85 million. This relates to a sale
which took place on 1 May 20X4, payable in three annual instalments of £50 million commencing
30 April 20X5 discounted at a market rate of interest adjusted to reflect the risks of Metcalfe of 8%.
Based on previous sales where consideration has been received in annual instalments, the directors of
Marland estimate a lifetime expected credit loss of £75.288 million in relation to this receivable balance.
The probability of default over the next twelve months is estimated at 25%. For trade receivables

containing a significant financing component, Marland chooses to follow the three-Stage approach for
impairments (rather than always measuring the loss allowance at an amount equal to lifetime credit
losses). No loss allowance has yet been recognised in relation to this receivable.
Requirement
Explain, with supporting calculations, how this receivable should be accounted for in the financial
statements of Marland for the year ended 30 April 20X5.
Interactive question 27: Debt instrument at fair value through other comprehensive
income
North Bank purchased a bond on 1 January 20X8 for its par value of £100,000 and measures it at fair
value through other comprehensive income. The instrument has a contractual term of five years and
interest rate of 5% payable annually in arrears on 31 December. The 12-month expected credit losses
on origination are £1,000.
On 31 December 20X8, the fair value of the debt instrument has decreased to £96,000 as a result of
changes in market interest rates. There has been no significant increase in credit risk since initial
recognition and expected credit losses shall be measured at an amount equal to 12-month expected
credit losses, which amounts to £1,500.
On 1 January 20X9, the bank sells the bond for its fair value of £96,000.
Requirement
Explain the impact of the above transaction in 20X8 and 20X9 on profit or loss, other comprehensive
income and the statement of financial position under IFRS 9.
7.15.8 Possible effects

Possible effects of the new model include the following.
(a) It is likely that this model will result in earlier recognition of credit losses than under the current
incurred loss model because it requires the recognition of not only credit losses that have already
occurred but also losses that are expected in the future. However, in the case of shorter-term and
higher-quality financial instruments, the effects may not be significant.
(b) The new model will require significantly more judgement when considering information related to
the past, present and future. It relies on more forward-looking information, which means that any
losses would be accounted for earlier than happens under the current rules.
(c) Costs of implementing the new model are likely to be material.
(d) There are differences between the IASB and the FASB approach which may lead to significant
differences in the figures reported if the new model is adopted.
7.16 Hedge accounting

The IAS 39 hedge accounting rules were criticised as being complex and not reflecting the entity's risk
management activities, nor the extent to which they are successful. The IASB addressed these issues in
IFRS 9 and the revised rules appear in the 2014 version of the standard. IFRS 9 requires a principles-
based approach to hedge accounting and the alignment of accounting with risk management activities.
The IFRS 9 approach to hedging is covered in section 9 of Chapter 17.

C
Summary and Self-test H
A
P
T
E
R
Summary
IAS 39 Financial Instruments: 16

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

Initial measurement
measurement
Impairment

Self-test
Answer the following questions.
1 Peacock
The Peacock Company purchases £40,000 of bonds. The asset has been designated as at fair value
through profit or loss.
One year later, 10% of the bonds are sold for £6,000. Total cumulative gains previously recognised
in profit or loss in respect of the asset are £1,000.
Requirement
In accordance with IAS 39 Financial Instruments: Recognition and Measurement, what is the amount
of the gain on the disposal to be recognised in profit or loss?
2 Vanadic
Some years ago the Vanadic Company raised finance on arm's-length terms, whereby interest of
5.5% would be paid annually in arrears and the loan repaid in full on 31 December 20X8. Taking
into account the transaction costs, the effective interest rate was 6%. Vanadic had paid all the
interest and capital due up to 31 December 20X2. The carrying amount of the loan on that date
was £10 million.
During 20X2 Vanadic encountered financial difficulties and agreed with its lenders revised terms for
20X3 onwards. Under the revised terms the coupon on the loan was raised and the term of the
loan extended.
The effective interest rate of the revised terms, excluding transaction costs, was 8% per annum.
The present value of the cash flows, excluding transaction costs, under the revised terms was
£10.5 million at 6% per annum and £9.5 million at 8%.
In addition, transaction costs of £700,000 were payable on 1 January 20X3 in respect of the
negotiations for the revised terms.
Requirements
Discuss and explain whether the following statements are true, according to IAS 39 Financial
Instruments: Recognition and Measurement.
(a) In all circumstances the transaction costs incurred in renegotiating the terms of any loan
should be recognised in profit or loss when payable.
(b) The revised terms negotiated by Vanadic are such that the original loan should be
derecognised and a new financial liability recognised.
3 Basic
The Basic Company manufactures personal computers. The Plank Company is a key supplier of
silicon chips to Basic.
Plank is having short-term liquidity problems so, in order to ensure continuity of supplies of silicon
chips, Basic made an interest-free loan of £7 million to Plank on 31 December 20X7. The loan is
repayable at par on 31 December 20X8. The market interest rate on loans with a similar credit
rating and term is 7% per annum. The annual interest rate on government bonds is 6%.
Requirement
What should the carrying amount of the loan be (to the nearest £1,000) in the statement of
financial position of Basic at 31 December 20X7 according to IAS 39 Financial Instruments:
Recognition and Measurement?

4 Colyear
C
The Colyear Company operates a small chain of shoe shops. Due to competition from larger rivals, H
revenue has fallen and Colyear is experiencing some liquidity problems. Colyear has therefore A
entered into two financing contracts, both of which have derivatives embedded within them. P
T
Contract (1) On 31 December 20X7 Colyear issued £15 million of 8% fixed rate debt maturing E
on 31 December 20Y2. Colyear has the option to extend the term of the loan for an R
additional three years at the same rate of interest. This debt has not been classified
as a financial liability at fair value through profit or loss.
16
Contract (2) On 30 June 20X7 Colyear signed a lease for a new retail site. The terms of the lease
provided for Colyear to benefit from paying a relatively low fixed annual rental of
£100,000. However, an additional rental payment of £50,000 would be made for
each year that annual revenue from the new retail site exceeded £5 million.
Requirement
Explain whether in each of the two contracts the embedded derivative should be separated from
the host contract in the financial statements of Colyear for the year to 31 December 20X7,
according to IAS 39 Financial Instruments: Recognition and Measurement.
5 Macmanus
On 1 January 20X7 The Macmanus Company issued a three-year £10 million bond at par. It has
not been classified as a financial liability at fair value through profit or loss.
The bond is redeemable on 1 January 20Y0 at a premium of 10%. The nominal interest rate is 6%,
payable on 31 December each year. The issue costs associated with the bond are £300,000. The
effective interest rate is 10.226%.
Requirement
What is the carrying amount of this liability in Macmanus's financial statements for the year ending
31 December 20X7 in accordance with IAS 39 Financial Instruments: Recognition and Measurement?
6 Boyes
The Boyes Company is about to issue a 5% fixed interest bond on 1 January 20X8 and is finalising
the terms of the issue with its investment bankers. The bond is not a financial liability at fair value
through profit or loss.
Requirement
Using the effective interest rate method, and assuming the other terms of the bond are held
constant, discuss and explain what impact any issue costs and any premium on redemption would
have on the effective interest rate with respect to the bond in Boyes's financial statements for the
year ending 31 December 20X8 in accordance with IAS 39 Financial Instruments: Recognition and
Measurement.
7 Gmund
The Gmund Company is a large manufacturer of jewellery. Gmund enters into a fixed price forward
contract to purchase 150 kilos of titanium in order to provide greater certainty as to its raw
material costs: titanium is a commodity traded on international commodities exchanges
worldwide.
The contract is in standard form and therefore permits Gmund either to take physical delivery of
the titanium after 12 months or to pay a net settlement in cash based on changes in the market
value of titanium. Gmund intends to take delivery of the titanium to make jewellery, as it always
has done with similar contracts in the past.
The Hononga Company is a wholesaler of titanium. It purchases large quantities of the metal and
then quickly delivers physical quantities of titanium to small jewellers, attempting to generate a
profit from short-term price fluctuations. Hononga enters into a one-month fixed price forward
contract to purchase 50 kilos of titanium.

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

C
Technical reference H
A
P
T
E
Recognition and derecognition R
 Initial recognition IAS 39.14
 Derecognition of financial asset IAS 39.17
– Transfers qualifying 16
IAS 39.18–20
– Transfers that do not qualify IAS 39.29–35
 Regular way transactions IAS 39.38, AG 53–56
 Derecognition of financial liabilities IAS 39.39–41
Measurement
 Initial measurement of financial assets and liabilities IAS 39.43–44
 Classification of financial assets IAS 39.9
 Classification of financial liabilities IAS 39.9
 Subsequent measurement of financial assets IAS 39.45–46
 Transaction costs IAS 39.43
 Subsequent measurement of financial liabilities IAS 39.47
 Fair value measurement considerations IAS 39.48
 Reclassification of financial assets IAS 39.50–54
 Gains and losses IAS 39.55–57
 Impairment of financial assets
– Objective evidence IAS 39.58–62
– Financial assets carried at amortised cost IAS 39.63–65
– Financial assets carried at cost IAS 39.66
– Available-for-sale assets IAS 39.67–70
Derivatives
 Derivatives – definition and classification IAS 39.9
 Embedded derivatives
– Definition IAS 39.10
– Relation with host instrument IAS 39.11–11A
– Accounting treatment IAS 39.11–11A

Answer to Interactive question 1

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

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

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

Convertible bonds
Present value factor at 7% for 4 years = 0.763
Cumulative present value factor at 7% for 4 years = 3.387
£
Present value of the principal (£4m  0.763) 3,052,000
Present value of the interest (£4m  5%  3.387) 677,400
Total liability component 3,729,400
Equity component (balancing figure) 170,600
Proceeds of the bond issue 3,900,000
Therefore the accounting entries on issue are (in £):

DEBIT Bank 3,900,000
CREDIT Liability 3,729,400
CREDIT Equity 170,600
Being initial recognition of convertible bonds
£
Opening carrying value at 1.10.X8 3,729,400
Finance cost (7% × 3,729,400) 261,058
Interest paid (5% × 4,000,000) (200,000)
Closing carrying value at 30.09.X9 3,790,458

The interest paid of £200,000 has gone through the books, therefore the adjustment required is:
C
DEBIT Finance costs £61,058 H
CREDIT Liability £61,058 A
P
Answer to Interactive question 5 T
E
Purchase of held for trading investment R
The held for trading investment should be classified as an asset held at fair value through profit or loss. It
is initially measured at fair value, in this case the cost of £1.75 million (500,000 shares  £3.50). The
16
transaction costs should not be included in the cost of the investment and should be written off to the
statement of profit or loss as a period cost. The investment is subsequently measured (at 30 June 20X9)
at fair value of £1.825 million (500,000 shares  £3.65) with the gain of £75,000 (£1.825m – £1.75m)
being recorded in profit or loss. The following adjustments are therefore required:
DEBIT Administrative expenses £15,000
CREDIT Held for trading investment £15,000
Being the correction in respect of transaction costs
DEBIT Held for trading investment £75,000

CREDIT Gain on investment (P/L) £75,000
Being the gain on the investment being credited to the statement of profit or loss
Purchase of a bond
The bond purchased by DG should be classified as a held-to-maturity financial asset, as DG intends to
hold it to redemption, it is quoted (a bond) and it has fixed payments (5% interest, £5.8 million
redemption value). It is initially recorded at the net cost of £4.5 million and then subsequently measured
at amortised cost using the effective interest rate (10.26%). Only the interest received of £250,000 (5%
 nominal value of £5 million) has been recorded in the statement of profit or loss. The following
adjustment is therefore required to bring the finance income up to the effective interest rate and to
correct the carrying amount of the asset:
DEBIT HTM financial asset £211,700
CREDIT Finance income £211,700
Being the additional finance income to be recognised in profit or loss
WORKING
£'000
1 July 20X8 purchased (£5m  90%) 4,500
Finance income (£4.5m  10.26%) 461.7
Interest received (£5m  5%) (250)
30 June 20X9 balance c/d 4,711.7
The financial asset will be held at £4.711.7 million and a further £211,700 (£461,700 – £250,000) will
be credited to the statement of profit or loss.

(a) (i) MNB has acquired a financial asset and the question states that it has been correctly classified
as held to maturity.
The requirements in respect of this category of financial asset under IAS 39 Financial
Instruments: Recognition and Measurement are as follows:
Initial measurement
The asset should be recorded at its fair value, plus transaction costs.
The initial value of MNB's investment is £3,200,000 (£3,000,000 + £200,000).
Subsequent measurement
The asset should be measured using the amortised cost method. Interest should be accrued
using the effective interest rate (allocating the true interest earned over the term of the
investment, including the actual interest received each year and the premium received on

maturity at a constant rate). The effective interest is added to the carrying value of the asset in
each accounting period and any cash flows received from the investment will be deducted
from its carrying value.
(ii) The financial statements for the year ended 31 December 20X0 will include:
• a financial asset of £3,245,600 (in the statement of financial position); and
• interest income of £225,600 (in profit or loss, in the statement of profit or loss and other
comprehensive income).
WORKING
£
1 January 20X0 3,200,000
Finance income (£3,200,000 × 7.05%) 225,600
Interest received (£3,000,000 × 6%) (180,000)
Balance c/d 31 December 20X0 3,245,600
(b) The investment is classified as held for trading, so it will be measured at fair value through profit
or loss. The journal entries will be:
Initial measurement:
DEBIT Financial asset £300,000
DEBIT Expense (in profit or loss) £12,000
CREDIT Cash £312,000
Being initial recognition of financial asset
Subsequent measurement at 31 December 20X0:
CREDIT Gain (in profit or loss) £40,000
Being subsequent measurement of financial asset
WORKING
£
Fair value at 31 December 20X0 (100,000  £3.40) 340,000
Cost (100,000  £3) (see Note) (300,000)
Revaluation gain (to profit or loss) 40,000
Note: Transaction costs are excluded from the initial fair value of a financial asset that is classified as
held for trading. These costs are charged to profit or loss immediately.

(a) Convertible bonds
A convertible instrument is considered part liability and part equity. IAS 32 requires that each part
is measured separately on initial recognition. The liability element is measured by estimating the
present value of the future cash flows from the instrument (interest and potential redemption)
using a discount rate equivalent to the market rate of interest for a similar instrument with no
conversion terms. The equity element is then the balance, calculated as follows:
£
PV of the principal amount £10 million at 7% redeemable in 5 yrs
(£10m  0.713) 7,130,000
PV of the interest annuity at 7% for 5 yrs
(5%  £10m)  4.100 2,050,000
Total value of financial liability element 9,180,000
Equity element (balancing figure) 820,000
Total proceeds raised 10,000,000
The equity element will not be remeasured; however, the liability element will be subsequently
remeasured at amortised cost recognising the finance cost using the effective interest rate of 7%
and deducting the coupon interest paid. The financial statements will include:

for the year ended 31 December 20X0 (within profit or loss) C
£ H
A
Finance cost (7%  9,180,000) 642,600
P
Statement of financial position as at 31 December 20X0 T
E
£
R
Equity 820,000
Financial liability (W) 9,322,600
WORKING 16
£
Liability recognised 1.1.X0 9,180,000
Finance cost (7%  9,180,000) 642,600
Interest paid (5%  10,000,000) (500,000)
At 31.12.X0 9,322,600
(b) Cumulative redeemable preference shares

IAS 32 requires that financial instruments are classified according to their substance, rather than
their legal form.
The main distinguishing feature of a liability is that it contains an obligation to transfer economic
benefit.
In this case the preference shares are redeemable so the company can be compelled to pay back
the capital to the shareholders. Furthermore, they are cumulative which means that QWE has an
obligation to pay the 6% dividend – even if there were insufficient distributable reserves to pay it in
any one year, it would become payable in the future when sufficient distributable reserves arise.
Therefore, these preference shares should be classified as liabilities and this will increase the
gearing of QWE.

The bonds are held-to-maturity financial assets (non-derivative financial assets with fixed or
determinable payments and fixed maturity that an entity has the positive intention and ability to hold to
maturity and are not designated/classified under any of the other three IAS 39 headings). They are
therefore held at amortised cost.
£'000
1 July 20X0 (100  £1,000) 100,000
Issue costs (80 + 20) (100)
99,900
Effective interest to 31 December 20X0 (99,900  3.0117%) 3,009
Cash paid 31 December 20X0 (100,000  3%) (3,000)
99,909
Effective interest to 30 June 20X1 (99,909  3.0117%) 3,009
Cash paid 30 June 20X1 (100,000  3%) (3,000)
99,918
Effective interest to 31 December 20X1 (99,918  3.0117%) 3,009
Cash paid 31 December 20X1 (100,000  3%) (3,000)
Carrying amount at 31 December 20X1 99,927

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

This is a derecognition issue. Legally the debt instrument remains the property of the entity. However, in
order to determine whether the investment in the debt instrument should be derecognised, the entity
needs to establish if substantially all the risks and rewards of ownership have been transferred.
In this case, the risks and rewards relating to the interest cash flows generated by the asset have been
transferred because the entity has no obligation to compensate the third party for any cash flows not
received ie, the third party suffers the risk. This is not the case for the ultimate maturity cash flow (the
principal).
Under IAS 39, where an entity transfers substantially all the risks and rewards of part of a financial asset,
that part is derecognised providing that part comprises only specifically identified cash flows. An interest
rate strip is given as an example by the standard.
Any difference between the proceeds received and the carrying amount (measured at the date of
derecognition) of the interest cash flows derecognised is recognised in profit or loss. The amount
derecognised is calculated by multiplying the carrying amount of the debt instrument by the
proportionate fair value of the interest flows versus the whole fair value of the debt instrument, both at
the date of the transfer. This leaves a 'servicing asset' (the principal element) which continues to be
recognised.

(a) AB Co should derecognise the asset. Its option is to repurchase the shares at their then fair value, so
it has transferred substantially all the risks and rewards of ownership.
(b) CD Co should not derecognise the asset, as it has retained substantially all the risks and rewards of
ownership.
(c) EF Co should not derecognise the asset, as it has retained substantially all the risks and rewards of
ownership. The investment should be retained in its books even though legal title is temporarily
transferred.
(d) GH Co has received 90% of its transferred receivables in cash, but whether it can retain this
amount permanently is dependent on the performance of the factor in recovering all of the
receivables. GH Co may have to repay some of it and therefore retains the risks and rewards of
100% of the receivables amount. The receivables should not be derecognised (IAS 39 para 16(b)).
The cash received should be treated as a loan.
The 10% of the receivables that GH Co will never receive in cash should be treated as interest over
the six-month period; it should be recognised as an expense in profit or loss and increase the
carrying amount of the loan.

At the end of the six months, the receivables should be derecognised by netting them against the
amount of the loan that does not need to be repaid to the factor. The amount remaining is bad C
debts which should be recognised as an expense in profit or loss. H
A
If there was any indication during the six months that the receivables were irrecoverable, the P
impairment loss should be recognised earlier. T
E
R
D.
16
Interest rate options are always treated as held for trading and therefore are held at 'fair value through
profit or loss' (ie, gains and losses reported immediately in profit or loss). An investment in another
company's redeemable preference shares may or may not be an available-for-sale financial asset. Their
redeemable nature makes them in substance debt and they are treated as an investment held to
maturity providing this is the intention (IAS 39).

Accounting treatment
The loan from Norton bank is to be repaid in ten years' time, but the terms of the loan state that
Chipping can pay it off in seven years. The issue arises as to whether the early repayment option is likely
to be exercised.
If, when the loan was taken out on 1 October 20X4 the option of early repayment was not expected to
be exercised, then at 30 September 20X5 the normal terms apply. The loan would be stated at
£40 million in the statement of financial position, and the effective interest would be 8% × £40m =
£3.2 million, the interest paid.
If at 1 October 20X4 it was expected that the early repayment option would be exercised, then the
effective interest rate would be 9.1%, and the effective interest 9.1% × £40m = £3.64m. The cash paid
would still be £3.2 million, and the difference of £0.44 million would be added to the carrying amount
of the financial liability in the statement of financial position, giving £40.44 million.
IAS 39 Financial Instruments: Recognition and Measurement requires that the carrying amount of a financial
asset or liability should be adjusted to reflect actual cash flows or revised estimates of cash flows. This
means that, even if it was thought at the outset that early repayment would not take place, if expectations
then change, the carrying amount must be revised to reflect future estimated cash flows using the effective
interest rate.
The directors of Chipping are currently in discussion with the bank regarding repayment in the next
financial year. However, these discussions do not create a legal obligation to repay the loan within
twelve months, and Chipping has an unconditional right to defer settlement for longer than twelve
months. Accordingly, it would not be correct to show the loan as a current liability on the basis of the
discussions with the bank.
Effect on profit for the year
If the loan from Norton bank is expected to be redeemed after seven years, the effective interest expense
for the year will be £3.64 million instead of £3.2 million.

(a) Statement of financial position
£
Non-current assets + Financial asset (441,014 + 35,281) 476,295

Finance income (441,014  (Working) 8%) 35,281
WORKING
Effective interest rate
600,000
= factor of 1.3605. From the four years line in the table the effective interest rate is 8%.
441,014

(b) Compound instrument
Presentation
£
Non-current liabilities
Financial liability component of convertible bond (Working) 1,797,467
Equity
Equity component of convertible bond (2,000,000 – (Working) 1,797,467) 202,533
WORKING
£
Fair value of equivalent non-convertible debt
Present value of principal payable at end of 3 years 1,544,367
(4,000  £500 = £2m  1
)
(1.09)3
Present value of interest annuity payable annually in arrears
for 3 years [(5%  £2m)  2.531] 253,100
1,797,467

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

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

Statement of financial position extracts at 31 December 20X2
£
Financial assets
4% debentures in MT Co (W1) 104,120
Interest rate option (W2) 13,750
Shares in EG Co (W3) 0
Financial liabilities
Shares in BW Co sold 'short' (W4) (28,000)

Statement of comprehensive income extracts year ended 31 December 20X2
£ C
Profit or loss H
Finance income A
P
Effective interest on 4% debentures in MT Co (W1) 6,120
T
Gain on interest rate option (W2) 6,750 E
Gain on sale of shares in EG Co (W3) 14,345 R
Finance costs
Loss on shares in BW Co sold 'short' (W4) (4,000)
Other comprehensive income 16
AFS financial assets – shares in EG Co (W3) (5,750)
WORKINGS
(1) Debentures (Financial asset HTM)
£
Cash paid on 1.1.20X2 (100,000 + 2,000) 102,000
Effective interest income (102,000  6%) 6,120
Coupon paid (100,000  4%) (4,000)
Amortised cost at 31.12.20X2 104,120
(2) Option (Financial asset at FVTPL)

1.9.20X2
CREDIT Cash £7,000
31.12.20X2
DEBIT Financial asset (£13,750 – £7,000) £6,750
CREDIT Profit or loss £6,750
(3) Shares (Available-for-sale financial asset – reclassification)
20X1
£
Purchase for cash ((25,000  £2) + (1%  £50,000)) 50,500
Fair value gain at 31.12.20X1 ((25,000  £2.25 bid 5,750 other
price) – £50,500)) comprehensive
income
Fair value at 31.12.20X1 56,250
20.12.20X2
DEBIT Cash ((25,000  £2.62) – (1%  65,500)) £64,845
DEBIT Other comprehensive income (reclassified) £5,750
CREDIT Financial asset £(56,250)
(4) Shares sold 'short' (Financial liability at fair value through profit or loss)
22.12.20X2
DEBIT Cash £24,000
CREDIT Financial liability £24,000
31.12.20X2
DEBIT Profit or loss (£28,000 – £24,000) £4,000

An impairment loss has been incurred if there is objective evidence of impairment. The amount of the
impairment loss for a loan measured at amortised cost is the difference between the carrying amount of
the loan and the present value of future principal and interest payments discounted at the loan's original
effective interest rate. In cases (a)–(d), the present value of the future principal and interest payments
discounted at the loan's original effective interest rate will be lower than the carrying amount of the
loan. Therefore, an impairment loss is recognised in those cases.

In case (e), even though the timing of payments has changed, the lender will receive interest on
interest, and the present value of the future principal and interest payments discounted at the loan's
original effective interest rate will equal the carrying amount of the loan. Therefore, there is no
impairment loss. However, this is unlikely given Customer B's financial difficulties.

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

DEBIT Profit or loss £32,048
CREDIT Financial asset £32,048

The fair value of Morden Co's promise is approximately £152,000. This is the present value of £200,000
7
in seven years at 4% (£200,000 × 1/1.04 ).
The fair value of Merton Co's promise is approximately £116,700. This is the present value of £200,000
7
in seven years at 8% (£200,000 × 1/1.08 ).
These two values are different, even though the amount and period are the same, due to the different
risk profiles of the two companies.

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

In Contract (1) there is an embedded derivative but this should not be separated from the host contract.
In Contract (2) there is an embedded derivative which should be separated from the host contract.
IAS 39.11 requires an embedded derivative to be separated from the host contract if:
(a) the economic characteristics and risks are not closely related to the host contract;
(b) a separate instrument with the same terms would meet the definition of a derivative; and
(c) the combined instrument has not been designated as at fair value through profit or loss
Contract (1)
Although there is a derivative embedded in the contract (it is not denominated in Sebacoyl's functional
currency), it does not satisfy the conditions for separation from the host contract. Its economic
characteristics and risks are closely related to those of the host contract, in that the R£ is the functional
currency of one substantial party to the contract.

Contract (2)
C
The derivative embedded in this contract must be separated out, because the N£, the currency in which H
the contract is denominated, is not the functional currency of either party, nor is it the currency used A
internationally as the measure of contract prices. P
T
E
Answer to Interactive question 23 R
The shares are initially measured at fair value (the purchase price here) plus transaction costs:
(80,000  £4.54) = £363,200 + (£363,200  1%) = £366,832 16
The investment is derecognised on 31 December. The fact that the same quantity of shares are
repurchased the next day does not prevent derecognition as the company has no obligation to
repurchase them, therefore the risks and rewards of ownership are not retained.
Immediately before derecognition a loss is recognised in other comprehensive income as the company
elected to hold the investment at fair value through other comprehensive income and the investment
must be remeasured to fair value at the date of derecognition) (IFRS 9 para 3.2.12a):
(80,000  £4.22 bid price) = £337,600 – £366,832 = £29,232 loss
The transaction costs on sale of £3,376 (£337,600  1%) are recognised in profit or loss.

The loans are now in Stage 3. Lifetime credit losses should continue to be recognised, and interest
revenue should switch to a net interest basis, that is on the carrying amount net of allowance for credit
losses.

The revenue associated with mortgage loan assets is the interest. Under IFRS 9, the variable element of
the interest is accrued on a time basis and the fixed element is reduced to reflect any initial transaction
costs and to reflect a constant return on the balance outstanding. Under IAS 39 (which continues to be
examinable for now), no reduction is made to the interest revenue to take account of expected credit
losses; credit losses are only accounted for when there is objective evidence that they have occurred.
IAS 18 provides that interest revenues should only be recognised when it is probable that the economic
benefits will flow to the entity (and the amount can be measured reliably).

The trade receivable of £128.85 million should be recognised in the statement of financial position as at
30 April 20X5 as a financial asset.
Interest on the trade receivable is £128.85m × 8% = £10.308m. This should be recognised in the
statement of profit or loss as interest income.
A loss allowance for the trade receivable should be recognised at an amount equal to 12 months'
expected credit losses. Although IFRS 9 Financial Instruments offers an option for the loss allowance for
trade receivables with a financing component to always be measured at the lifetime expected losses,
Marland has chosen instead to follow the three stage approach of IFRS 9.
The twelve-month expected credit losses are calculated by multiplying the probability of default in the
next twelve months by the lifetime expected credit losses that would result from the default. Here this
amounts to £18.822 million (£75.288m × 25%). Because this allowance is recognised at 1 May 20X4,
the discount must be unwound by one year: £18.822m × 8% = £1.506m.
Overall adjustment:
DEBIT Finance costs (impairment of receivable) (18.822 + 1.506) £20.328m
CREDIT Loss allowance £20.328m

North Bank classifies the bond at fair value through other comprehensive income (FVOCI). It recognises
a loss allowance equal to 12-month expected credit losses on origination. This is recognised in profit or
loss. Any subsequent increase in the loss allowance is also recognised in profit or loss. The fair value
movements on the bond are recognised in other comprehensive income until sale when they are
recycled to profit or loss.
1 January 20X8
DEBIT Debt instrument – FVOCI £100,000
(Purchase of bond at FVOCI)
DEBIT Impairment allowance – profit or loss £1,000
CREDIT Other comprehensive income £1,000
(12-month expected credit losses on origination)
Expected credit losses are not recognised in the statement of financial position for debt instruments
measured at FVOCI as the carrying amount of this asset should be the fair value. The impairment
allowance is instead recognised in other comprehensive income as the accumulated impairment
amount.
31 December 20X8
DEBIT Cash 5,000
CREDIT Interest income £5,000
(Interest income at 5% of £100,000)
DEBIT Impairment allowance – profit or loss £500

CREDIT Other comprehensive income £500
(Increase in 12-month expected credit losses)
DEBIT Other comprehensive income £4,000

CREDIT Debt instrument – FVOCI £4,000
(Fair value adjustment to reduce asset value to £96,000)
1 January 20X9
DEBIT Cash £96,000
CREDIT Debt instrument – FVOCI £96,000
DEBIT Loss on sale – profit or loss £2,500
(Proceeds from sale and recycling of fair value loss to profit or loss)
The gross carrying amount of the debt instrument may be reduced through use of an allowance
account.

C
Answers to Self-test H
A
P
T
1 Peacock E
R
IAS 39.27 states that upon derecognition of a part of a financial asset the amount recognised in
profit or loss should be the difference between the carrying amount allocated to the part
derecognised and the sum of: 16
(i) the consideration received for the part derecognised; and
(ii) any cumulative gain or loss allocated to it that had been recognised in other comprehensive
income.
The previous gains had been recognised in profit or loss and so are not included in the calculation.
The carrying amount is measured as original cost plus previous gains £4,100 (ie, 10%  41,000).
The carrying amount of the proportion sold is deducted from the proceeds (£6,000) to give the
gain of £1,900.
2 Vanadic
It is not the case that 'the transaction costs incurred in renegotiating the terms of any loan should
be recognised in profit or loss when payable' in all circumstances.
It is true that 'the revised terms negotiated by Vanadic are such that the original loan should be
derecognised and a new financial liability recognised'.
Transaction costs are recognised in profit or loss if the revision of loan terms is to be treated as the
extinguishment of the loan. But if the revision is treated as a modification, the costs are amortised
over the remaining life of the modified liability (IAS 39 AG 62).
Derecognition of the old loan and recognition of the new liability is required if the present value of
the cash flows under the new terms is 10% or more different from the present value of the original
loan. The cash flows under the new terms must be discounted at the 6% effective interest rate of
the original loan and include the £700,000 transaction costs (IAS 39 AG 62).
With transaction costs payable at the start of the period of the revised terms, they are added on in
full to the £10.5 million present value, giving a total of £11.2 million. This is 12% different from
the £10 million present value of the old loan, so the original loan should be derecognised and the
new financial liability recognised.
3 Basic
IAS 39.43 requires a financial asset to be measured initially at fair value.
A zero interest rate loan issued at par would not result from an arm's-length transaction and IAS 39
AG 64 requires the fair value in such a case to be determined as the present value of the cash
receipts (ie, redemption amount) under the effective interest method. The discount rate should be
that on similar loans. So initially it will be measured at £7.0m/1.07 = £6,542,000.
This loan will fall within IAS 39.9's definition of loans and receivables which under IAS 39.46 should
be subsequently measured at amortised cost using the effective interest method. As this
subsequent measurement is made on the same day as the initial measurement, the carrying
amount will be £6,542,000.
4 Colyear
IAS 39.11 requires an embedded derivative to be separated from the host contract if:
(i) the embedded derivative's economic characteristics and risks are not closely related to those
of the host contract;
(ii) a separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative; and
(iii) the hybrid contract is not measured at fair value through profit or loss.

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

8 Luworth
C
(a) HTM (b) FV through P/L (c) AFSFA
H
20X1 20X2 20X1 20X2 20X1 20X2 A
£'000 £'000 £'000 £'000 £'000 £'000 P
Profit or loss T
Interest income (W1)/(W2) 1,200 1,200 1,200 1,387 1,200 1,387 E
R
Gain/(loss) due to change in
FV (W2) – – (187) – – *(187)
1,200 1,200 1,013 1,387 1,200 1,200
16
Other comprehensive
income
Available-for-sale financial
assets – – – – (187) 187
1,200 1,200 1,013 1,387 1,013 1,387
Statement of financial
position
Financial asset (W1)/(W2) 20,000 – 19,813 – 19,813 –
Reserves
Gain/(loss) due to change in
FV (W2) – – – – (187) –
* Reclassified from equity to profit or loss on derecognition.

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

£'000
Cash 20,000
Effective interest (as above) 1,200
Coupon received (as above) (1,200)
Fair value loss (187)
At 31.12.20X1 (W3) 19,813
Interest at 7% (7%  19,813) 1,387
At 31.12.20X2 0
(3) Fair value at 31.12.20X1

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

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

CHAPTER 17
Financial instruments:
hedge accounting
Introduction
Topic List
1 Hedge accounting: the main points
2 Hedged items
3 Hedging instruments
4 Fair value hedge
5 Cash flow hedge
6 Hedge of a net investment
7 Conditions for hedge accounting
8 Disclosures
9 Current developments: IFRS 9 changes
10 Audit focus: fair value
11 Auditing financial instruments
12 Auditing derivatives
Technical reference
813
Introduction
Learning objectives
Tick off
 Identify and explain current and emerging issues in corporate reporting
 Determine and calculate how different bases for recognising, measuring and classifying
financial assets and financial liabilities can impact upon reported performance and position
 Evaluate the impact of accounting policies and choice in respect of financing decisions for
example hedge accounting and fair values
 Explain and appraise accounting standards that relate to an entity's financing activities
which include: financial instruments; leasing; cash flows; borrowing costs; and
government grants
 Determine for a particular scenario what comprises sufficient, appropriate audit evidence
 Design and determine audit procedures in a range of circumstances and scenarios, for
example identifying an appropriate mix of tests of controls, analytical procedures and tests
of details
 Demonstrate and explain, in the application of audit procedures, how relevant ISAs affect
audit risk and the evaluation of audit evidence
Specific syllabus references for this chapter are: 1(e), 4(a), 4(c), 4(d), 14(c), 14(d), 14(f)

1 Hedge accounting: the main points
Section overview
Pay particular attention to this first section, as it contains the main points you need to know.
1.1 Introduction
In earlier levels of your study for the ACA qualification, such as Financial Management, you have covered
the way hedging is an important means by which a business can manage the risks it is exposed to.
As an example, a manufacturer of chocolate can fix now the price at which it buys a specific quantity of
C
cocoa beans at a predetermined future date by arranging a forward contract with the cocoa beans H
producer. A
P
The forward price specified in the forward contract may be higher or lower than the spot price at the T
time the contract is agreed, depending on seasonal and other factors. But by agreeing the forward E
contract both the manufacturer and the producer have removed the risk they otherwise would face of R
unfavourable price movements (price increases being unfavourable to the chocolate manufacturer and
price decreases unfavourable to the cocoa beans producer) between now and the physical delivery date.
Equally, they have removed the possibility of favourable price movements (price decreases being 17
favourable to the chocolate manufacturer and price increases favourable to the cocoa beans producer)
over the period.
Another way of achieving the same effect would be for the chocolate manufacturer to purchase cocoa
bean futures on a recognised trading exchange. On the delivery date the manufacturer would close out
the futures in the futures market and then buy the required quantity in the spot market. The profit/(loss)
on the futures transaction should offset the increase/(decrease) in the spot price over the period.
Hedge accounting is the accounting process which reflects in financial statements the commercial
substance of hedging activities. It results in the gains and losses on the linked items (eg, the purchase of
coffee beans and the futures market transactions) being recognised in the same accounting period and
in the same section of the statement of profit or loss and other comprehensive income ie, both in profit
or loss, or both in other comprehensive income.
Hedge accounting reduces or eliminates the volatility in profit or loss which would arise if the items
were not linked for accounting purposes.
Point to note:
The forward contract is a derivative. Without hedge accounting, the profit/(loss) in the futures market
would be recognised as the contract is remeasured to fair value at each reporting date, but the
increased/(decreased) cost of the cocoa beans would be recognised at the later date when the
chocolate is sold. Both would be recognised in profit or loss, but possibly in different accounting
periods.
In the previous chapter the point was made that financial assets should be classified/designated at the
time of their initial recognition, not at any later date. This is to prevent businesses making classifications/
designations with the benefit of hindsight so as to present figures to their best advantage. Similarly,
hedge accounting is only permitted by IAS 39 Financial Instruments: Recognition and Measurement if the
hedging relationship between the two items (the cocoa beans and the futures contract in the above
example) is designated at the inception of the hedge. And designation is insufficient by itself; there must
be formal documentation, both of the hedging relationship and of management's objective in
undertaking the hedge.
The effect is that hedge accounting is an accounting policy option, not a requirement. If the hedging
relationship does not meet IAS 39's conditions (eg, it is not properly documented), then hedge
accounting is not permitted. Some businesses take the view that the costs of meeting these conditions
outweigh the benefits of hedge accounting; simply by not preparing the right documentation, they
avoid having to comply with the relevant parts of IAS 39.
But if a business does comply with IAS 39's conditions for hedge accounting, then the hedge
accounting provisions of this standard do become compulsory.
Financial instruments: hedge accounting 815

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

The effectiveness of the hedge is measured as the extent to which the change in the hedging
instrument offsets the change in the hedged item.
(a) If the loss on the hedged item is £10,000 and the gain on the hedging instrument is £10,000, the
hedge is fully effective.
(b) If the loss on the hedged item is £10,000 and the gain on the hedging instrument is £9,000, the
hedge is not fully effective. Its effectiveness can be measured as 10,000/9,000 = 111% or as
9,000/10,000 = 90%.
(c) Hedge accounting is only permitted if, both at inception and during the life of the hedging
relationship, the measure of effectiveness falls between 80% and 125%.
Definitions
Note: Here are three definitions you may need for the illustration that follows:
A forward contract is a commitment to undertake a future transaction at a set time and at a set price.
A future represents a commitment to an additional transaction in the future that limits the risk of
existing commitments.
An option represents a commitment by a seller to undertake a future transaction, where the buyer has
the option of not undertaking the transaction.

Illustration 1: Basic hedging
1 January
On 1 January the price (the spot price) of a consignment of cocoa beans is £1,000.
You know you will need to buy a consignment of cocoa beans on 28 February, as they will be needed to
fulfil a customer order. You are afraid that the price of cocoa beans will rise significantly between
1 January and 28 February.
You therefore contract with a cocoa beans supplier to buy a consignment of cocoa beans at £1,050 on
28 February.
28 February
The price of a consignment of cocoa beans is now £1,100. C
You nevertheless can hold the supplier to the forward contract and can buy the cocoa beans at £1,050. H
A
However, if the market had not behaved as predicted and the price of cocoa beans was £980 on P
T
28 February, you would still be obliged to buy the cocoa beans at the price of £1,050.
E
Similarly, if the customer had pulled out of the transaction, you would still have to buy the consignment R
of cocoa beans and dispose of them as best you could.
Hedging deals with the bad news you do not expect! 17
1 January
You have already agreed to buy a consignment of cocoa beans for £1,200 on 28 February, which means
you appear to be at risk of paying too much for the cocoa beans.
You buy a three-month cocoa futures contract at £1,100 that expires on 31 March. This means you
are committing to buying an additional consignment of cocoa beans, not at today's spot price, but
at the futures price of £1,100. £1,100 represents what the market thinks the spot price will be on
31 March.
28 February
You buy the consignment of cocoa beans at £1,200.
You are still committed to buying the consignment at £1,100 on 31 March, but that will mean that you
have two consignments of cocoa beans rather than just the one you need. You therefore sell the futures
contract you bought on 1 January to eliminate this additional commitment. The futures contract is now
priced at £1,233, as the market now believes that £1,233 will be the spot price on 31 March.
Because you have sold the contract for more than the purchase price, you have made a gain on the
futures contract of 1,233 – 1,100 = £133. This can be set against the purchase you made.
Net cost = 1,200 – 133 = £1,067; the cost of paying more for the cocoa beans has been offset by the
profit made on the futures contract.
1 January
You know you will need to buy a consignment of cocoa beans on 28 February, as they will be needed to
fulfil a customer order. You think it is likely that the price of cocoa beans will rise significantly between
1 January and 28 February, but you believe that with current market uncertainty, the price of cocoa
beans could even fall.
You therefore take out an option to buy cocoa beans at £1,050 on 28 February. Because you are being
given the privilege of choosing whether or not to fulfil the option contract, you have to pay a premium
of £30.

28 February
Scenario 1
What if the price of the cocoa beans has now risen to £1,100?
You can hold the supplier to the option contract and buy the cocoa beans at £1,050.
Total cost = 1,050 + 30 = £1,080.
Scenario 2
What if the price of cocoa beans has fallen to £980? You could let the option contract lapse and buy
cocoa beans at £980.
Total cost = 980 + 30 = £1,010.
Scenario 3
What if your customer pulls out of the contract? You would not have to buy the cocoa beans and the
only cost to you will be the premium of £30.
Illustration 2: Basic hedging

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

On 1 August 20X5 an entity owned 50,000 litres of vegetable oil which had cost it £5 per litre and
which had a selling price (spot price = fair value) of £6 per litre. The entity was concerned that the fair
value might fall over the next three months, so it took out a three-month future to sell at £6 per litre.
On 31 October the spot price of the oil had fallen to £5.60. On that date the entity closed out its future
and sold its inventory, both transactions being at the spot price.
The sale of 50,000 litres at £5.60 generates revenue of £280,000; deducting the cost of £250,000 the
profit recognised in profit or loss should be £30,000.
The entity also makes a profit of £0.40 (6.00 – 5.60) per litre in the futures market, so on 50,000 litres a
profit of £20,000 should be recognised in profit or loss.
Subject to any futures market transaction costs, the entity has protected itself against a fall in fair value
below the £6 fair value at 1 August 20X5.

1.5 Accounting for a simple cash flow hedge
On 1 November 20X5 an entity, whose functional currency is the £, entered into a contract to sell
goods on 30 April 20X6 for $300,000. In fixing this $ price it worked on the basis of the spot exchange
rate of $1.50 = £1, so that revenue would be £200,000. To ensure it received £200,000 on
30 June 20X6 the entity took out a six-month future to sell $300,000 for £200,000.
On 31 December 20X5 (which is the company's reporting date) an equivalent futures contract traded at
a value of £18,182. This may be taken as an acceptable approximation to fair value. The future was
therefore worth £18,182 and the entity recognised that amount as a financial asset and as a profit in
other comprehensive income.
On 30 April 20X6 the spot exchange rate was $1.75 = £1 and the future was worth £28,571 (£200,000
– ($300,000/1.75)). The entity closed out its future position at the then spot price and sold the goods.
The accounting entries should be: C
H
DEBIT Customer ($300,000/1.75) £171,429 A
DEBIT Financial asset (28,571 – 18,182) £10,389 P
T
DEBIT Other comprehensive income £18,182 E
(Reclassification of gain to profit or loss) R
CREDIT Revenue £200,000
The customer account and the financial asset are then cleared by cash receipts. Note that revenue is
measured at the amount fixed as a result of the hedging transaction. 17
Interactive question 1: Simple derivative and hedging

BCL entered into a forward contract on 31 July 20X0 to purchase $2 million at a contracted rate of £1:
$0.64 on 31 October 20X0. The contract cost was nil. BCL prepares its financial statements to
31 August 20X0. At 31 August 20X0 an equivalent contract for the purchase of $2 million could be
acquired at a rate of £1:$0.70.
Requirements
(a) Explain how this financial instrument should be classified and prepare the journal entry required for
its measurement as at 31 August 20X0.
(b) Assume now that the instrument described above was designated as a hedging instrument in a
cash flow hedge, and that the hedge was 100% effective.
(i) Explain how the gain or loss on the instrument for the year ended 31 August 20X0 should
now be recorded and why different treatment is necessary.
(ii) Prepare an extract of the statement of profit or loss and other comprehensive income for BCL
for the year ended 31 August 20X0, assuming the profit for the year of BCL was £1 million,
before accounting for the hedging instrument.
Interactive question 2: Simple fair value hedge

VB acquired 40,000 shares in another entity, JK, in March 20X3 for £2.68 per share. The investment was
classified as available for sale on initial recognition. The shares were trading at £2.96 per share on
31 July 20X3. Commission of 5% of the value of the transaction is payable on all purchases and
disposals of shares.
Requirement
(a) Prepare the journal entries to record the initial recognition of this financial asset and its subsequent
measurement at 31 July 20X3 in accordance with IAS 39 Financial Instruments: Recognition and
Measurement.
The directors of VB are concerned about the value of VB's investment in JK and, in an attempt to hedge
against the risk of a fall in its value, are considering acquiring a derivative contract. The directors wish to
use hedge accounting in accordance with IAS 39.

Requirement
(b) Discuss how both the available for sale investment and any associated derivative contract would be
subsequently accounted for, assuming that the criteria for hedge accounting were met, in
accordance with IAS 39.
2 Hedged items
Section overview
This section deals with detailed issues related to hedged items in a hedging relationship.
Definitions
Hedged item: An asset, liability, firm commitment, highly probable forecast transaction or net
investment in a foreign operation that:
 exposes the entity to risk of changes in fair value or future cash flows; and
 is designated as being hedged.
Firm commitment: A binding agreement for the exchange of a specified quantity of resources at a
specified price on a specified future date or dates.
Forecast transaction: An uncommitted but anticipated future transaction.
Point to note:
Neither firm commitments nor forecast transactions are normally recognised in financial statements. As
is explained in more detail in a later part of this chapter, it is only when they are designated as hedged
items that they are recognised.
2.1 Financial risks

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

2.2 Nature of hedged items
In this section we discuss some of the key aspects of the definition of a hedged item.
(a) The hedged item can be:
(i) a single asset, liability, unrecognised firm commitment, highly probable forecast transaction or
net investment in a foreign operation;
(ii) a group of assets, liabilities, firm commitments, highly probable forecast transactions or net
investments in foreign operations with similar risk characteristics; or
(iii) a portion of a portfolio of financial assets or financial liabilities which share exposure to
interest rate risk. In such a case the portion of the portfolio that is designated as a hedged
item is a hedged item with regard to interest rate risk only.
C
(b) Assets and liabilities designated as hedged items can be either financial or non-financial items. H
A
(i) Financial items can be designated as hedged items for the risks associated with only a P
portion of their cash flows or fair values. So a fixed rate liability which is exposed to foreign T
currency risk can be hedged in respect of currency risk, leaving the credit risk not hedged. E
R
(ii) But non-financial items such as inventories shall only be designated as hedged items for
foreign currency risks or for all risks. The reason is that it is not possible to separate out the
appropriate portions of the cash flow or fair value changes attributable to specific risks other 17
than foreign currency risk.
(c) Unrecognised assets and liabilities cannot be designated as hedged items. So unrecognised
intangibles cannot be hedged items.
(d) Only assets, liabilities, firm commitments or highly probable transactions that involve a party
external to the entity can be designated as hedged items. The effect is that hedge accounting
can be applied to transactions between entities or segments in the same group only in the
individual or separate financial statements of those entities or segments and not in the consolidated
financial statements.
(e) As an exception, an intra-group monetary item qualifies as a hedged item in the consolidated
financial statements if it results in an exposure to foreign exchange rate gains and losses that are
not eliminated on consolidation.
Illustration: Intra-group hedge

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

IAS 39 permits the designation of a group of assets as a hedged item provided that the following two
conditions are met.
 The individual assets or liabilities in the group share the risk exposure that is designated as
being hedged.
 The change in the fair value attributable to the hedged risk for each individual item in the group
is expected to be approximately proportional to the overall change in fair value attributable to the
hedged risk of the group items.

Worked example: Group of assets
An entity constructs a portfolio of shares to replicate a stock index and uses a put option on the index to
protect itself from fair value losses.
Requirement
Can the portfolio of shares be designated as a hedged item?
Solution
The portfolio cannot be designated as a hedged item. Similar financial instruments should be
aggregated and hedged as a group only if the change in fair value attributable to the hedged risk for
each individual item in the group is expected to be approximately proportional to the overall change in
fair value attributable to the hedged risk of the group. In the scenario above, the change in the fair value
attributable to the hedged risk for each individual item in the group (individual share prices) is not
expected to be approximately proportional to the overall change in fair value attributable to the hedged
risk of the group; even if the index rises, the price of an individual share may fall.
2.4 Hedging an overall net position

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

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

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

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

A forecast transaction (as defined above) qualifies as a hedged item only if the transaction is highly
probable. Examples of forecast transactions that qualify as a hedged item include the following:
(a) The anticipated issue of fixed rate debt. This can be recognised as a hedged item under a cash flow
hedge of a highly probable forecast transaction that will affect profit or loss.
(b) Expected, but not contractual, future foreign currency revenue streams, provided that the revenues
C
are highly probable. A hedge of an anticipated sale can qualify as a cash flow hedge. H
A
P
Illustration: Forecast transaction T
E
An airline may use models based on past experience and historical economic data to project its revenues R
in various currencies. If it can demonstrate that forecast revenues for a period of time into the future in a
particular currency are highly probable, it may designate a currency borrowing as a cash flow hedge of
the currency risk of the future revenue stream. The portion of the gain or loss on the borrowing that is 17
determined to be an effective hedge is recognised in other comprehensive income until the revenues
occur.
It is unlikely that an entity can reliably predict 100% of revenues for a future year. On the other hand, it
is possible that a portion of predicted revenues, normally those expected in the short term, will meet the
'highly probable' criterion.
Because forecast transactions can only be hedged under cash flow hedges, the ways to assess the
probability of a future transaction are covered below under cash flow hedges.
2.8 Intra-group and intra-entity hedging transactions

It has already been noted that hedged items have to involve a party external to the entity, with the
result that intra-group transactions can be designated as hedged items only in the individual or separate
financial statements and not in consolidated financial statements. There are only two cases, both
involving foreign exchange translation, where intra-group transactions will be recognised in the
consolidated financial statements.
The first case is a result of IAS 21 The Effects of Changes in Foreign Exchange Rates under which foreign
exchange gains and losses on an intra-group monetary asset or liability between entities with different
functional currencies are not fully eliminated in the consolidated profit or loss. This is because a foreign
currency monetary item represents a commitment to convert one currency into another one and
exposes the reporting entity to a gain or loss through currency fluctuations. Because such exchange
differences are not fully eliminated on consolidation, they will affect profit or loss in the entity's
consolidated financial statements and hedge accounting may be applied.
The second case arises because IAS 39 permits the foreign currency risks of a highly probable forecast
intra-group transaction to be designated as a hedged item in the consolidated financial statements
provided the following two conditions are met.
 The highly probable forecast intra-group transaction is denominated in a currency other than the
functional currency of the group member entering into that transaction.
 The foreign currency risk will affect the group's consolidated profit or loss.

Worked example: Hedging intra-group monetary items
An Australian company, whose functional currency is the Australian dollar, has forecast purchases in
Japanese yen that are highly probable. The Australian entity is wholly owned by a Swiss entity, which
prepares consolidated financial statements (which include the Australian subsidiary) in Swiss francs. The
Swiss parent entity enters into a forward contract to hedge the change in yen relative to the Australian
dollar.
Requirement
Explain whether that hedge can qualify for hedge accounting in the Swiss entity's consolidated financial
statements.
Solution
The hedge can qualify for hedge accounting. Since the Australian entity did not hedge the foreign
currency exchange risk associated with the forecast purchases in yen, the effects of exchange rate
changes between the Australian dollar and the yen will affect the Australian entity's profit or loss and,
therefore, would also affect consolidated profit or loss. IAS 39 does not require the operating unit that is
exposed to the risk being hedged to be a party to the hedging instrument.
2.9 Items that do not qualify as hedged items

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

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

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

An entity cannot designate a pay-variable, receive-fixed interest rate swap as a cash flow hedge of a
variable rate, held-to-maturity investment because it is inconsistent with the designation of a debt
investment as being held to maturity to designate a swap as a cash flow hedge of the debt investment's
variable interest rate payments.

A forecast purchase of a held-to-maturity investment, on the other hand, can be a hedged item with
respect to interest rate risk. Held-to-maturity investments can also be a hedged item with respect to
foreign currency risk and credit risk.
2.9.3 Equity method investments and investment in subsidiaries in respect of fair value hedges
The equity method of accounting (eg, for associates) recognises in profit or loss a share of (the
associate's) profit or loss, not the change in the fair value of the investment (in the associate). The
definition of a fair value hedge does not include risks associated with changes in shares of profit or loss.
The same analysis applies to investments in subsidiaries.
2.9.4 Future earnings

Future earnings cannot be hedged items because they are the net result of different transactions with C
different risk profiles. However, highly probable forecast transactions can be hedged items, so it is H
theoretically possible to hedge the individual components of future revenue and future expenses. A
P
T
2.9.5 Derivative instruments E
R
IAS 39 does not permit designating a derivative instrument (whether a standalone or a separately
recognised embedded derivative) as a hedged item (obviously, it may be a hedging instrument) either
individually or as part of a hedged group in a fair value or cash flow hedge. This is not really a problem
17
because derivatives are always classified as held for trading, so gains/losses are recognised in profit or
loss. So if from a commercial perspective a derivative is hedged by another derivative, the normal
accounting treatment means that they would both be booked at fair value through profit or loss and a
natural offset in profit or loss would occur.
As exceptions:
 Derivatives may be designated as hedging instruments (not hedged items) in a cash flow hedge.
 The effect of IAS 39 AG 94 is to permit the designation of a purchased option as a hedged item.
2.9.6 Business risk

IAS 39 does not permit an entity to apply hedge accounting to a hedge of the risk that a transaction will
not occur, even if, for example, that would result in less revenue to the entity than expected. The risk
that a transaction will not occur is an overall business risk that is not eligible as a hedged item. Hedge
accounting is permitted only for risks associated with recognised assets and liabilities, firm
commitments, highly probable forecast transactions and net investments in foreign operations.
3 Hedging instruments
Section overview
This section considers in detail the financial instruments that can be designated as hedging instruments
for hedge accounting purposes.
3.1 Hedging instruments
Definition
Hedging instrument: A designated derivative or, for a hedge of the risk of changes in foreign currency
exchange rates only, a designated non-derivative financial asset or non-derivative financial liability,
whose fair values or cash flows are expected to offset changes in the fair value or cash flows of a
designated hedged item.

An implication of this definition is that financial assets and liabilities whose fair value cannot be reliably
measured cannot be designated as hedging instruments.
The types of hedging instruments that can be designated in hedge accounting are as follows:
 Derivatives, such as forward contracts, futures contracts, options and swaps
 Non-derivative financial instruments, but only for the hedging of currency risk. This category
includes foreign currency cash deposits, loans and receivables, available for sale monetary items
and held-to-maturity instruments carried at amortised cost
3.2 Derivatives
Any derivative financial instrument, with the exception of written options to which special rules apply,
can be designated as a hedging instrument. Derivative instruments have the important property that
their fair value is highly correlated with that of the underlying.
3.3 Options
Options provide a more flexible way of hedging risks compared to other derivative instruments such as
forwards, futures and swaps, because they give to the holder the choice as to whether or not to exercise
the option.
3.3.1 Purchased options

When an entity purchases a put option, it buys the right to sell the underlying at the strike price. If the
price of the underlying falls below the strike price, the entity exercises its option and receives the strike
price; it has protected the value of its position. Similarly, if an entity needs to buy an asset in the future,
it can purchase a call option on the asset that gives the entity the right to purchase the asset at the
strike price, protecting it from a rise in the price of the asset in the future.
The difference between the purchased option and a forward contract is that under a forward contract
the entity is obliged to buy or sell at the strike price, whereas under a purchased option it has the right,
but not the obligation, to buy or sell at the strike price.
Purchased options, whether call options or put options, have the potential to hedge price, currency
and interest rate risks and can always qualify as hedging instruments.
Examples of purchased options include options on equities, options on currencies and options on
interest rates. An interest rate floor is achieved through a put option on an interest rate, and an interest
rate cap is achieved through a call option on an interest rate.
Illustration: Use of purchased options in cash flow hedges

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

In a hedging relationship, the hedging instrument is normally designated in its entirety. The only
exceptions are that the following are permitted (but not required):
(a) Separating the intrinsic value of an option and its time value and designating only the change in
the intrinsic value as the hedging instrument
(b) Separating the interest element and the spot price of a forward

Those exceptions recognise that the intrinsic value of the option and the premium on the forward
generally can be measured separately.
Illustration: Purchased options in fair value hedges

Entity A has purchased a three year £10 million debt with fixed 4% interest. The debt was bought at par
and the entity wishes to hedge the risk of a decrease in the fair value of the debt resulting from a
possible increase in interest rates. It buys a £10 million year interest rate cap on three month LIBOR with
an exercise price of 4%. An interest rate cap is a call option on LIBOR that pays the holder the difference
between the market rate of LIBOR and the exercise price. The payment that the buyer of the interest
rate cap receives compensates for the decrease in the value of the bond caused by the increase in
interest rates.
The interest rate cap can be designated as a hedging instrument in a hedge of changes in the fair value C
of the three-year debt as a result of changes in interest rates. The change in the fair value of the debt H
A
can result not only from changes in the risk-free element of the interest rate, but also from a P
deterioration in the credit rating of the debt. In the section on hedged items, it was stated that IAS 39 T
allows a financial item to be hedged with respect to the risks associated with only a portion of its cash E
flow or fair value, provided that effectiveness can be established. R
It is therefore possible to designate the hedge as the risk of changes in the fair value resulting from an
increase in interest rates above 4%. The effectiveness of the hedge will be improved if the entity 17
designated only the intrinsic value of the cap as the hedging instrument. The time value of the cap will,
in this case, be excluded from the hedge relationship and changes in its value will be recognised in
profit or loss as they occur.
4 Fair value hedge

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

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

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

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

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

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

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

Illustration: Gain or loss on hedged item recognised in profit or loss
At 1 November 20X5 an entity held inventory with a cost of £400,000 and a fair value of £600,000. The
entity acquired a derivative to hedge against a fall in the fair value of its inventory below £600,000. At
its year end two months later the fair value of its inventory had fallen by £20,000 and the derivative it
holds had a value of £20,000.
The journals required at the year end are as follows.
To recognise the gain on the derivative hedging instrument
DEBIT Profit or loss £20,000
CREDIT Inventories £20,000 C
To adjust the carrying amount of inventories by the loss in its fair value (because closing inventories H
A
reduce cost of sale, a decrease in their carrying amount increases cost of sales and reduces profit). P
The effect is as follows: T
E
(a) The loss on the hedged item has been recognised in profit or loss. R
(b) There is a nil net effect in profit or loss, because the hedge has been 100% effective.
(c) Inventories are carried at £380,000. This is neither cost (£400,000) nor fair value (£580,000). 17
(d) The entity has been protected against loss of profit. If it had sold the inventory on 1 November, it
would have made a profit of £200,000 (600,000 – 400,000); if it sells the inventory on
1 January 20X6, it will make a profit of £200,000 (580,000 – 380,000).
Interactive question 3: Fair value hedge

A company owns inventories of 40,000 gallons of oil which cost £800,000 on 1 December 20X3.
In order to hedge the fluctuation in the market value of the oil, on 1 December 20X3 the company
signs a futures contract to deliver 40,000 gallons of oil on 31 March 20X4 at the futures price of £22 per
gallon.
The market price of oil on 31 December 20X3 is £22.25 per gallon and the futures price at that date for
delivery on 31 March 20X4 is £24 per gallon.
Requirements
Explain how these transactions should be accounted for at 31 December 20X3:
(a) Without hedge accounting
(b) With hedge accounting
If only particular risks attributable to a hedged item are hedged, recognised changes in the hedged
item's fair value unrelated to the hedged risk are recognised in accordance with paragraph IAS 39.55.
This means that changes in fair value of a hedged financial asset or liability that is not part of the
hedging relationship would be accounted for as follows:
(a) For instruments measured at amortised cost, such changes would not be recognised.
(b) For instruments measured at fair value through profit or loss, such changes would be recognised in
profit or loss in any event.
(c) For available-for-sale financial assets, such changes would be recognised in other comprehensive
income, as explained above. However, exceptions to this would include foreign currency gains and
losses on monetary items and impairment losses, which would be recognised in profit or loss in any
event.
If the fair value hedge is 100% effective (as in the above Illustration), then the change in the fair
value of the hedged item will be wholly offset by the change in the fair value of the hedging

instrument and there will be no effect in profit or loss. Whenever the hedge is not perfect and the
change in the fair value of the hedged item is not fully cancelled by change in the fair value of the
hedging instrument, the resulting difference will be recognised in profit or loss. This difference is
referred to as hedge ineffectiveness.
Worked example: Fair value hedge of variable rate debt instrument

Does IAS 39 permit an entity to designate a portion of the risk exposure of a variable rate debt
instrument as a hedged item in a fair value hedge?
Solution
Yes. A variable rate debt instrument may have an exposure to changes in its fair value due to credit risk.
It may also have an exposure to changes in its fair value relating to movements in the market interest
rate in the periods between which the variable interest rate on the debt instrument is reset. For
example, if the debt instrument provides for annual interest payments reset to the market rate each
year, a portion of the debt instrument has an exposure to changes in fair value during the year.
Interactive question 4: Fair value hedge of inventory

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

On 1 July 20X6 a jewellery trader acquired 10,000 ounces of a material which it held in its inventory.
This cost £200 per ounce, so a total of £2 million. The trader was concerned that the price of this
inventory would fall, so on 1 July 20X6 he sold 10,000 ounces in the futures market for £210 per ounce
for delivery on 30 June 20X7. On 1 July 20X6 the conditions for hedge accounting were all met.
At 31 December 20X6, the end of the trader's reporting period, the fair value of the inventory was £220
per ounce while the futures price for 30 June 20X7 delivery was £227 per ounce. On 30 June 20X7 the
trader sold the inventory and closed out the futures position at the then spot price of £230 per ounce.
Requirement
Set out the accounting entries in respect of the above transactions.
Solution
Debit Credit
1 July 20X6 £ £
Inventory 2,000,000
Cash 2,000,000
(To record the initial purchase of material)
At 31 December 20X6 the increase in the fair value of the inventory was £200,000 (10,000 × (£220 –
£200)) and the increase in the forward contract liability was £170,000 (10,000 × (£227 – £210)). Hedge
effectiveness was 85% (170,000 as a % of 200,000), so hedge accounting was still permitted.
Debit Credit
Profit or loss 170,000
Financial liability 170,000
(To record the loss on the forward contract)
Inventories 200,000
(To record the increase in the fair value of the inventories)

At 30 June 20X7 the increase in the fair value of the inventory was another £100,000 (10,000 × (£230 –
£220)) and the increase in the forward contract liability was another £30,000 (10,000 × (£230 – £227)).
30 June 20X7
Financial liability 30,000
(To record the loss on the forward contract)
Inventories 100,000
(To record the increase in the fair value of the inventories)
Profit or loss 2,300,000
Inventories 2,300,000
(To record the inventories now sold)
C
Cash 2,300,000 H
Profit or loss – revenue 2,300,000 A
P
(To record the revenue from the sale of inventories) T
Financial liability 200,000 E
R
Cash 200,000
(To record the settlement of the net balance due on closing the financial
liability)
17
Note that because the fair value of the material rose, the trader made a profit of only £100,000 on the
sale of inventories. Without the forward contract, the profit would have been £300,000 (2,300,000 –
2,000,000). In the light of the rising fair value the trader might in practice have closed out the futures
position earlier, rather than waiting until the settlement date.
Worked example: Fixed rate loan

On 1 January 20X5, Alpha Bank purchased loan notes of £100 million at fixed interest rate of 6% for
three years. The bank believes that interest rates are likely to increase, and enters into an interest rate
swap contract with notional principal of £100 million, three year term. Under the swap contract, the
bank pays fixed interest payments based on 6% at the end of each year and receives at the end of each
year market interest rate at beginning of the year.
Alpha Bank has designated this as a fair value hedge. The market interest rate is 6% on 1 January 20X5,
5.5% on 31 December 20X5 and 6.25% on 31 December 20X6. The fair values of the loan notes and
interest rate swap are as follows:
Amounts in £ 31 December 20X7 31 December 20X6 31 December 20X5
Fair value of loan notes before
100,000,000 asset 99,764,706 asset 100,923,160 asset
redemption
Fair value of interest rate swap – 235,294 asset (923,160) liability
Requirement
Prepare journal entries for 20X5, 20X6 and 20X7 in respect of this transaction and show extracts of the
statement of profit or loss and the statement of financial position at the end of each year.
Solution
The journal entries required are as follows.
1 January 20X5
DEBIT Loan asset £100,000,000
CREDIT Cash £100,000,000
(Purchase of loan notes)
31 December 20X5
DEBIT Cash £6,000,000
CREDIT Interest income £6,000,000
(Interest on loan at 6% fixed on £100m)

DEBIT Loan asset – fair value adjustment £923,160
CREDIT Fair value gain on loan £923,160
(Fair value gain on fixed rate loan due to fall in market interest rates)
DEBIT Fair value loss – interest rate swap £923,160
CREDIT Derivative liabilities £923,160
(Loss in fair value of interest rate swap)
No net interest is settled on the swap as the fixed and market rates are the same.
31 December 20X6
DEBIT Interest income/expense £500,000
(Net interest paid on the swap at 6% – 5.5% = 0.5% of £100m)
DEBIT Fair value loss – loan asset £1,158,454
CREDIT Loan asset – fair value adjustment £1,158,454
(Loss in fair value of loan asset due to increase in market interest rates)
DEBIT Derivative liabilities £923,160
DEBIT Derivative assets £235,294
CREDIT Fair value gain – interest rate swap £1,158,454
(Fair value gain on interest rate swap – it is an asset this year so the liability is reversed and
asset recognised)
31 December 20X7
DEBIT Cash £250,000
CREDIT Interest income/expense £250,000
(Net interest received on the swap at 6.25% – 6% = 0.25% of £100m)
DEBIT Loan asset – fair value adjustment £235,294
CREDIT Fair value gain on loan £235,294
(Fair value gain on fixed rate loan due for redemption at par)
DEBIT Fair value loss – interest rate swap £235,294
CREDIT Derivative assets £235,294
(Loss in fair value of interest rate swap now matured)
Extract of statement of profit or loss for years ended 31 December
Amounts in £ 20X7 20X6 20X5
Interest income on loan 6,000,000 6,000,000 6,000,000
Net interest income/(expense) on interest rate swap 250,000 (500,000) –
Fair value gain/(loss) on fixed rate loan 235,294 (1,158,454) 923,160
Fair value gain/(loss) on interest rate swap (235,294) 1,158,454 (923,160)
Net impact of transaction on profit or loss 6,250,000 5,500,000 6,000,000
Extract of statement of financial position (assets/liabilities only) as at 31 December
Amounts in £ 20X7 20X6 20X5
Assets
Loan notes (before redemption) 100,000,000 99,764,706 100,923,160
Derivative assets – 235,294 –
Liabilities
Derivative liabilities – – (923,160)

The effect is as follows:
 The gains and losses on the fair value of loan notes, the hedged item, have been recognised in
profit or loss.
 There is a nil net effect in profit or loss, because the hedge has been 100% effective. The net
impact on the profit or loss reflects changing market interest rates as a fixed to floating interest rate
swap has been used.
 The bank has hedged the fair value risk in the loan notes due to changes in market interest rates.
The fair value risk due to changes in credit quality has not been hedged in the above example.
4.2.1 Interest rate futures

An interest rate futures contract has interest-bearing instruments as its underlying asset. Futures C
H
contracts are available in relation to short term interest rates in major currencies like sterling, euros, yen
A
and Swiss francs. These derivatives can be used to gain exposure to, or hedge exposure against, interest P
rate movements. Three-month sterling future (short sterling) is a 90-day sterling LIBOR interest rate T
future traded on ICE Futures Europe with the following characteristics: E
R
Unit of trade £500,000 (this is a notional amount on which interest effect is measured)
Quote 100 minus interest rate
Tick size 0.01 (smallest permitted quote movement ie, one basis point) 17
Tick value £12.50 (£500,000  0.01%  3/12)
The contract is cash settled ie, one party pays to the other the difference in value between the interest
for three months at the rate agreed when the contract was originated and actual rate on maturity.
Worked example: Fair value hedge using interest rate futures

Zeta Bank has a fixed rate financial asset of £10 million and is concerned that interest rate will increase
from the current levels.
Requirement
Explain how Zeta Bank can hedge the fair value of the fixed rate financial asset of £10 million against
increase in interest rate using interest rate futures.
Solution
If interest rates increase, the fair value of the fixed rate financial asset will decrease. Zeta Bank requires a
futures position that will yield profits when interest rate increases to offset this loss. It should therefore
sell £(10,000,000 / 500,000) = 20 futures contracts. If the interest rate increases the gain on the futures
position will offset the loss on the fixed rate financial asset.
Zeta Bank should designate the futures contract as the hedging instrument and the fixed rate financial
asset as the hedged item in a fair value hedge. If the IAS 39 conditions for hedge accounting are met
the fair value movements on the futures contract and the financial asset will be recognised and offset in
profit or loss.
4.3 Hedging of firm commitments

The hedging of a firm commitment should be treated as a fair value hedge except that a firm
commitment with a price fixed in foreign currency may be treated as either a fair value hedge or a
cash flow hedge of the foreign currency risk.
When an unrecognised firm commitment to acquire an asset or to assume a liability is designated as a
hedged item in a fair value hedge, the accounting treatment is as follows:
(a) The subsequent cumulative change in the fair value of the firm commitment is attributable to
the hedged risk since inception of the hedge is recognised as an asset or liability with a
corresponding gain or loss recognised in profit or loss.
(b) The changes in the fair value of the hedging instrument are also recognised in profit or loss.

(c) When the firm commitment is fulfilled, the initial carrying amount of the asset or liability is
adjusted to include the cumulative change in the firm commitment that has been recognised in
the statement of financial position (SOFP) under the first point above.
4.4 Discontinuing fair value hedge accounting

Fair value hedge accounting should be discontinued if the hedging instrument expires or is sold,
terminated or exercised, if the criteria for hedge accounting are no longer met or if the entity revokes
the designation.
The discontinuance should be accounted for prospectively ie, the previous accounting entries are not
reversed. The hedged item is not adjusted for any further changes in its fair value and adjustments
already made are recognised in profit or loss over the life of the item.
5 Cash flow hedge
Section overview
The application of cash flow hedge accounting is discussed in this section through a series of practical
examples.
5.1 Cash flow hedge

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

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

5.2.1 Specifically identifiable
Identification of hedged forecast transaction
A forecast transaction such as the purchase or sale of the last 15,000 units of a product in a specified period
or as a percentage of purchases or sales during a specified period does not qualify as a hedged item.
This is because the hedged forecast transaction must be identified and documented with sufficient
specificity so that when the transaction occurs, it is clear whether the transaction is or is not the hedged
transaction. Therefore, a forecast transaction may be identified as the sale of the first 15,000 units of a
specific product during a specified three-month period, but it could not be identified as the last
15,000 units of that product sold during a three-month period because the last 15,000 units cannot be
identified when they are sold. For the same reason, a forecast transaction cannot be specified solely as a
percentage of sales or purchases during a period.
C
Documentation of timing of forecast transaction H
A
For a hedge of a forecast transaction, the documentation of the hedge relationship that is established at P
inception of the hedge should identify the date on which, or time period in which, the forecast T
transaction is expected to occur. This is because the hedge must relate to a specific identified risk and it E
must be possible to measure its effectiveness reliably. In addition, the hedged forecast transaction must R
be highly probable.
To meet these criteria, an entity is not required to predict and document the exact date a forecast 17
transaction is expected to occur. However, it is required to identify and document the time period
during which the forecast transaction is expected to occur within a reasonably specific and generally
narrow range of time from a most probable date, as a basis for assessing hedge effectiveness. To
determine that the hedge will be highly effective, it is necessary to ensure that changes in the fair value
of the expected cash flows are offset by changes in the fair value of the hedging instrument and this test
may be met only if the timing of the cash flows occur within close proximity to each other.
5.2.2 What is 'highly probable'?

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

The length of time until a forecast transaction is projected to occur is also a factor in determining
probability. Other factors being equal, the more distant a forecast transaction is, the less likely it is that
the transaction would be regarded as highly probable and the stronger the evidence that would be
needed to support an assertion that it is highly probable.
For example, a transaction forecast to occur in five years may be less likely to occur than a transaction
forecast to occur in one year. However, forecast interest payments for the next 20 years on variable rate
debt would typically be highly probable if supported by an existing contractual obligation.

In addition, other factors being equal, the greater the physical quantity or future value of a forecast
transaction in proportion to the entity's transactions of the same nature, the less likely it is that the
transaction would be regarded as highly probable and the stronger the evidence that would be required
to support an assertion that it is highly probable. For example, less evidence generally would be needed
to support forecast sales of at least 100,000 units in the next month than 950,000 units in that month
when recent sales have averaged 950,000 units per month for the past three months.
A history of having designated hedges of forecast transactions and then determining that the forecast
transactions are no longer expected to occur would call into question both an entity's ability to predict
forecast transactions accurately and the propriety of using hedge accounting in the future for similar
forecast transactions.
5.3 Cash flow hedge accounting

If a cash flow hedge meets the qualifications for hedge accounting during the period it should be
accounted for as follows:
(a) The portion of the gain or loss on the hedging instrument that is determined to be an effective
hedge should be recognised in other comprehensive income and held in a separate
component in equity.
(b) The ineffective portion of the gain or loss on the hedging instrument should be recognised in
profit or loss.
On a cumulative basis the effective portion can be calculated by adjusting the separate component of
equity associated with the hedged item to the lesser of the following (in absolute amounts):
 The cumulative gain or loss on the hedging instrument from inception of the hedge
 The cumulative change in the fair value (present value) of the expected future cash flows on the
hedged item from inception of the hedge
Any remaining gain or loss on the hedging instrument is the ineffective portion and should be
As an exception to the general rule set out above, if an entity designates a non-derivative monetary
asset as a foreign currency cash flow hedge of the repayment of the principal of a non-derivative
monetary liability, the exchange differences on both the monetary asset and the monetary liability are
recognised in profit or loss in the period in which they arise under IAS 21. IAS 39 AG 83 confirms that if
there is a hedge relationship between a non-derivative monetary asset and a non-derivative monetary
liability, changes in the foreign currency component of those financial instruments are recognised in
profit or loss.
Interactive question 5: Cash flow hedge

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

Interactive question 6: Swap in cash flow hedge 1
An entity issues a fixed rate debt instrument and enters into a receive-fixed, pay-variable, interest rate
swap to offset the exposure to interest rate risk associated with the debt instrument.
Requirement
Can the entity designate the swap as a cash flow hedge of the future interest cash outflows associated
with the debt instrument?
Interactive question 7: Swap in cash flow hedge 2

An entity manages interest rate risk on a net basis. On 1 January 20X6 it forecasts aggregate cash C
inflows of £1 million on a fixed rate financial asset and aggregate cash outflows of £900,000 on a fixed H
rate financial liability in the first quarter of 20X7. For risk management purposes it uses a receive- A
variable, pay-fixed, forward rate agreement (FRA) to hedge the forecast net cash inflow of £100,000. P
T
The entity designates as the hedged item the first £100,000 of cash inflows on fixed rate assets in the E
first quarter of 20X7. R
Requirement
Can it designate the receive-variable, pay-fixed FRA as a cash flow hedge of the exposure to variability to
17
cash flows in the first quarter of 20X7 associated with the fixed rate assets?
5.4 Reclassification of gains/losses to profit or loss

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

Worked example: Cash flow hedge
Bets Co has the £ as its functional currency and a reporting date of 31 December. Bets Co signs a
contract on 1 November 20X1 to purchase a non-current asset in foreign currency (LC) on
1 November 20X2 for LC60 million. Bets Co hedges the foreign currency risk in this transaction by
entering into a forward contract to buy LC60 million on 1 November 20X2 at £1: LC1.5.
Spot and forward exchange rates at the following dates are:
Spot Forward (for delivery on 1.11.X2)
1.11.X1 £1: LC1.45 £1: LC1.5
31.12.X1 £1: LC1.20 £1: LC1.24
1.11.X2 £1: LC1.0 £1: LC1.0 (actual)
The conditions for hedge accounting are met at 1 November 20X1.
Requirement
Show the accounting entries relating to these transactions at 1 November 20X1, 31 December 20X1
and 1 November 20X2.
Solution
Entries at 1 November 20X1
The fair value of the forward contract at inception is zero so no entries should be recorded (other than
any transaction costs), but risk disclosures should be made.
The contractual commitment to buy the asset should be disclosed if material (IAS 16).
Entries at 31 December 20X1
The gain on the forward contract should be calculated as:
£
Value of contract at 31.12.X1 (LC60m/1.24) 48,387,097
Gain on contract 8,387,097
The change in the fair value of the expected future cash flows on the hedged item (which is not
recognised in the financial statements) should be calculated as:
£
At 31.12.X1 (LC60m/1.20) 50,000,000
At 1.11.X1 (LC60m/1.45) 41,379,310
8,620,690
As this change in fair value is greater than the gain on the forward contract, the hedge is deemed to be
fully effective and the whole of the gain on the forward should be recognised in other comprehensive
income:
DEBIT Financial asset (Forward a/c) £8,387,097
CREDIT Other comprehensive income £8,387,097
Entries at 1 November 20X2
The further gain on the forward contract should be calculated as:
£
The further change in the fair value of the expected future cash flows on the hedged item should be
calculated as:
£
At 1.11.X2 (LC60m/1.00) 60,000,000
At 31.12.X1 (LC60m/1.20) 50,000,000
10,000,000

As this change in fair value is less than the gain on the forward contract, part of the gain on the forward
contract is said to be ineffective and this part should be recognised in profit or loss.
The effective part of the hedge is calculated on a cumulative basis by comparing the cumulative gain on
the forward contract from the inception of the hedge (1 November 20X1) with the cumulative change
in fair value of the cash flows on the hedged item from the inception of the hedge.
The cumulative gain on the forward contract is calculated as:
£
The cumulative change in the fair value of the expected future cash flows on the hedged item is
calculated as: C
H
£ A
At 1.11.X2 (LC60m/1.00) 60,000,000 P
At 1.11.X1 (LC60m/1.45) 41,379,310 T
E
18,620,690
R
The ineffective portion of the hedge is therefore £(20,000,000 – 18,620,690) = £1,379,310. This should
be recognised in profit or loss for the year. The remainder £(11,602,923 –1,379,310) = £10,233,593 is
the effective portion, which should be other comprehensive income: 17
DEBIT Financial asset (Forward a/c) £11,612,903

CREDIT Other comprehensive income £10,233,593
CREDIT Profit or loss £1,379,310
Note that the hedge is still highly effective (and hence hedge accounting should continue to be used):
£10,233,593/£11,612,903 = 88% which is within the 80%–125% range.
Purchase of asset at market price
DEBIT Asset (LC60m/1.0) £60,000,000
CREDIT Cash £60,000,000
Settlement of contract to purchase non-current asset
CREDIT Financial asset (Forward a/c) £20,000,000
Realisation of gain on hedging instrument
The cumulative gain of £18,620,690 recognised in other comprehensive income and held in equity
should be:
 reclassified to profit or loss as the asset is used ie, to reduce depreciation charges over the asset's
useful life; or
 adjusted against the initial cost of the asset (reducing future depreciation).
Following IAS 12 paragraph 61A, deferred tax on the gain would also be recognised in equity.
Interactive question 8: Foreign currency hedge

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

Interactive question 9: Foreign currency hedge
An entity exports a product at a price denominated in a foreign currency. At the date of the sale, the
entity obtains a receivable for the sale price payable in 90 days and takes out a 90-day forward
exchange contract in the same currency as the receivable to hedge its foreign currency exposure. The
conditions for hedge accounting were met.
Under IAS 21, the sale is recorded at the spot rate at the date of sale, and the receivable is restated
during the 90-day period for changes in exchange rates with the difference being taken to profit or loss
(IAS 21.23 and IAS 21.28).
Requirement
If the foreign exchange forward contract is designated as a hedging instrument, does the entity have a
choice whether to designate it as a fair value hedge of the foreign currency exposure of the receivable or
as a cash flow hedge of the collection of the receivable?
How should gains and losses on the receivable and the forward contract be accounted for?

RapidMart is a company that operates a chain of large out of town supermarkets. It has expanded
rapidly over the last 10 years, opening new stores in its home country and overseas. It has also moved
into a wide-range of non-food sales and the provision of services, such as opticians. The company is
currently preparing its consolidated financial statements for the year ending 30 September 20X5
During the last year, RapidMart began to operate an online retail division, RapidMart Direct, as a pilot
scheme. The service uses a fleet of delivery vans. This has proved to be very popular with customers and
the company wants to expand this operation. The finance director identified a key risk of volatility of
diesel prices and has taken out a forward contract to hedge against this.
On 1 August 20X5, RapidMart entered into a forward contract to hedge its expected fuel requirements
for the second quarter of the next financial year for delivery of 1 million litres of diesel on
31 December 20X5 at a price of £2.04 per litre.
The company intended to settle the contract net in cash and purchase the actual required quantity of
diesel in the open market on 31 December 20X5.
At the company's year end the forward price for delivery on 31 December 20X5 had risen to £2.16 per
litre of fuel.
Requirement
How should the above transaction be accounted for in the financial statements of RapidMart for the
year ending 30 September 20X5?
Interactive question 11: Foreign currency receivables and forward contract

Armada is a public limited company reporting under IFRSs. It is preparing the financial statements as at
31 December 20X1. Included in trade receivables is an amount due from a customer located abroad.
The amount (30.24 million Coronna) was initially recognised when the exchange rate was £1 = 5.6
Coronna.
At 31 December 20X1, the exchange rate was £1 = 5.4 Coronna. No adjustment has been made to the
trade receivable since it was initially recognised.
Given the size of the exposure, the company entered into a forward contract, at the same time as the
receivable was initially recognised, in order to protect cash flows from fluctuations in the exchange rate.
The forward contract is to sell 30.24 million Coronna and it satisfies the necessary criteria to be
accounted for as a hedge.

In the period between inception of the forward contract and the year end, the loss in fair value of the
forward contract was £220,000. The company elected to designate the spot element of the hedge as the
hedging relationship. The difference between the change in fair value of the receivable and the change in
fair value of the forward contract since inception is the interest element of the forward contract.
Requirement
Show how this transaction should be accounted for in the financial statements of Armada for the year
ended 31 December 20X1.

C
Bruntal is a manufacturer and retailer of gold jewellery. H
A
On 31 October 20X1, the cost of Bruntal's inventories of finished jewellery was £8.280 million with a P
gold content of 24,000 troy ounces. At that date their sales value was £9.938 million. T
E
The selling price of gold jewellery is heavily dependent on the current market price of gold (plus a R
standard percentage for design and production costs).
Bruntal's management wished to reduce its business risk of fluctuations in future cash inflow from sale of
the jewellery by hedging the value of the gold content of the jewellery. In the past this has proved to be 17
an effective strategy.
Therefore it sold futures contracts for 24,000 troy ounces of gold at £388 per troy ounce at
31 October 20X1. The contracts mature on 30 October 20X2.
On 30 September 20X2 the fair value of the jewellery was £9.186 million and the forward price of gold
per troy ounce for delivery on 30 October 20X2 was £352.
Requirement
Explain how the above transactions would be treated in Bruntal's financial statements for the year ended
30 September 20X2.

On 1 November 20X2, Blenheim entered into a contract to purchase 3,000 tonnes of refined sunflower
oil. The contract is for delivery in February 20X3 at a price of £1,440 per tonne. Blenheim uses sunflower
oil to make its products.
At 31 December 20X2, an equivalent new contract for delivery of 3,000 tonnes of refined sunflower oil
in February 20X3 could be entered into at £1,400 per tonne.
Blenheim does not intend to take delivery of the sunflower oil and instead intends to settle the contract
net in cash, then purchase the actual required quantity based on demand at the time.
The contract is designated as a cash flow hedge of the highly probable forecast purchase of sunflower
oil. All necessary documentation was prepared to treat the contract as a cash flow hedge. No
accounting entries have been made.
Tax rules follow accounting rules in respect of financial instruments in the tax jurisdiction (with both
profit and other comprehensive income items subject to tax at 30%) in which Blenheim operates. No
current or deferred tax adjustments have been made for this transaction.
Requirement
Show how this transaction should be accounted for in the financial statements of Blenheim for the year

Interactive question 14: Hedging
PQR has entered into a foreign currency forward contract, purchased to hedge the commitment to
purchase a machine in foreign currency in six months' time.
Requirement
Explain, with reference to IAS 39, how this should be accounted for.
5.5 Discontinuing cash flow hedge accounting

Cash flow hedge accounting should be discontinued if the hedging instrument expires or is sold,
terminated or exercised, if the criteria for hedge accounting are no longer met, a forecast transaction is
no longer expected to occur or if the entity revokes the designation.
The discontinuance should be accounted for prospectively ie, the previous accounting entries are not
reversed. The cumulative gain or loss on the hedging instrument should be reclassified to profit or loss,
as the hedged item is recognised in profit or loss.
6 Hedge of a net investment
Section overview
This section discusses issues specific to the accounting treatment of hedge of net investments.
6.1 Definition
In a hedge of a net investment in a foreign operation the hedged item is the amount of the
reporting entity's interest in the net assets of that operation. Under this definition from IAS 21
monetary items that are receivable from or payable to a foreign operation for which settlement is
neither planned nor likely to occur in the foreseeable future form part of the net investment.
The amount that an entity may designate as a hedge of a net investment may be all or a proportion of
its net investment at the commencement of the reporting period. This is because the exchange rate
differences reported in equity on consolidation which form part of a hedging relationship relate only to
the retranslation of the opening net assets. Profits or losses arising during the period cannot be
hedged in the current period. But they can be hedged in the following periods, because they will then
form part of the net assets which are subject to translation risk.
6.2 Accounting treatment

Hedges of a net investment in a foreign operation should be accounted in a similar way to cash flow
hedges; that is:
 the portion of gain or loss on the hedging instrument that is determined to be an effective hedge
should be recognised in other comprehensive income; and
 the ineffective portion should be recognised in profit or loss.
The gain or loss on the hedging instrument that has been recognised in other comprehensive income
should be reclassified to profit or loss on disposal of the foreign operation. If only part of an interest in a
foreign operation is disposed of, only the relevant proportion of this gain or loss should be reclassified to
profit or loss.

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

Entity A, whose functional currency is £, has a subsidiary in France. The subsidiary was purchased on
30 June 20X6 for €20 million and the acquisition was financed with a loan of €20 million. The carrying
amount of the subsidiary in the consolidated financial statements (including goodwill acquired in the C
business combination) is €20 million. Entity A has designated the foreign currency loan of €20 million as H
a hedge of its net investment in the foreign subsidiary. A
P
Entity A has a 30 June year end. The foreign currency rates at 30 June 20X6 and 30 June 20X7 were T
£1 = €1.52 and £1 = €1.48 respectively. In the year ended 30 June 20X7 the exchange difference on the E
R
opening net investment should be calculated as:
€ £
At 30 June 20X6 20,000,000 13,157,895 17
At 30 June 20X7 20,000,000 13,513,514
Exchange gain 355,619
There is a corresponding loss on the foreign currency loan of £355,619. Because the hedge is perfectly
effective, both the gain and the entire loss will be recognised in other comprehensive income. There is
no ineffective portion of the loss on the hedging instrument to be recognised in profit or loss.
6.4 Hedging with derivatives

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

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

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

income
Adjustment to hedged item Profit or loss N/A
Hedge ineffectiveness is recorded in profit or loss Yes Yes
Gains or loss reclassified to profit or loss later N/A Yes

6.7 Types of hedge and their treatment
The following grid will be useful in distinguishing the types of hedge and their treatment.
Firm commitment Forecast transaction

(highly probable)
FOREIGN CURRENCY Either fair value hedge or cash flow Cash flow hedge
hedge
OTHER Fair value hedge Cash flow hedge
7 Conditions for hedge accounting
Section overview
This section discusses in detail the conditions for hedge accounting, paying particular attention to
establishing effectiveness.
7.1 Summary of conditions

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

Documentation must include identification of the hedging instrument, the hedged item or transaction,
the nature of the risk being hedged, details of how the hedge effectiveness will be calculated and a
statement of the entity's risk management objective and strategy for undertaking the hedge.
Note that retrospective designation with the benefit of hindsight is not permitted. Hedge accounting
may only be applied prospectively, from the later of the date of designation and the date that the
formal documentation is prepared. This date may be later than the date on which an entity acquires the
hedging instrument itself.
Point to note:
Hedge accounting is prohibited if the hedging relationship is designated for only part of the life of the
hedging instrument.
In addition to the above, the documentation relating to the hedge of a forecast transaction must
include the date on, or the period in, which the forecast transaction is expected to occur. This is
because hedge accounting relates to a specific identified and designated risk, so it must be possible to
measure its effectiveness and the hedged forecast transaction has to be highly probable.
Illustration: Hedge documentation

Entity A manufactures and sells umbrellas. Its functional currency is the US dollar, but 40% of its sales
are made in the UK and denominated in sterling. Entity A forecasts highly probable sales in the UK for
the next winter season on a monthly basis. Using these forecasts it enters into forward contracts to sell
pounds sterling in exchange for dollars.

It is probably the case that Entity A is not able to forecast individual sales transactions in respect of its
umbrellas. But it can still treat a number of sales (such as the first 10,000 in any period) as highly
probable forecast transactions and designate the forward contracts as hedging instruments under a cash
flow hedge.
7.3 Hedge effectiveness
Definition
Hedge effectiveness: The degree to which the changes in the fair value or cash flows of the hedged
item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the
C
hedging instrument. H
A
P
T
Hedge effectiveness should be tested on both a prospective and retrospective basis because hedge
E
accounting should only be applied when: R
 at the time of designation the hedge is expected to be highly effective; and
 the hedge turns out to have been highly effective throughout the financial reporting periods for 17
which it was designated.
At a minimum an entity should assess effectiveness when preparing its interim or annual financial
statements.
Highly effective criteria
Hedge effectiveness should be determined in accordance with the methodology in the hedge
documentation. The highly effective hurdle is achieved if the actual results of a hedge are within the
range from 80% to 125%. One of the ways of calculating this is to express the absolute amount of the
change in value of the hedging instrument as a percentage of the absolute amount of the change in
value of the hedged item, or vice versa.
Methodology
IAS 39 does not specify a method to be used in assessing the effectiveness of a hedge. Several
mathematical techniques can be used to measure hedge effectiveness, including the ratio analysis
method referred to above and statistical measurement techniques such as regression analysis. If
regression analysis is used, the entity's documented policies for assessing effectiveness must specify how
the results of the regression will be assessed.
However, the method chosen should be based on an entity's risk management strategy, documented
up front and applied consistently over the duration of the hedging relationship.
After-tax basis
IAS 39 permits, but does not require, assessment of hedge effectiveness on an after-tax basis. If the
hedge is undertaken on an after-tax basis, it should be so designated at inception as part of the formal
documentation of the hedging relationship and strategy.
Requirement to assess effectiveness
IAS 39 requires an entity to assess hedges for hedge effectiveness on an ongoing basis. An entity cannot
assume hedge effectiveness just because the principal terms of the hedging instrument and of the
hedged item are the same. This is because hedge ineffectiveness may arise because of other attributes
such as the liquidity of the instruments or their credit risk.
It may, however, designate only certain risks in an overall exposure as being hedged and thereby
improve the effectiveness of the hedging relationship. For example, for a fair value hedge of a debt
instrument, if the derivative hedging instrument has a credit risk that is equivalent to the AA-rate, it may
designate only the risk related to AA-rated interest rate movements as being hedged, in which case
changes in credit spreads generally will not affect the effectiveness of the hedge.

Periodic or cumulative assessment
The issue arises as to whether hedge effectiveness should be assessed separately for each period or
cumulatively over the life of the hedging relationship. IAS 39 allows both methods.
Expected hedge effectiveness may only be assessed on a cumulative basis if the hedge is so designated
and that condition is incorporated into the appropriate hedging documentation. The effect of using a
cumulative basis is that even if a hedge is not expected to be highly effective in a particular period,
hedge accounting is still permitted if effectiveness is expected to remain sufficiently high over the life of
the hedging relationship. However, ineffectiveness in any period is required to be recognised in profit or
loss as it occurs.
To illustrate: an entity designates a LIBOR-based interest rate swap as a hedge of a borrowing whose
interest rate is UK base rate plus a margin. UK base rate changes perhaps once each quarter or less, in
increments of 25–50 basis points, while LIBOR changes daily. Over a period of one to two years, the
hedge is expected to be almost perfect. However, there will be quarters when UK base rate does not
change at all, while LIBOR has changed significantly. Hedge accounting is still permitted.
Illustration: Periodic or cumulative assessment

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

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

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

Worked example: Measuring ineffectiveness in a fair value hedge
An entity holds significant inventories of copper for use in its production process. It enters into a
derivative in respect of all its inventories linked to the price of copper and completes the documentation
to designate it as a hedge of changes in the fair value of the copper inventory. The hedge is expected to
be highly effective.
At the next reporting date the copper inventory has increased in fair value by £2,000 and the fair value
of the derivative is a liability of £2,100. The hedge is 105% effective (2,100/2,000). Alternatively it may
be determined as being 95.24% effective (2,000/2,100).
Requirement
Calculate the net expense in profit or loss.
C
Solution H
The copper inventory being the hedged item, its carrying amount is increased by the £2,000 increase in A
P
its fair value, with the same amount being recognised in profit or loss. The derivative is recorded as a T
financial liability at £2,100, with the same amount being recognised in profit or loss. The net expense in E
profit or loss of £100 represents the hedge ineffectiveness. R
Interactive question 15: Comprehensive fair value hedge 17
Toprate Exports, whose functional currency is the $, has significant receipts in pounds sterling (GBP). In
order to protect itself from currency fluctuations relating to its foreign currency receivables, it frequently
enters into contracts to sell GBP forward. On 31 October 20X1 the company recognised a receivable of
GBP 1 million, due on 31 January 20X2.
On 31 October 20X1 the company entered into a three month forward contract for settlement on
31 January 20X2 to sell GBP 1 million at $1 = GBP 0.6202. The spot rate on 31 October 20X1 was $1 =
GBP 0.6195.
At 31 December 20X1, the forward rate for settlement on 31 January 20X2 was $1 = GBP 0.6440 (spot
rate on 31 December 20X1 was $1 = GBP 0.6435).
The applicable $ yield curve gives the following (annualised) rate for discounting a cash flow occurring
on 31 January 20X2:
At 31 December 20X1 0.325%
The company set up the appropriate documentation on 31 October 20X1 to treat the forward contract
as a fair value hedge and designated the hedging relationship as being changes in the spot element of
the forward exchange contract.
Requirement
Explain, showing relevant financial statement extracts, the accounting treatment of these transactions in
Toprate Exports' financial statements (insofar as the information provided permits) for the year ended
31 December 20X1. (Notes to the financial statements are not required.)
You should perform any discounting necessary to the nearest month and work to the nearest $1.
Worked example: Ineffectiveness in a cash flow hedge

On 30 September 20X5, Entity A hedges the anticipated sale of 24 tonnes of pulp on 1 March 20X6 by
entering into a short forward contract on 24 tonnes of pulp. The contract requires net settlement in
cash determined as the difference between the future spot price on a specified commodity exchange
and £1,000. Entity A expects to sell the pulp in a different local market. Entity A determines that the
forward contract is an effective hedge of the anticipated sale and that the other conditions for hedge
accounting are met. Hedge effectiveness is assessed by comparing the entire change in the fair value of
the forward contract with the change in the fair value of the expected cash inflows. On 31 December
20X5, the spot price of pulp has increased both in the local market and on the exchange. The increase

in the local market exceeds the increase in the exchange. As a result the present value of the expected
cash inflow from the sale on the local market is £1,100. The fair value of Entity A's forward contract is
negative £80. Entity A determines that the hedge is still highly effective.
Requirement
Calculate any hedge ineffectiveness that should be recognised in profit or loss.
Solution
There is no ineffectiveness to be recognised in profit or loss.
In a cash flow hedge, the effective portion of the hedge is limited to the lower of:
 the cumulative gain/loss on the hedging instrument ie, £80; and
 the cumulative change in fair value of the hedged item ie, £100.
The gain/loss on the hedging instrument is the lower amount, so there is no ineffectiveness to be
recognised in profit or loss. The accounting entry required is:
DEBIT Other comprehensive income £80
CREDIT Forward £80
7.6 Macro hedging

Macro hedging, also known as portfolio hedging, is a technique whereby financial instruments with
similar risks are grouped together and the risks of the portfolio are hedged together. Often this is done
on a net basis with assets and liabilities included in the same portfolio. For example, instead of using
interest rate swaps to hedge interest rate exposure on a loan by loan basis, banks hedge the risk of their
entire loan book or specific portions of the loan book.
In general, IAS 39 does not permit an overall net position to be designated as a hedged item, for
example a UK entity that has to make a purchase of £10 million in 30 days and a sale of £2 million in
30 days cannot designate the net purchase of £8 million as the hedged item. The exception is that IAS
39 permits macro hedging for the interest rate risk associated with a portfolio of financial assets or
liabilities. There are, however, clearly prescribed procedures that must be followed in order to do so.
8 Disclosures
Section overview
This section covers the disclosures required in respect of hedging.
Under IFRS 7 Financial Instruments: Disclosures an entity should disclose the following separately for each
type of hedge described in IAS 39 (ie, fair value hedges, cash flow hedges and hedges of net
investments in foreign operations):
 A description of each type of hedge;
 A description of the financial instruments designated as hedging instruments and their fair values
at the reporting date
 The nature of the risks being hedged
For cash flow hedges, an entity should disclose the following:
 The periods when the cash flows are expected to occur and when they are expected to affect profit
or loss
 A description of any forecast transaction for which hedge accounting had previously been used,
but which is no longer expected to occur
 The amount that was recognised in other comprehensive income during the period
 The amount that was reclassified from equity to profit or loss for the year, showing the amount
included in each line item in the statement of comprehensive income

 The amount that was reclassified from equity during the period and included in the initial cost or
other carrying amount of a non-financial asset or non-financial liability whose acquisition or
incurrence was a hedged highly probable forecast transaction
An entity should disclose the following separately:
 In fair value hedges, gains or losses:
– on the hedging instrument; and
– on the hedged item attributable to the hedged risk
 The ineffectiveness recognised in profit or loss that arises from cash flow hedges
 The ineffectiveness recognised in profit or loss that arises from hedges of net investments in foreign
operations
C
H
Interactive question 16: Hedge accounting with a swap A
P
On 1 October 20X0, Privet issued £30 million (par value) of fixed rate 6% debenture loans to the market T
at par. Interest on the debenture loans is paid quarterly on the last day of each calendar quarter (ie, E
1.5% per quarter). The debenture loans will be redeemed on a future specified date at par. R
To comply with the company's risk management policies, it entered into a receive-fixed, pay-variable
interest rate swap agreement at market rates on £30 million to hedge the fair value of its debt. The
17
terms of the swap are to pay the agreed variable rate established and fixed at the beginning of each
quarter and receive 5.25% per annum fixed rate in return. The swap has a maturity date the same as
that of the debentures.
The variable interest rate applicable to the swap for the three months to 31 December 20X0 determined
on 1 October 20X0 was 4.72% per annum.
As a result of a rise in market interest rates, the fair value of the company's debenture loans fell to
£29,762,240 by the company's year end, 31 December 20X0.
The net fair value of the swap at 31 December 20X0 was £238,236 (loss).
No transaction costs were incurred on issue of the debenture loans or on entering into the swap
agreement. All necessary documentation to treat the swap as a hedge was set up on 1 October 20X0.
Requirement
Explain, with reference to IAS 39, how this should be accounted for in the financial statements as at
31 December 20X0. Your answer should include relevant calculations and journal entries (insofar as the
information provided permits).
9 Current developments: IFRS 9 changes
Section overview
 IFRS 9 introduces a more principles-based approach to hedge accounting aligned to risk
management activities of an entity.
 The hedge accounting terminology and types of hedges are the same as IAS 39.
 IFRS 9 allows more exposures to be hedged and non-derivatives to be designated as hedging
instruments.
 The hedge effectiveness testing has been made more objective with the 80% – 125% rules-based
criteria removed.
 Voluntary discontinuation of hedge accounting is not permitted when the risk management
objective has not changed for the hedging relationship.

Note: For the purpose of the exam, the candidate would be expected to use IAS 39, but must
understand the changes introduced in IFRS 9.
9.1 Background
The IAS 39 hedge accounting rules have been criticised as being complex and not reflecting the way an
entity normally manages its risks. The IASB addressed these issues in IFRS 9 which adopts a more
principles-based approach aligned to the normal risk management activities of an entity. IFRS 9 will be
effective from 1 January 2018.
The IASB will allow an accounting policy choice to apply either the IFRS 9 hedging model or the IAS 39
model, with an additional option to use IAS 39 for macro hedging (currently a separate project) if using
IFRS 9 for general hedge accounting.
The accounting for macro hedging is not part of IFRS 9 and IASB has decided to develop an accounting
approach for dynamic risk management as a separate project.
9.2 IFRS 9 hedge accounting

A number of areas have been re-addressed in IFRS 9; however, the following does not change from
IAS 39:
 The terminology used in IAS 39 and IFRS 9 is generally the same.
 The three types of hedges – fair value hedge, cash flow hedge and net investment hedge are the
same.
 Hedge ineffectiveness is recognised in profit or loss except for other comprehensive income option
for equity investments.
 Hedge accounting with written options is prohibited.
The key areas which have been re-addressed in IFRS 9 are discussed below:
9.2.1 Hedged items

IFRS 9 permits the following additional exposures to be designated as hedged items, which are not
allowed under IAS 39.
Risk components of non-financial items
In IAS 39, a non-financial item can only be designated as the hedged item for its foreign currency risk or
for all of its risks, but there is no such restriction for financial items.
IFRS 9 allows separately identifiable and reliably measurable risk components of non-financial
items to be designated as hedged items.
Components
IFRS 9 allows a component that is a proportion of an entire item or a layer component to be
designated as a hedged item in a hedging relationship. A layer component may be specified from a
defined, but open, population or a defined nominal amount. For example, an entity could designate
20% of the fixed rate bond as hedged item, or the top layer of £20 principal from a total amount of
£100 (defined nominal amount) of fixed-rate bond. It is necessary to track the fair value movements of
the nominal amount from which the layer is defined.
Groups of items and net positions
In IAS 39, groups of items are eligible as hedged items only if the designated items within the group
share the same designated risk exposure. In addition, the change in fair value attributable to the hedged
risk for each individual item within the group should be approximately proportional to the overall
change in the fair value attributable to the hedged risk of the group. These restrictions are not
consistent with the way many entities manage risk.
IFRS 9 allows hedge accounting to be applied to groups of items and net positions if the group
consists of individually eligible hedged items and those items are managed together on a group basis for
risk management purposes.

For a cash flow hedge of a group of items, if the variability in cash flows is not expected to be
approximately proportional to the group's overall variability in cash flows, the net position is eligible as
a hedged item only if it is a hedge of foreign currency risk. In addition, the designation must specify
the reporting period in which forecast transactions are expected to affect profit or loss, including the
nature and volume of these transactions.
Aggregated exposures
IAS 39 does not allow hedge accounting for aggregated exposures ie, a combination of non-derivative
exposure and a derivative being the hedged item.
IFRS 9 allows aggregated exposures that include a derivative to be eligible hedged item.
Worked example: Aggregated exposure as hedged item C

Zeta Bank has a fixed rate foreign currency loan which exposes it to both foreign exchange rate risk and H
A
fair value risk due to changes in interest rates. The bank enters into a cross-currency interest rate swap to P
eliminate the foreign exchange risk and fair value risk due to changes in interest rates but is now T
exposed to variable functional currency interest payments. E
R
Zeta Bank may hedge the aggregated exposure (foreign currency loan + cross-currency interest rate
swap) by using, for example, a pay fixed and receive floating interest rate swap in its own functional
currency. 17
Equity investments at fair value through other comprehensive income

IFRS 9 allows an entity to classify equity investments not held for trading, at fair value through other
comprehensive income through an irrevocable option on origination of the instrument. The gains and
losses are recognised in other comprehensive income and never reclassified to profit or loss.
IFRS 9 allows these equity investments at fair value through other comprehensive income to be
designated as hedged items. In this case, both the effective and ineffective portion of the fair value
changes in the hedging instruments are recognised in other comprehensive income.
Fair value designation for credit exposures
Many banks use credit derivatives to manage credit risk exposures arising from their lending activities.
The hedges of credit risk exposure allow banks to transfer the risk of credit loss to a third party. This may
also reduce regulatory capital requirements.
IAS 39 allows fair value option to be applied if it eliminates or significantly reduces an accounting
mismatch. However, this election is only available at initial recognition, is irrevocable and requires the
financial instrument, like a loan, to be designated in its entirety. As a result, banks do not often achieve
hedge accounting on credit risk of the exposures with the result that the fair value changes on credit
derivatives, like credit default swaps create volatility in the profit or loss.
IFRS 9 allows credit exposure or part of the credit exposure to be measured at fair value through
profit or loss if an entity uses a credit derivative measured at fair value through profit or loss to
manage the credit risk of all, or part of, the credit exposure. In addition, an entity may make the
designation at initial recognition or subsequently, or while the financial instrument is unrecognised.
Interactive question 17: Credit derivative and credit exposures

Excel Bank extends a fixed rate loan commitment of £1 million to a customer. The bank's risk
management strategy is to hedge the credit risk exposure of any individual loan commitment to the
extent that it exceeds £500,000. As a result, Excel Bank enters into a credit default swap of £500,000 in
relation to this loan commitment to the customer.
Requirement
Explain the accounting for the credit default swap and the loan commitment under IAS 39 and IFRS 9.

9.2.2 Hedging instruments
The key changes in IFRS 9 in respect of eligibility and accounting for hedging instruments are as follows:
Eligibility of hedging instruments
IAS 39 requires hedging instruments to be derivatives except for hedge of foreign currency risk.
IFRS 9 allows both derivatives at fair value through profit or loss and non-derivative financial assets or
financial liabilities measured at fair value through profit or loss to be hedging instruments (with the
exception of financial liability designated at fair value through profit or loss with changes in fair value
attributable to changes in credit risk recognised in other comprehensive income).
An entity may exclude the following from hedging relationships:
 Time value of purchased options
 Forward element of forward contracts and foreign currency basis spreads
Time value of purchased options
The change in fair value of the time value of the option is recognised in profit or loss in IAS 39. This
can create volatility in profit or loss.
In IFRS 9, an entity may designate only the change in intrinsic value of a purchased option as the
hedging instrument in a fair value or cash flow hedge. The change in fair value of the time value of
the option is recognised in other comprehensive income to the extent it relates to the hedged item.
This change in IFRS 9 makes options more attractive as hedging instruments.
The method used to reclassify the amounts from equity to profit or loss is determined by whether the
hedged item is transaction-related or time period-related.
The time value of a purchased option relates to a transaction-related hedged item if the nature of the
hedged item is a transaction for which the time value has the character of costs of the transaction. For
example, future purchase of a commodity or non-financial asset.
The change in fair value of the time value of option (transaction-related hedged item) is
accumulated in other comprehensive income over the term of the hedge, to the extent it relates to the
hedged item. It is then treated as follows:
 If the hedged item results in the recognition of a non-financial asset or liability or firm
commitment for a non-financial asset or liability, the amount accumulated in equity is removed
and included in the initial cost or carrying amount of the asset or liability.
 For other hedging relationships, the amount accumulated in equity is reclassified to profit or
loss as a reclassification adjustment in the period(s) in which the hedged expected cash flows affect
profit or loss.
The time value of a purchased option relates to a time-period-related hedged item if the nature of the
hedged item is such that the time value has the character of the cost for obtaining protection against a
risk over a particular time period but the hedged item does not result in a transaction that involves the
notion of a transaction cost. For example, price risk of a commodity or interest rate risk of a bond.
The change in fair value of the time value of option (time-period-related hedged item) is
accumulated in other comprehensive income over the term of the hedge, to the extent it relates to the
hedged item. The time value of the option at the date of designation is amortised on a straight-line or
other systematic and rational basis, and the amortisation amount is reclassified to profit or loss as a
reclassification adjustment.
Forward points and foreign currency basis spreads
In IAS 39, if only the spot component is designated as part of the hedging relationship, the forward
points are recognised in profit or loss on a fair value basis.
IFRS 9 allows these forward points to be treated in a similar manner as that allowed for the time value
component on options. The change in fair value of the forward points is recognised in other
comprehensive income and accumulated in equity. This is then amortised to profit or loss on a
systematic and rational basis.
IFRS 9 also allows foreign currency basis spread in a foreign currency derivative to be excluded from
designation as the hedging instrument and treated in a similar manner as allowed for forward points.

9.2.3 Hedge effectiveness
Under IFRS 9, the 80% – 125% 'bright line' test of whether a hedging relationship qualifies for hedge
accounting is replaced by an objective-based assessment, ie, that:
 There is an economic relationship between the hedged item and the hedging instrument ie, the
hedging instrument and the hedged item have values that generally move in the opposite
direction because of the same risk, which is the hedged risk.
 The effect of credit risk does not dominate the value changes that result from that economic
relationship ie, the gain or loss from credit risk does not frustrate the effect of changes in the
underlying on the value of the hedging instrument or the hedged item, even if those changes were
significant.
 The hedge ratio of the hedging relationship (quantity of hedging instrument vs quantity of hedged C
item) is the same as that resulting from the quantity of the hedged item that the entity actually H
hedges and the quantity of the hedging instrument that the entity actually uses to hedge that A
quantity of hedged item. For example, if an entity hedges 90% of the exposure on an item, it P
T
should designate the hedging relationship using a hedge ratio that is the same as that resulting E
from 90% of the exposure and the quantity of the hedging instrument that the entity actually uses R
to hedge those 90%.
This allows genuine hedging relationships to be accounted for as such whereas the IAS 39 rules
sometimes prevented management from accounting for an actual hedging transaction as a hedge. 17
In IAS 39, changes to a hedging relationship generally require discontinuation of hedge accounting
which could result in hedge ineffectiveness that is inconsistent with the risk management view of the
hedge.
In IFRS 9, if a hedging relationship ceases to meet the hedge effectiveness requirement relating to the
hedge ratio but the risk management objective for that designated hedging relationship remains the
same, the entity can adjust the hedge ratio so that it meets the qualifying criteria again in which
case discontinuation is not required. This is referred to as rebalancing.
9.2.4 Discontinuation of hedge accounting

In IAS 39, hedge accounting is discontinued when hedging instrument expires or is sold, terminated or
exercised, the hedge no longer meets the criteria for hedge accounting, the entity revokes the
designation or for cash flow hedges, the forecast transaction is no longer probable.
In IFRS 9, voluntary discontinuation of hedge accounting is not permitted when the risk
management objective has not changed for the hedging relationship.
9.3 Impact on financial statements

IFRS 9 introduces a principles-based approach that aligns hedge accounting with risk management. It
requires use of judgement, in particular with regards to whether hedging relationships will meet the
hedge effectiveness criteria and when rebalancing will be required. There are additional exposures
that may be hedged and more instruments, including non-derivatives that may be designated as
hedging instruments. The entity will need to have appropriate processes in place to identify new
hedging opportunities, and ensure that the extensive new disclosure requirements are met. The
auditors will need to test management judgements with regards to hedge effectiveness criteria, and
also obtain comfort over the fair value measurement of components of non-financial hedged items,
purchased options, forward contracts and cross-currency swaps.

9.4 IFRS 9 hedging v IAS 39 hedging: summary of key differences
The IFRS 9 model for hedge accounting differs from that in IAS 39 in the following key areas:
IAS 39 IFRS 9
Eligibility of hedging Derivatives may be designated as hedging Any financial instrument may be
instruments instruments. a hedging instrument if it is
measured at fair value through
Non-derivatives may be designated as
profit or loss.
hedging instruments only for hedge of
foreign currency risk.
Therefore, non-derivative items can be more widely used as hedging
instruments under IFRS 9.
Eligibility of hedged Recognised assets, liabilities, firm In addition to IAS 39 eligible
items commitments, highly probable forecast hedged items, IFRS 9 allows a
transactions and net investments in risk component of a non-
foreign operations may be designated as financial asset or liability to be
hedged items. In some circumstances, risk designated as a hedged item in
components of a financial asset or liability some circumstances.
may be designated as a hedged item.
Therefore more items can be designated as hedged items under IFRS 9.
Qualifying criteria for A hedging relationship only qualifies for Hedge effectiveness criteria are
applying hedge hedge accounting if certain criteria are principles-based and aligned
accounting met, including a quantitative hedge with risk management activities.
effectiveness test under which hedge
effectiveness must fall in the range 80% –
125%.
Therefore, genuine hedging relationships are accounted for as such
under IFRS 9 whereas IAS 39 rules sometimes prevented this.
Rebalancing The concept of rebalancing does not exist Rebalancing is permitted by
within IAS 39. IFRS 9 in some circumstances
(see above).
As a result of guidance on rebalancing, hedge accounting may continue
whereas it would not have been able to under IAS 39.
Discontinuation of Hedge accounting may be discontinued Hedge accounting may not be
hedging relationships at any time. discontinued where the hedging
relationship continues to meet
qualifying criteria. Can only
discontinue when qualifying
criteria are no longer met.
Accounting for the The part of an option that reflects time The time value component of an
time value component value and the forward element of a option is a cost of hedging
of options and forward contract are treated as derivatives presented in OCI.
forward contracts held for trading purposes.
The forward element of a
forward contract may also be
presented in OCI.
IFRS 9 therefore decreases volatility in profit or loss.

10 Audit focus: fair value
Section overview
 Fair value measurements of assets, liabilities and components of equity may arise from both the
initial recording of transactions and later changes in value.
 Auditing fair value requires both the assessment of risk and evaluating the appropriateness of the
fair value.
 Fair value is a key issue to investment property, pension costs, share-based payments and many
other areas of financial accounting.
C
H
10.1 Audit issues around fair value A
For the auditor the use of fair values will raise a number of issues. The determination of fair value will P
T
generally be more difficult than determining historical cost. It will be more difficult to establish whether E
fair value is reasonable for complex assets and liabilities than for more straightforward assets or liabilities R
which have an actively traded market and therefore a market value.
Generally speaking, the trend towards fair value accounting will increase audit work required, not only
17
because determining fair values is more difficult, but also because fair values fluctuate in a way that
historical costs do not, and will need vouching each audit period. Fair value will, for the same reasons,
increase audit risk.
ISA (UK) 540 (Revised June 2016) Auditing Accounting Estimates, Including Fair Value Accounting Estimates,
and Related Disclosures addresses audit considerations relating to the measurement, presentation and
disclosure of material assets, liabilities and specific components of equity presented or disclosed at fair
value in financial statements. The ISA treats fair values as a type of accounting estimate and therefore
the requirements of the ISA apply to fair values as they would to any other type of accounting estimate.
Point to note:
A revised standard was issued in June 2016. The key changes include provisions specific to PIEs, added
emphasis on the need for the auditor to maintain professional scepticism and revisions required by the
introduction of ISA 701.
The standard requires auditors to obtain an understanding of the entity's applicable financial reporting
framework in order to provide a basis for the identification and assessment of the risks of material
misstatement. This means that the auditor must have a sound knowledge of the accounting
requirements relevant to the entity and when fair value is allowed. Where IFRS 13 Fair Value
Measurement applies the auditor will have to ensure that it has been applied correctly and adequate
disclosures provided.
10.2 Auditing fair value measurements and disclosures

10.2.1 Risk assessment
Management is responsible for establishing the process for determining fair values. This process will
vary considerably from organisation to organisation. Some companies will habitually value items at
historical cost where possible, and may have poor processes for determining fair values if required.
Others may have complex systems for determining fair value if they have a large number of assets and
liabilities which they account for at fair value, particularly where a high degree of estimation is
involved.
Not all financial statement items requiring measurement at fair value involve estimation uncertainty. In
accordance with IFRS 13, entities should maximise the use of relevant observable inputs. For example, if
using a Level 1 input (eg, the unadjusted quoted price in an active market of equity shares in a listed
company), there is no estimation uncertainty.

For others, however, there may be moderate (eg, Level 2 inputs) or relatively high estimation
uncertainty (eg, Level 3 inputs), particularly where they are based on significant assumptions, for
example:
 Fair value estimates for derivative financial instruments not publicly traded
 Fair value estimates for which a highly specialised entity-developed model is used or for which
there are assumptions or inputs that cannot be observed in the marketplace
ISA 540 requires the auditor to assess the entity's process for determining fair value measurements and
disclosures and the related control activities and to assess the risks of material misstatement.
In practical terms, this would include considering the following:
 The valuation techniques adopted (ie, Level 1, 2 or 3)
 The valuation approach used in making the accounting estimate (ie, income approach, market
approach, cost approach)
 The market in which the transaction is assumed to have taken place (ie, principal market or most
advantageous market)
 The relevant control activities over the process (eg, controls over data and the segregation of
duties between those committing the entity to the underlying transaction and those responsible for
undertaking the valuations)
 The expertise and experience of those persons determining the fair value measurements
 The role that information technology has in the process
 The types of accounts or transactions requiring fair value measurements or disclosures (eg,
whether the accounts arise from routine/recurring transactions or non-routine/unusual
transactions)
 The significant management assumptions used (particularly where Level 3 unobservable inputs
are used)
 Whether there has been or ought to have been a change from the prior period in the methods for
making the accounting estimates, and, if so, why. (A change in valuation technique is considered
to be a change in accounting estimate in accordance with IAS 8.)
 Whether, and if so, how management has assessed the effect of estimation uncertainty
 The extent to which the process relies on a service organisation
 The extent to which the entity uses the work of experts in determining fair value measurements
and disclosures
 Documentation supporting management's assumptions
 The methods used to develop and apply management assumptions and to monitor changes in
those assumptions
 The integrity of change controls and security procedures for valuation models and relevant
information systems, including approval processes
 Controls over the consistency, timeliness and reliability of the data used in valuation models
10.2.2 Evaluating the appropriateness of fair value

ISA 540 requires the auditor to evaluate whether the fair value measurements and disclosures in the
financial statements are in accordance with the entity's applicable financial reporting framework.
In some cases, the financial reporting framework may prescribe the method of measurement – for
example, a particular model that is to be used in measuring a fair value estimate. In many cases,
however, the method is not specified, or there may be a number of alternative methods available.
The auditor may consider the following:
 How management considered the nature of the asset or liability when selecting a particular
method
 Whether the entity operates in a particular business, industry or environment in which there are
methods commonly used to make the particular type of estimate

10.2.3 Audit procedures in response to risk assessment
ISA 540 states that the auditor must perform further audit procedures designed to address the risk of
misstatement.
The nature, timing and extent of further audit procedures will depend heavily on the complexity of the
fair value measurement. For example, the fair value measurement of assets that are sold in open, active
markets that provide readily available and reliable information on the prices at which exchanges actually
occur should be relatively straightforward eg, published price quotations for marketable securities.
Alternatively, a specific asset may not have an active market or may possess characteristics that make it
necessary for management to estimate its fair value (eg, an investment property or a complex derivative
financial instrument). The estimation of fair value may be achieved through the use of a valuation
model (for example, a model premised on projections and discounting of future cash flows, or an
option pricing model) or through the help of an expert such as an independent expert (eg, to value C
property, brands or other specialist assets). H
A
Complex fair value measurements, particularly Level 3 unobservable inputs are normally P
T
characterised by greater uncertainty regarding the reliability of the measurement process. This greater
E
uncertainty may be the result of the following: R
 Length of the forecast period
 The number of significant and complex assumptions associated with the process 17
 A higher degree of subjectivity associated with the assumptions and factors used in the process
 A higher degree of uncertainty associated with the future occurrence or outcome of events
underlying the assumptions used
When obtaining audit evidence, the auditor evaluates whether the following are true:
 The assumptions used by management are reasonable
 The fair value was measured using an appropriate model (eg, the model prescribed in IFRS 13 if
applicable)
 Management used relevant information that was reasonably available at the time
Other actions by the auditor would include the following:
 The auditor should consider the effect of subsequent events on the fair value measurements and
disclosures in the financial statements.
 The auditor should evaluate whether the disclosures about fair values made by the entity are in
accordance with its financial reporting framework (eg, IFRS 13 disclosure requirements).
 The auditor should obtain written representations from management.
Where an accounting estimate has high estimation uncertainty the auditor may conclude that this must
be communicated as a KAM in accordance with ISA 701. (ISA 540.A114)
11 Auditing financial instruments
Section overview
 Financial instruments include items such as cash, accounts receivable and payable, loans
receivable and payable, debt and equity investments, and derivatives.
 Financial instruments should be classified as either financial assets, financial liabilities or equity
instruments.
 The key audit issue with these instruments is risk and IAS 32, IAS 39 (IFRS 9) and IFRS 7 deal with
the accounting/disclosure related to these instruments.
 Guidance for the auditor is provided by IAPN 1000.

11.1 IAPN 1000
In December 2011, the IAASB issued IAPN 1000 Special Considerations in Auditing Financial Instruments.
IAPN 1000 has been developed to help auditors with different levels of familiarity with financial
instruments. It is therefore structured in two sections. Section I provides background and educational
material to help those less familiar with financial instruments in understanding some of the common
features, and how they are used, managed and controlled by entities and particular financial reporting
issues. Section II provides guidance on the relevant auditing considerations.
The introduction of the IAPN sets out the scope. It explains that the IAPN does not address the simplest
financial instruments such as cash, simple loans, trade accounts receivable and trade accounts payable,
nor the most complex ones. It also does not address specific accounting requirements, such as those
relating to hedge accounting, offsetting or impairment.
11.1.1 Section I – Background information about financial instruments

Purpose and risks of using financial instruments
Financial instruments are used for the following purposes:
 Hedging purposes (ie, to change an existing risk profile to which an entity is exposed)
 Trading purposes (ie, to enable an entity to take a risk position to benefit from long-term
investment returns or from short-term market movements)
 Investment purposes (eg, to enable an entity to benefit from long-term investment returns)
Management and those charged with governance might not:
 fully understand the risks of using financial instruments
 have the expertise to value them appropriately
 have sufficient controls in place over financial instrument activities
Business risk and the risk of material misstatement also increase when management inappropriately
hedge risk or speculate.
In particular the entity may be exposed to the following types of risk:
(a) Credit risk (the risk that one party will cause a financial loss to another party by failing to discharge
an obligation)
(b) Market risk (the risk that the fair value or future cash flow of a financial instrument will fluctuate
because of changes in market prices eg, currency risk, interest rate risk, commodity and equity
price risk)
(c) Liquidity risk (includes the risk of not being able to buy or sell a financial instrument at an
appropriate price in a timely manner due to a lack of marketability for that financial instrument)
(d) Operational risk (related to the specific processing required for financial instruments)
The risk of fraud may also be increased where an employee in a position to perpetrate a financial fraud
understands both the financial instruments and the process for accounting for them but management
and those charged with governance have a lesser degree of understanding.
Controls relating to financial instruments
The level of sophistication of an entity's internal control will be affected by the size of the entity and the
extent and complexity of the financial instruments used. An entity's internal control over financial
instruments is more likely to be effective when management and those charged with governance have:
(a) established an appropriate control environment;
(b) established a risk management process;
(c) established information systems that provide an understanding of the nature of the financial
instrument activities and the associated risks; and

(d) designed, implemented and documented a system of internal control to:
 provide reasonable assurance that the use of financial instruments is within the entity's risk
management policies;
 properly present financial instruments in the financial statements;
 ensure that the entity is in compliance with applicable laws and regulations; and
 monitor risk.
The appendix to IAPN 1000 provides examples of controls that may exist in an entity that deals with a
high volume of financial instrument transactions. These include authorisation, segregation of duties
(particularly of those executing the transaction (dealing) and those initiating cash payments and receipts
(settlements)) and reconciliations of the entity's records to external banks' and custodians' records.
C
Completeness, accuracy and existence
H
The IAPN discusses a number of practical issues. For example, it explains that where transactions are A
P
cleared through a clearing house the entity should have processes to manage the information delivered
T
to the clearing house. Adequate IT controls must also be maintained. E
R
It also explains that in financial institutions where there is a high volume of trading a senior employee
typically reviews daily profits and losses on individual traders' books to evaluate whether they are
reasonable based on the employee's knowledge of the market. Doing so may enable management to
17
determine that particular trades were not completely or accurately recorded, or may identify fraud by a
particular trader.
Valuation of financial instruments
Section I also provides material on financial reporting requirements. It explains that many financial
reporting frameworks require financial instruments, including embedded derivatives, to be measured at
fair value. In general the objective of fair value is to arrive at the price at which an orderly transaction
would take place between market participants at the measurement date under current market
conditions; that is, it is not the transaction price for a forced liquidation or distressed sale. In meeting
this objective all relevant market information is taken into account. It also explains that fair value
measurement may arise at both the initial recording of transactions and later when there are changes in
value. Changes in fair value measurement may be treated differently depending on the reporting
framework. The IAPN then explores features of different financial reporting frameworks, including the
following:
 The fair value hierarchy (as adopted by IFRS 13)
 The effects of inactive markets
 Management's valuation processes
 The use of models, third-party pricing sources and experts (entities often make use of a third party
to obtain fair value information, particularly when expertise or data are required that management
does not possess)
11.1.2 Section II – Audit considerations relating to financial instruments

IAPN 1000 identifies certain factors that make auditing complex financial instruments particularly
challenging:
 Management and the auditors may find it difficult to understand the nature of the instruments and
the risks to which the entity is exposed.
 Markets can change quickly, placing pressure on management to manage their exposures
effectively.
 Evidence supporting valuation may be difficult to obtain.
 Individual payments may be significant which may increase the risk of misappropriation of assets.
 The amount recorded may not be significant but there may be significant risks and exposures
associated with these complex financial instruments.
 A few employees may exert significant influence on the entity's financial instruments transactions,
in particular where compensation arrangements are tied to revenue from these.

Professional scepticism
The need for professional scepticism increases with the complexity of the financial instruments, for
example with regard to the following:
 Evaluating whether sufficient appropriate audit evidence has been obtained (which can be
particularly challenging when models are used or in determining if markets are inactive)
 Evaluating management's judgements and potential for management bias in applying the
applicable financial reporting framework (eg, choice of valuation techniques, use of assumptions in
valuation techniques)
 Drawing conclusions based on the audit evidence obtained (for example assessing the
reasonableness of valuations prepared by management's experts)
Planning considerations
The auditor's focus in planning is particularly on the following:
 Understanding the accounting and disclosure requirements
ISA 540 requires the auditor to obtain an understanding of the requirements of the applicable
financial reporting framework relevant to accounting estimates.
 Understanding the complex financial instruments
This helps the auditor to identify whether:
– important aspects of a transaction are missing or inaccurately recorded;
– a valuation appears appropriate;
– the risks inherent in them are fully understood and managed by the entity; or
– the financial instruments are appropriately classified into current and non-current assets and
liabilities.
Understanding management's process for identifying and accounting for embedded derivatives will
help the auditor to understand the risks to which the entity is exposed.
 Determining whether specialised skills and knowledge are needed in the audit
The engagement partner must be satisfied that the engagement team and any auditor's experts
collectively have the appropriate competence and capabilities.
 Understanding and evaluating the system of internal control in the light of the entity's financial
instrument transactions and the information systems that fall within the scope of the audit
This understanding must be obtained in accordance with ISA 315. This understanding enables the
auditor to identify and assess the risks of material misstatement at the financial statement and
assertions levels, providing a basis for designing and implementing responses to the assessed risks
of material misstatement.
 Understanding the nature, role and activities of the internal audit function
Areas where the work of the internal audit function may be particularly relevant are as follows:
– Developing a general overview of the extent of use of financial instruments
– Evaluating the appropriateness of policies and procedures and management's compliance
with them
– Evaluating the operating effectiveness of financial instrument control activities
– Evaluating systems relevant to financial instrument activities
– Assessing whether new risks relating to financial instruments are identified, assessed and
managed
 Understanding management's process for valuing financial instruments, including whether
management has used an expert or a service organisation
Again this understanding is required in accordance with ISA 540.

 Assessing and responding to the risk of material misstatement (see below)
Assessing and responding to the risks of material misstatement
Factors affecting the risk of material misstatement include the following:
 The volume of financial instruments to which the entity is exposed
 The terms of the financial instruments
 The nature of the financial instruments
 Fraud risk factors (eg, where there are employee compensation schemes, difficult financial market
conditions, ability to override controls)
The assessment of risk will determine the appropriate audit approach in accordance with ISA 330 The
Auditor's Responses to Assessed Risks, including substantive procedures and tests of controls. Where the
entity is involved in a high level of trading and use of financial instruments it is unlikely that sufficient C
H
evidence will be obtained through substantive testing alone. Where there are relatively few transactions A
of this nature a substantive approach may be more efficient. In reaching a decision on the nature, P
timing and extent of testing of controls the auditor may consider factors such as: T
E
 the nature, frequency and volume of financial instrument transactions; R
 the strength of controls including design;
 the importance of controls to the overall control objectives;
 the monitoring of controls and identified deficiencies in control procedures; 17
 the issues controls are intended to address;
 frequency of performance of control activities;
 level of precision the controls are intended to achieve;
 evidence of performance of control activities; and
 timing of key financial instrument transactions (eg, whether they are close to the period end).
Designing substantive procedures will include consideration of the following:
 Use of analytical procedures – they may be less effective as substantive procedures when performed
alone, as the complex drivers of valuation often mask unusual trends
 Non-routine transactions – this applies to many financial instrument transactions and a substantive
approach will normally be the most effective means of achieving the planned audit objectives
 Availability of evidence – eg, when the entity uses a third-party pricing source, evidence may not
be available from the entity
 Procedures performed in other audit areas – these may provide evidence about completeness of
financial instrument transactions eg, tests of subsequent cash receipts and payments, and the
search for unrecorded liabilities
 Selection of items for testing – where the financial instrument portfolio comprises instruments with
varying complexity and risk judgemental sampling may be useful
In some cases 'dual-purpose' tests may be used ie, it may be efficient to perform a test of controls and a
test of details on the same transaction eg, testing whether a signed contract has been maintained (test
of controls) and whether the details of the financial instrument have been appropriately captured in a
summary sheet (test of details). Areas of significant judgement would normally be tested close to, or at
the period end.
Procedures relating to completeness, accuracy, existence, occurrence and rights and obligations may
include the following:
 Remaining alert during the audit when inspecting records or documents (eg, minutes of meetings
of those charged with governance, specific invoices and correspondence with the entity's
professional advisers)
 External confirmation of bank accounts, trades and custodian statements
 Reconciliation of external data with the entity's own records
 Reading individual contracts and reviewing support documentation

 Reviewing journal entries or the internal control over the recording of such entries to determine if
entries have been made by employees other than those authorised to do so
 Testing controls eg, by reperforming controls
Valuation of financial instruments
Management is responsible for the valuation of complex financial instruments and must develop a
valuation methodology. In testing how management values the financial instrument, the auditor should
undertake one or more of the following procedures:
(a) Test how management made the accounting estimate and the data on which it is based (including
any models)
(b) Test the operating effectiveness of controls over how management made the accounting estimate,
together with appropriate substantive procedures
(c) Develop a point estimate or a range to evaluate management's point estimate
(d) Determine whether events occurring up to the date of the auditor's report provide audit evidence
regarding the accounting estimate
Audit procedures may include the following:
 Reviewing and assessing the judgements made by management
 Considering whether there are any other relevant price indicators or factors to take into account
 Obtaining third-party evidence of price indicators eg, by obtaining a broker quote
 Assessing the mathematical accuracy of the methodology employed
 Testing data to source materials
Significant risk
The auditor's risk assessment may lead to the identification of one or more significant risks relating to
valuation. The following circumstances would be indicators that a significant risk may exist:
 High measurement uncertainty
 Lack of sufficient evidence to support management's valuation
 Lack of management understanding of its financial instruments or expertise to value these correctly
 Lack of management understanding of the complex requirements of the applicable financial
reporting framework
 The significance of valuation adjustments made to model outputs when the applicable reporting
framework requires or permits such adjustments
Where significant risks have been identified the auditor is required to evaluate how management has
considered alternative assumptions or outcomes and why it has rejected them, or how management has
addressed estimation uncertainty in making the accounting estimate. The auditor must also evaluate
whether the significant assumptions used by management are reasonable. To do this the auditor must
exercise professional judgement.
The IAPN also considers audit considerations for valuation in three specific circumstances: when
management uses a third-party pricing source, when management estimates fair value using a model
and when a management's expert is used.
Possible approaches to gathering evidence regarding information from third-party pricing sources may
 For Level 1 inputs, comparing the information from third-party pricing sources with observable
market prices
 Reviewing disclosures provided by third-party pricing sources about their controls and processes,
valuation techniques, inputs and assumptions
 Testing the controls management has in place to assess the reliability of information from
third-party pricing sources

 Performing procedures at the third-party pricing source to understand and test the controls and
processes, valuation techniques, inputs and assumptions used for asset classes or specific financial
instruments of interest
 Evaluating whether the prices obtained from third-party pricing sources are reasonable in relation
to prices from other third-party pricing sources, the entity's estimate or the auditor's own estimate
 Evaluating the reasonableness of valuation techniques, assumptions and inputs
 Developing a point estimate or a range for some financial instruments priced by the third-party
pricing source and evaluating whether the results are within a reasonable range of each other
 Obtaining a service auditor's report that covers the controls over validation of the prices
When management estimates fair value using a model IAPN 1000 states that testing the model can be
accomplished by two main approaches: C
H
(a) The auditor can test management's model, by considering the appropriateness of the model used A
by management, the reasonableness of the assumptions and data used, and the mathematical P
T
accuracy. E
(b) The auditor can develop their own estimate and then compare the auditor's valuation with that of R
the entity.
When a management expert is used the requirements which must be applied are the basic requirements 17
of ISA 500 as discussed in Chapter 6. Procedures would include evaluating the competence, capabilities
and objectivity of the management's expert, obtaining an understanding of their work and evaluating
the appropriateness of that expert's work as audit evidence.
Presentation and disclosure
Audit procedures around presentation and disclosure are designed in consideration of the assertions of
occurrence and rights and obligations, completeness, classification and understandability, and accuracy
and valuation.
Other relevant audit considerations
Written representations should be sought from management in accordance with ISA 540 and ISA 580
Written Representations.
11.1.3 Practice Note 23

Practice Note 23 Special Considerations in Auditing Financial Instruments was revised in July 2013. The
revised Practice note is based on IAPN 1000 discussed above. Some additional points are however
included as follows:
Section 1
 Operational risk includes model risk (the risk that imperfections and subjectivity of valuation models
are not properly understood, accounted for or adjusted for) (PN23.18)
 Complete and accurate recording of financial instruments is an essential core objective (PN23.24-1)
 When quoted prices are used as evidence of fair value the source should be independent and
where possible more than one quote (PN23.44-1)
 Where a price has been obtained from a pricing service and that price has been challenged, when
considering whether the corrected price is a suitable basis for valuation consideration should be
given to how long the challenge process has taken and whether the underlying data remains valid
(PN23.56-1)
 A key control over management's valuation process may be an independent price verification
function which forms part of internal control (PN23.62-1)
Section 2
 Although it is not part of the auditor's role to determine the amount of risk an entity should take
on, obtaining an understanding of the risk management process may identify risks of material
misstatement (PN23.70-1)

 Assertions about valuation may be based on highly subjective assumptions therefore evaluating
audit evidence in respect of these requires considerable judgment (PN23.71-2)
 Determining materiality for financial instruments may be particularly difficult (PN23.73-1)
 When deciding which audits other than those of listed entities require an engagement quality
control review the existence of financial instruments may be a relevant factor (PN23.73-2)
 When obtaining an understanding of the entity's financial instruments the auditor will consider the
view of any correspondence with regulators in accordance with the FCA Code (PN23.76-2)
 The involvement of experts or specialists may be needed (PN23.79)
 The auditor may need to consider the control environment applicable to those responsible for
functions dealing with financial instruments (PN23.89-2)
 Substantive procedures will include reviewing operational data such as reconciling differences
(PN23.104)
 The auditor may use information included in a Prudent Valuation Return (prepared by UK banks
and other regulated entities in the financial sector) to understand the uncertainties associated with
the financial instruments used and disclosed by these entities (PN23.108-1)
 Tests of valuation include: verifying the external prices used to value financial instruments,
confirming the validity of valuation models and evaluating the overall results and reserving for
residual uncertainties (PN23.113-1)
 The auditor must consider whether management has given proper consideration to the models
used (PN23.134-1)
 When evaluating the amount of an adjustment that might be required the auditor considers all
factors taken into account in the valuation process and uses experience and judgment
(PN23.137-1)
Interactive question 18: Convertible debenture

On 1 January 20X8 Berriman plc issued a £10 million debenture at par. The debenture has a nominal
rate of interest of 4% and is redeemable on 1 January 20Y3. On this date the holder has the option to
convert the debenture to 6 million £1 ordinary shares in Berriman plc. The financial statements currently
show a long-term liability which represents the net proceeds of the debenture. The first payment of
interest on 31 December 20X8 has also been recorded.
Requirements
(a) Identify the issues surrounding this debenture
(b) List the audit procedures you would perform
Case Study: Royal Bank of Scotland

In the Royal Bank of Scotland (RBS)'s financial statements for the year ended 31 December 2014,
Deloitte, RBS's statutory auditors, noted that the valuation of complex or illiquid financial instruments
was an area of audit risk which had merited specific audit focus. Their auditor's report described the risk,
and the audit team's responses to the risk, as follows:
Risk
The valuation of the Group's financial instruments was a key area of focus of our audit given the degree of
complexity involved in valuing some of the financial instruments and the significance of the judgements
and estimates made by the directors. As set out in Note 11 of the consolidated financial statements,
financial instruments held at fair value comprised assets of £534 billion and liabilities of £497 billion. In the
Group's accounting policies, the directors have described the key sources of estimation involved in
determining the valuation of financial instruments and in particular when the fair value is established using
a valuation technique due to the instrument's complexity or due to the lack of availability of market-based
data.

Our audit has focused on testing the valuation adjustments including those for credit risk, funding
related and own credit. A particular area of focus of our audit has been in testing the valuation of the
more illiquid financial instruments disclosed as level 3 instruments which comprised assets of £5 billion
and liabilities of £5 billion.
How the scope of our audit responded to the risk
We tested the design and operating effectiveness of the key controls in the Group's financial instrument
valuation processes including the controls over data feeds and other inputs into valuation models and
the controls over testing and approval of new models or changes to existing models.
Our audit work also included testing a sample of the underlying valuation models and the assumptions
used in those models using a variety of techniques. This work included valuing a sample of financial
instruments using independent models and source data and comparing the results to the Group's
valuations and the investigation of any significant differences. C
H
For instruments with significant, unobservable valuation inputs, we used our own internal valuation A
experts to assess and challenge the valuation assumptions used, including considering alternative P
valuation methodologies used by other market participants. T
E
R
12 Auditing derivatives 17
Section overview
It is necessary for auditors to understand the process of derivative trading in order to audit derivatives
successfully.
12.1 Auditing derivatives in the modern world

The key to using derivatives as part of an overall investment strategy is to have adequate internal
controls in place and trained personnel handling the investments. Derivatives, which have been around
for a very long time in one form or another, have been put to good use by transferring risk from one
party, the hedger, to another, the speculator. There are many factors in today's world which can cause
derivative investment strategies to go wrong. As we have seen, such factors can include the following:
 A lack of internal controls
 A laissez-faire management
 Greed
 Ineffective systems to identify and monitor risk
 Inexperience
An understanding of the business process involved in derivatives trading is necessary in order to audit
derivatives successfully. The steps in a typical process are as follows:
(1) Entering the deal in the trader's deal sheet
(2) Trader types the deal into the system and sends an email
(3) The back office include the deal in reports
(4) Back office process the deal using market quote information from agencies
(5) Enter details into a 'pre-programmed' Excel sheet and/or other processing package
(6) Confirm deal with brokers/counterparties
(7) Carry out monthly settlement/processing
(8) Net off between Accounts Payable and Accounts Receivable and wire the payment as necessary
Each type of derivative will be different and non-standard derivatives will be unique. This poses
challenges for the auditor.
Generally, however, the auditor should seek to:
(a) understand the client's business in order to establish the real role played by, and the risks that are
inherent in, the derivatives activity;
(b) document the system. This would involve documenting various processes;

(c) identify the controls in each process in order to establish the risk passed to the client by
inadequate or missing controls; and, therefore, to establish the audit risk and thus the audit work
that needs to be performed;
(d) carry out the appropriate control and substantive audit procedures; and
(e) make conclusions and report on the outcome of the audit of derivatives.
Obviously the exact nature of what is to be done is dependent on the circumstances of the client.
Ensuring that the information has been captured completely and accurately in each case is important.
Worked example: Systems and processes

Typically a large oil refining company in one country will obtain oil from different sources and refine it,
producing various petroleum products for its customers.
Imagine the company is involved in trading in crude oil futures. The traders will take forward positions
strategically with the information relating to future oil price movement available at the time. If the
traders expect the price to rise, they will take a long position (buy the commodity forward) and if they
expect it to fall they will take a short position (sell the commodity forward).
Requirement
Identify the key processes that the auditor would seek evidence for in connection with this.
Solution
Capture of information: The primary source document is the trader's deal sheet. This document should
contain the date, time, oil index, quantity traded, position (long or short), nature of trade (hedge or
speculation) and rationale for the trade.
Processing of information: The back office report should contain the same information as in the deal
sheet.
Confirmation of information: There should be a statement from the clearing agents (since these are
futures) confirming the details. (Note: Swaps transactions would be confirmed differently, via
counterparty and broker confirmations and options are confirmed in the same way that futures are.)
Depositing of margin money: There should be evidence that margin money had been deposited with
the exchange as required (in case the mark to market crosses the exchange's threshold limits).
Settlement: There will be clearing statements from clearing agents. These should be used in
collaboration with internally generated information to confirm that the appropriate settlement amounts
changed hands.
Accounting: The deals have been accounted for correctly.
In all these processes controls will have been implemented and the auditor should identify these and
assess their utility.
Interactive question 19: Derivatives

You are the auditor in charge of the audit of Johannes plc, a UK company with the £ as its functional
currency.
On 1 January 20X7, Johannes plc (J) entered into a forward contract to purchase 40,000 barrels of crude
oil at $70 per barrel on 1 January 20X9. J is not using this as a hedging instrument and is speculating
that the price of oil will rise and plans to net settle the contract if the price rises. J does not pay anything
to enter into this forward contract. At 31 December 20X7 the fair value of the forward contract has
increased to £500,000. At 31 December 20X8, the fair value of the forward contract has declined to
£400,000.

Requirements
(a) Identify the accounting entries you would expect to see at the inception of the contract, at
31 December 20X7, and at 31 December 20X8.
(b) Identify the risks you would expect to find in this arrangement, and the audit procedures that you
would carry out.
(c) Outline the steps that you would take to ensure compliance with IFRS 7 Financial Instruments:
Disclosures.
C
H
A
P
T
E
R
17

Summary
IAS 39 Financial Instruments:

Recognition and Measurement
Designated
hedging relationships
Hedged item Hedging instrument
Hedge accounting
conditions
Hedge effectiveness Documentation
Types of hedge
Hedge of
Fair value hedges Cash flow hedges
net investment
IFRS 7 Financial Instruments:

Disclosures
Hedge accounting

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

5 Tried & Tested plc
You are a senior in the firm that acts as auditors and advisers to Tried & Tested plc (T&T). The
finance director of T&T is proposing to restructure the company's loans to find cheaper sources of
finance, because she thinks that the company's financial gearing is too high in relation to its
uncertain cash inflows. The engagement partner has attended a meeting with the finance director
and has obtained the following information.
T&T: Notes of meeting
 T&T has completed 2 years of a 10-year 8.5% fixed-rate mortgage on its premises amounting
to £2.5 million, and it is on this loan that the finance director is looking to reduce interest
costs.
 T&T's bank has indicated that it could swap the interest charges on its loan with another of its
customers, LeytonPlus plc (LP), which wishes to fix its interest liabilities in view of uncertain
interest rate prospects.
 LP has a floating rate loan of £3.8 million on which it currently pays LIBOR + 2.0%.
The swap agreement
Because of its higher credit rating T&T has negotiated that it should pay LP at a rate of LIBOR + 1%
as its contribution to the swap. For its part LP would pay 8.8% fixed to T&T. The bank will charge
T&T 0.04% per annum of the swap value for the service. The swap agreement would last for five
years and would be for £2.5 million (assume the current LIBOR to be 6%).
Other credit facilities
LP and T&T have additional loan facilities available to them as follows:
 LP can obtain fixed rate loans at 10% per annum for up to 20 years.
 T&T can obtain floating rate loans at LIBOR + 1.0%.
You have been sent the following note by the engagement partner.
On the basis of my meeting notes please draft notes covering the following issues:
 The audit and assurance issues regarding the swap arrangement including an assessment of
whether the proposed swap may be designated a hedge.
 The control structure you would expect to be in place to manage the risks associated with the
swap.
 The finance director has had little experience of swap agreements and requires confirmation
of the net reduction in annual interest costs to T&T if the swap is agreed. Please produce this
calculation.
Requirement
Respond to the partner's note.
6 Anew plc
Anew plc (Anew), a client of your firm, has recently established a treasury and investment division
within its existing business. The division deals in derivatives, in addition to other treasury and
investment instruments, for both trading and hedging purposes. Most of the company's derivative
trading activities relate to sales, positioning and arbitrage. Sales activities involve offering products
to customers and banks in order to enable them to transfer, modify or reduce current and future
risks. Positioning involves managing market risk positions with the expectation of profiting from
favourable movements in prices, rates or indices. Arbitrage involves profiting from price
differentials between markets or products.
The company has adopted a comprehensive system for the measurement and management of risk.
Part of the risk management process involves managing the company's exposure to fluctuations in
foreign exchange and commission rates to reduce exposure to currency and commission rate risks
to acceptable levels as determined by the board of directors within the guidelines issued by the
Central Bank. The company uses different types of derivatives, including swaps, forwards and
futures, forward rate agreements, options and swaptions.

Requirements
(a) In planning the audit of Anew, identify and explain five key risks that may arise from the
derivatives trading activities that the newly formed division is involved in.
(b) Identify and explain the general controls and application controls which you consider
necessary for ensuring that these risks are controlled appropriately.
(c) You have as one of the assistants on the audit, Melanie, who has just completed the
professional level examinations. She has asked you for a briefing note on 'how to distinguish
derivatives activity for trading purposes from derivatives activity for hedging purposes and
how these are accounted for and audited within the international accounting and auditing
framework'. In response to this request and considering that Melanie's main interest is in the
audit of these instruments draft a memorandum to Melanie providing her with the advice she
requires, clarifying any ambiguous phrases in her request. C
H
Your memorandum should be structured under the following headings. A
P
(i) Derivative instruments T
(ii) Use of derivatives for trading purposes E
(iii) Use of derivatives for hedging purposes R
(iv) The audit of derivative instruments
7 Terent Property plc
17
You are a senior in the firm that acts as auditors and advisers to Terent Property plc (TP), a listed
property developer. The engagement partner has recently been to a meeting with the finance
director of TP, Michael Mainor (MM), to discuss the expansion of TP's property portfolio. In order
to finance this expansion TP will require further funding, but it expects that operating cash flows
arising from proposed developments will more than offset any financing costs. The proposals for
new developments were discussed at the meeting with the engagement partner, who has made
the following notes.
Meeting notes
 TP has a range of sites to develop over the next seven years and is considering financing the
portfolio over that period.
 MM is concerned that, in order to arrange sufficient financing over such a period, higher
returns than normal will have to be offered to investors. He is considering issuing convertible
debt and has had a quotation of likely costs from his banking adviser (Exhibit 1).
 In order to keep investors with the company over such a long period, enhanced interest
convertible debt (Exhibit 1) is being considered, and that is the basis of the quotation
provided.
 MM has mentioned the following matters.
– He is uncertain as to the impact on the financial statements of such an issue and he is
worried about City reaction, since as recently as last year the company had a rights issue,
which proved to be a difficult exercise.
– MM is concerned with the board's reaction to the financing proposal. The directors have
been advised by their bankers that the rates quoted really are the lowest they are likely to
achieve. He is particularly concerned that the financing meets the normal criteria of the
company for investing (Exhibit 2).
You have been sent the following note from the engagement partner.
To Senior
Have a look at this and let me know how the proposed debt will impact on the points raised by
MM. Please clarify what this type of debt is. Also, for our purposes, outline any assurance issues
arising for the forthcoming audit and, very importantly, those relating to fair value.
Signed: A Partner

Exhibit 1
Financing arrangements – Terent Property plc
A £10 million convertible debt with enhanced interest is proposed.
Issued at a 10% premium and redeemed at par.
Issue costs of £288,000 are expected.
Nominal 4.9% for the first two years.
Nominal 15.1% for the next five years.
Interest payable annually in arrears.
Redemption without conversion after seven years.
Exhibit 2
Background file note
Current capital structure is
£m
Share capital (£1 shares) 10.0
Retained earnings 9.6
Long-term debt (11% irredeemable bonds) 8.2
Corporation tax rate: 23%. The current share price of TP is £12.48 and P/E ratio is 8 (before
interest charges). The company operates a policy that any additional debt financing must reduce
the company's overall cost of capital.
Requirement
Respond to the partner's note.

Technical reference
Hedging relationships IAS 39.71
 Types of hedging relationships IAS 39.86–87

 Examples IAS 39 AG 102–104
Hedge accounting
 Definition IAS 39.85

C
 Conditions IAS 39.88 H
A
Hedged items P
T
 Qualifying item IAS 39.78–80, AG 99A E
 Items that cannot be designated IAS 39 AG 98–99 R
 Intra-group transactions IAS 39.80
 Portion of an instrument as a hedged item IAS 39.81
 Groups of assets as hedged instruments IAS 39.83–84 17
 Interest rate exposure of a portfolio IAS 39.81A
 Non-financial assets IAS 39.82, AG 100
Hedging instruments
 Qualifying instruments IAS 39.72–73
 Written and purchased options IAS 39 AG 94
 Non-qualifying instruments IAS 39 AG 95–97
 Designations of hedging instruments IAS 39.74–77
Fair value hedges

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

 Recognition of gains or losses IAS 39.95
 Hedge of a forecast transaction IAS 39.97
 Discontinuing cash flow hedge accounting IAS 39.101
Hedges of a net investment IAS 39.102
Hedge effectiveness
 Criteria IAS 39 AG 105
 Timing of assessment IAS 39 AG 106
 Methods of assessing effectiveness IAS 39 AG 107
Auditing fair value measurements and disclosures

 Understanding the entity's process ISA 540.8
 Evaluating reasonableness ISA 540.18, A116–A119
 Audit procedures ISA 540.13
 Written representations ISA 540.22

Auditing financial instruments
 Professional scepticism IAPN 1000.71
 Planning IAPN 1000.73–.84
 Substantive procedures IAPN 1000.96
 Valuation IAPN 1000.114, .118


(a) Explanation
This forward contract is a derivative. It is a financial liability because it is unfavourable at the year
end.
Under the forward contract, BCL has to pay £3.125 million ($2m ÷ 0.64).
C
At the year end, an equivalent contract would only have cost £2.857 million ($2m ÷ 0.7). H
A
Therefore, the contract is standing at a loss of £0.268 million (£3.125m – £2.857m) at the year P
end. This is why it is a financial liability. T
E
Normally derivatives are treated as being held for trading so this contract will be treated as a R
financial liability at fair value through profit or loss.
Journal entry:
17
DEBIT Profit or loss £0.268m
CREDIT Financial liability £0.268m
Being the recognition of the liability and loss on forward contract
(b) (i) Recording the gain or loss
If the forward contract is to be treated as a hedging instrument, it should still be measured at
its fair value of £0.268 million but the loss should be recognised in other comprehensive
income instead of profit or loss.
Why different treatment is necessary
The reason for hedging is to try to offset the gain/loss on the hedged item with the
corresponding loss/gain on the hedging instrument.
With a cash flow hedge, the hedged item is often a future or forecast transaction which has
not yet been recorded in the financial statements. If the normal accounting treatment was
applied the loss on this hedging instrument would be recognised in profit or loss in one
period and the gain on the hedged item would be recognised in profit or loss in a later
period, so the offsetting effect would not be reflected.
When the gain on the hedged item occurs and is recognised in profit or loss, the loss on the
forward contract should be reclassified from other comprehensive income to profit or loss.
This matches the gain and loss and better reflects the offsetting that was the purpose of the
transaction.
(ii) Extract from statement of profit or loss and other comprehensive income
for the year ended 31 August 20X0
£m
Profit for the year 1
Other comprehensive income
Loss on forward contract (0.268)
Total comprehensive income 0.732

(a) Initial recognition
DEBIT Available-for-sale financial asset £112,560
CREDIT Bank £112,560
Being the initial recognition of available-for-sale asset (at fair value, including transaction costs)
(W1)
Measurement at 31 July 20X3
DEBIT Available-for-sale financial asset £5,840
Being the gain on remeasurement of the available-for-sale financial asset (W2). (The gain will be
recognised in other components of equity.)
WORKINGS
(1) Fair value March 20X3
£
Fair value (40,000 shares @ £2.68) 107,200
Commission (5% × 107,200) 5,360
112,560
(2) Gain to 31 July 20X3

£
Fair value (40,000 shares @ £2.96) 118,400
Previous value (112,560)
5,840
(b) Fair value hedge

Under the normal rules of IAS 39, the gain or loss on an available-for-sale financial asset is
recognised in other comprehensive income and the gain or loss on a derivative is recognised in
profit or loss.
However, assuming that the derivative meets the criteria to be treated as a hedging instrument, it
would be treated as a fair value hedge. This means that:
 the gain or loss on the financial asset (the 'hedged item') would be taken to profit or loss;
and
 this would be offset by the corresponding loss or gain on the derivative.
This treatment is a fair reflection of the economic substance of the hedging arrangement, where
the intention is that the changes in value of the derivative will cancel out the changes in value of
the hedged item.

The futures contract was intended to protect the company from a fall in oil prices (which would have
reduced the profit when the oil was eventually sold). However, oil prices have actually risen, so that the
company has made a loss on the contract.
(a) Without hedge accounting
The futures contract is a derivative and therefore should be remeasured to fair value under IAS 39.
The loss on the futures contract should be recognised in profit or loss:
DEBIT Profit or loss (40,000  [£24 – £22]) £80,000

(b) With hedge accounting
The loss on the futures contract should be recognised in profit or loss, as before.
There is an increase in the fair value of the inventories:
£
Fair value at 31 December 20X3 (40,000 × £22.25) 890,000
Fair value at 1 December 20X3 = cost (800,000)
Gain 90,000
The gain should also be recognised in profit or loss and adjusted against the carrying amount of
the inventories:
DEBIT Inventory £90,000
C
The net effect on profit or loss is a gain of £10,000 compared with a loss of £80,000 without H
hedging. A
P
Note: The hedge is highly effective: 80,000/90,000 = 89% which is within the 80%–125% range. T
E
R
Yes. The inventories may be hedged for changes in fair value due to changes in the copper price
because the change in fair value of inventories will affect profit or loss when the inventories are sold or 17
their carrying amount is written down. The adjusted carrying amount becomes the cost basis for the
purpose of applying the lower of cost and net realisable value test under IAS 2.
The hedging instrument used in a fair value hedge of inventories may alternatively qualify as a cash flow
hedge of the future sale of the inventory.

The hedge is fully effective, as the gain on the hedging instrument is less than the loss on the cash flows
and the gain of £8,800 is therefore all recognised in other comprehensive income (IAS 39.95–96). The
double entry is:
DEBIT Hedging instrument (SOFP) £8,800

No. A cash flow hedge is defined as a hedge of the exposure to variability in cash flows attributable to a
particular risk. In this case, the issued debt instrument does not give rise to any exposure to volatility in
cash flows since the interest is calculated at a fixed rate.
The entity may designate the swap as a fair value hedge of the debt instrument, but it cannot designate
the swap as a cash flow hedge of the future cash outflows of the debt instrument.

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

IAS 39 allows both of these two methods.
If the hedge is treated as a fair value hedge, the gain or loss on the fair value remeasurement of the
hedging instrument and the gain or loss on the fair value remeasurement of the hedged item for the
hedged risk should be recognised immediately in profit or loss.

If the hedge is treated as a cash flow hedge, the portion of the gain or loss on remeasuring the forward
contract that is an effective hedge should be recognised in other comprehensive income. The amount
should be reclassified in profit or loss in the same period or periods during which the hedged item (the
liability) affects profit or loss ie, when the liability is remeasured for changes in foreign exchange rates.
Therefore, if the hedge is effective, the gain or loss on the derivative is released to profit or loss in the
same periods during which the liability is measured, not when the payment occurs.

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

Given that RapidMart is hedging the volatility of the future cash outflow to purchase fuel, the forward
contract is accounted for as a cash flow hedge, assuming all the criteria for hedge accounting are met
(ie, the hedging relationship consists of eligible items, designation and documentation at inception as a
cash flow hedge, and the hedge effectiveness criteria are met).
At inception, no entries are required as the fair value of a forward contract at inception is zero.
However, the existence of the hedge is disclosed under IFRS 7 Financial Instruments: Disclosures.
At the year end the forward contract must be valued at its fair value of £0.12 million as follows. The gain
is recognised in other comprehensive income (items that may subsequently be reclassified to profit or
loss) in the current year as the hedged cash flow has not yet occurred. This will be reclassified to profit
or loss in the next accounting period when the cost of the diesel purchase is recognised.
WORKING
£m
Market price of forward contract for delivery on 31 December (1m  £2.16) 2.16
RapidMart's forward price (1m  £2.04) (2.04)
Cumulative gain 0.12
The gain is recognised in other comprehensive income as the cash flow has not yet occurred:
DEBIT Forward contract (Financial asset in SOFP) £0.12m
CREDIT Other comprehensive income £0.12m
Foreign currency receivables

£'000
Receivable originally recorded (30,240/5.6) 5,400
Receivable at year end (30,240/5.4) 5,600
Exchange gain 200
DEBIT Trade receivables (£'000) 200

CREDIT Profit or loss (other income) 200
Forward contract
This is a cash flow hedge (£'000):
DEBIT Other comprehensive income 200
DEBIT Finance cost (forward points) 20
CREDIT Financial liability 220

As the change in cash flow affects profit or loss in the current period, a reclassification adjustment is
required (£'000):
DEBIT Profit or loss 200
CREDIT Other comprehensive income 200

Bruntal is hedging the volatility of the future cash inflow from selling the gold jewellery. The futures
contracts can be accounted for as a cash flow hedge in respect of those inflows, providing the criteria
for hedge accounting are met.
The gain on the forward contract should be calculated as:
£
Forward value of contract at 31.10.X1 (24,000 × £388) 9,312,000 C
H
Forward value of contract at 30.9.X2 (24,000 × £352) 8,448,000
A
Gain on contract 864,000 P
T
The change in the fair value of the expected future cash flows on the hedged item (which is not E
recognised in the financial statements) should be calculated as: R
£
At 31.10.X1 9,938,000
At 30.9.X2 9,186,000 17
752,000
As this change in fair value is less than the gain on the forward contract, the hedge is not fully effective
and only £752,000 of the gain on the forward should be recognised in other comprehensive income.
The remainder should be recognised in profit or loss:
DEBIT Financial asset (Forward a/c) £864,000
Note that the hedge is still highly effective (and hence hedge accounting should continue to be used):
£752,000/£864,000 = 87% which is within the 80%–125% range.
Note: Bruntal could also have accounted for this transaction as a fair value hedge if, at inception, its
documented objective of the hedge had been to hedge the fair value of its inventories.

Cash flow hedge
Value of contract: £'000 £'000
Price at 31 December 20X2 (3,000  1,400) 4,200
Price at 1 November 20X2 (3,000  1,440) (4,320)
Loss (120)
DEBIT Other comprehensive income 120

CREDIT Financial liability 120
The tax treatment follows the IFRS treatment. However, the current tax credit has not yet been
recorded. This is credited to other comprehensive income rather than profit or loss, as the loss itself on
the contract is recognised in other comprehensive income (IAS 12.61A):
£'000 £'000
DEBIT Current tax liability (SOFP) (120  30%) 36
CREDIT Income tax credit (OCI) 36

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

The purpose of the forward contract is to hedge the fair value of the recognised receivable due to
fluctuations in exchange rates. It is therefore a fair value hedge.
Providing relevant documentation has been set up, which appears to be the case here, hedge
accounting rules can be used provided that:
 the hedge is expected to be highly effective at achieving offsetting changes in fair value;
 the effectiveness of the hedge can be reliably measured; and
 the hedge is assessed to actually have been highly effective.
The foreign currency receivable will initially be recognised at the spot rate at the date of the transaction
ie, at $1,614,205 (GBP 1 million/0.6195).
At 31 December 20X1, the receivable is restated in accordance with IAS 21 to $1,554,002
(GBP 1 million/0.6435). A loss of $60,203 ($1,614,205 – $1,554,002) is therefore recognised in profit or
loss.
The forward contract is recognised in the financial statements at 31 October 20X1. However, no double
entries are recorded, as the value of a forward contract at inception is zero.

However, recognition of the hedge will trigger disclosure under IFRS 7 as follows:
 A description of the hedge
 A description of the forward contract designated as a hedging instrument
 The nature of the risk being hedged (ie, change in exchange rates affecting the fair value of the
receivable)
 Gains and losses on the hedging instrument and the hedged item
At 31 December 20X1, the change in fair value of the forward contract is recognised in profit or loss as
this is a fair value hedge:
$
1 59,572
[( 1mGBP/0.6440  (1mGBP/0.6202))  ] C
1
H
1.00325 12 A
At 31 October 20X1 (zero at inception) (0) P
59,572 T
Change in fair value of forward contract (gain)
E
The company has designated changes in the spot element of the forward contract as the hedge. The R
change in the spot element is:
$
1 60,187 17
[( 1mGBP/0.6435  (1mGBP/0.6195))  ]
1
1.00325 12
At 31 October 20X1 (zero at inception) (0)
Change in fair value of spot element of forward contract (gain) 60,187
Effectiveness of the hedge is calculated as:
Cumulative change in fair value of spot element of hedging instrument

Cumulative change in fair value of hedged item
$60,187
= = 99.97% (or 100.03% if measured the other way around)
($60,203*)
* If the effect of discounting short-term receivables to obtain a more precise fair value is taken into
account, this could be measured at $60,187 giving effectiveness of exactly 100%.
The hedge is measurable and within the 80% to 125% effectiveness range. Therefore hedge accounting
can be used, assuming the hedge is expected to be highly effective until 31 January 20X2.
The interest element (which arises due to different interest rates between the currencies of the forward
contract) is excluded from the hedging relationship and recognised as a finance cost:
$ $
DEBIT Forward contract 59,572
DEBIT Finance costs (P/L) (60,187 – 59,572) 615
CREDIT Profit or loss 60,187
Profit or loss: $
Loss on foreign currency receivable (60,203)
Gain on hedging instrument 60,187
Finance costs (615)
Statement of financial position:

$
Current assets
Trade receivables (1,614,205 – 60,203) 1,554,002
Forward contract hedging instrument 59,572

As the company entered into the swap agreement with the purpose of hedging the fair value of the
company's own debt, this is a fair value hedge. However, in order for hedge accounting to apply, the
hedge must meet certain criteria per IAS 39.88:
• At the inception of the hedge, there is formal designation and documentation of the hedging
relationship and the entity's risk management objective and strategy for undertaking the hedge.
• The hedge is expected to be 'highly effective' in achieving offsetting changes in fair value
attributable to the hedged risk, consistent with the originally documented risk management
strategy.
• The hedge effectiveness can be reliably measured.
• The hedge is assessed on an ongoing basis and determined actually to have been highly effective
throughout the financial reporting periods for which the hedge was designated.
If, at any time, any of these criteria are not met, hedge accounting is discontinued and the swap, being
a derivative, is measured at 'fair value through profit or loss'.
The loan is held initially at amortised cost. It is initially recorded at its fair value at inception
($30 million). Interest for the first three months is accrued and paid. As there are no transaction costs
and no redemption premium, the effective interest rate to be applied to the debenture loans is the same
as the nominal rate. Therefore the profit or loss charge will equal the interest actually paid:
£
Cash 30,000,000
Effective interest for the quarter (30,000,000  6%  3/12) 450,000
Coupon interest paid (450,000)
c/d at 31 December 20X0 30,000,000
The double entries are: £ £

DEBIT Finance costs 450,000
CREDIT Debenture loan 450,000
DEBIT Debenture loan 450,000

CREDIT Cash 450,000
The swap is initially recorded at its fair value. Given that it was entered into at 'market rates', its fair
value is zero at 1 October 20X0 so there will be no specific accounting entry on that date.
However, disclosures will be required under IFRS 7 Financial Instruments: Disclosures.
The interest receipts and payments on the swap are recorded as follows:
£ £
DEBIT Finance costs (£30m  4.72%  3/12) 354,000
DEBIT Cash 39,750
CREDIT Finance income (£30m  5.25%  3/12) 393,750
At the year end, the fair value hedge accounting rules are applied.
First, the effectiveness of the hedge must be tested to ensure that hedge accounting can be
followed, ie, that the gain/loss on the swap as a proportion of the loss/gain on the debenture loans
hedged must be within the range 80% to 125%.
The gain in the debentures during the period is £30,000,000 – £29,762,240 = £237,760.
Therefore the ratio is:
£237,760/£238,236 = 99.8% or £238,236/£237,760 = 100.2% if the ratio is measured as the
reciprocal (either is acceptable as it is the ratio that is being tested).
This is within the 80%–125% range and therefore the swap, although not fully effective, is deemed
'highly effective' and hedge accounting can be used.

The change in the fair value of the swap is recognised as a derivative liability in the statement of
financial position and is reported as a loss in profit or loss as follows:
£ £
DEBIT Other expense 238,236
CREDIT Swap liability 238,236
Under fair value hedge accounting, the change in fair value of the hedged item is also recognised
in profit or loss, any difference between the two being ineffectiveness of the hedge:
£ £
DEBIT Debenture loans 237,760
CREDIT Other income 237,760
C
IAS 39 is not specific about where each of the above items is disclosed. They could be shown H
together in 'other income and expense', to emphasise that they are two halves of a hedged A
transaction. However, this would be broken down in the notes to satisfy the requirement of IFRS 7 P
para 24(a). T
E
The overall effect on the statement of financial position is as follows: R
£
Debenture loans (at amortised cost) 30,000,000
17
Change in fair value of loans 237,760
Amount shown in SOFP 29,762,240
Derivative (swap) liability 238,236
30,000,476
In this way, it can be seen that the initial fair value of the debentures of £30 million has been
effectively hedged.
Without hedge accounting profit or loss would be distorted by showing the loss of £238,236 on
the swap in profit or loss, without recognising the corresponding gain on the debentures (as they
would still be held at their amortised cost of £30 million).
Statement of comprehensive income for the year ended 31 December 20X0 (extracts)
£
Other income 237,760
Other expense (238,236)
Finance income 393,750*
Finance costs (450,000 + 354,000*) 804,000
(410,726)
Statement of financial position as at 31 December 20X0 (extracts)
£
Current assets
Cash X – 450,000 + 393,750 – 354,000
Debenture loans 29,762,240
Swap liability 238,236
Equity
Retained earnings X – 410,726
* Can be shown netted as both relate to the swap instrument

IAS 39
The credit default swap (CDS) is recognised as a derivative at fair value through profit or loss. The loan
commitment cannot be accounted for at fair value through profit or loss as IAS 39 does not allow fair
value option for a proportion of an exposure. As a result, there will be volatility in the profit or loss since
there is no offset for the fair value changes in the CDS.
IFRS 9
The credit default swap (CDS) is recognised as a derivative at fair value through profit or loss. IFRS 9
allows fair value option for a proportion of the loan commitment. If this option is elected, then
£500,000 of the loan commitment is accounted for at fair value through profit or loss and as a result
provides an offset to the fair value through profit or loss on the CDS.

(a) Issues
The treatment of the debenture does not appear to comply with accounting standards. It should
be treated as a hybrid instrument, split into its equity and liability components. Normally the
liability component should be calculated as the discounted present value of the cash flows of the
debenture, discounted at the market rate of interest for a comparable borrowing with no
conversion rights. The remainder of the proceeds represents the fair value of the right to convert
and this element should be reclassified as equity.
(b) Procedures
 Obtain a copy of the debenture deed and agree the nominal interest rate and conversion
terms
 Assuming the revised treatment is adopted, review schedule calculating the fair value of the
liability at the date of issue. Confirm that an appropriate discount rate has been used (ie,
market rate of interest for a comparable borrowing with no conversion rights)
 Agree initial proceeds and interest payment to cash book and bank statement
 Review adequacy of disclosures in accordance with accounting standards

(a) There are no accounting entries at the inception of the forward contract.
On 31 December 20X7 there is an increase in derivative asset (increase in fair value of forward
contract) of £500,000 and this is reflected in profit or loss as a gain.
On 31 December 20X8 there is a decrease in derivative asset of £100,000 and this is reflected as a
loss in profit or loss for the year.
(b) As illustrated in part (a) one of the risks is that the fair value of the asset will go down. This is
referred to as market risk – a risk relating to the adverse changes in the fair value of the derivative;
in this case the forward contract. This is a very real risk for J.
There is foreign exchange risk. This is the risk that J's earnings will be affected as a result of
fluctuations in currency exchange rates. J's functional currency is £ but crude oil prices are quoted
in the US$. The movement in the £/$ exchange rate will affect J's earnings arising from this
contract.
There is credit risk – the risk that the counterparty will not settle the obligation at full value.
There is the related settlement risk – the risk that settlement will take place without J receiving
value from the counterparty.
Solvency risk is the risk that J will not have the funds to settle when the payment for the barrels
becomes due. This may be related to the market risk described above.

There is also interest rate risk. This is the risk that J will suffer loss as a result of fluctuations in the
value of the forward contract due to changes in market interest rates. If the movement in interest
rates is such that the price of crude goes down then J will be affected adversely.
As auditor, I would need to do the following:
 Assess the audit risk and design audit procedures to ensure that risk is reduced to an
acceptable level.
 Understand J's accounting and internal control system to enable me to assess whether it is
adequate to deal with forward contracts of this type specifically but with any type of
derivatives J carries out, generally. I would need to assess the control environment to ensure
that it is strong enough and that J has clear control objectives in place. Control objectives
would include authorised execution of the deal, checking completeness and accuracy of the
information, prevention and detection of errors, appropriate accounting for changes in the C
value of the derivative (the forward contract), and general ongoing monitoring. H
A
 Check that appropriate reconciliations are carried out and that there are appropriate controls P
T
around the reconciliations. The reconciliations would include:
E
– the one between the dealer's deal sheet and the back office records used for the ongoing R
monitoring process;
– the one between the clearing and bank accounts and the broker statements to ensure 17
that all outstanding items are identified and promptly cleared; and
– the one between J and the appropriate brokers and agents.
 Check that data security procedures are adequate to ensure recovery in the case of disaster.
 I would carry out procedures to ensure that the amounts recorded at the year ends
(31 December 20X7 and 31 December 20X8) are appropriate. These would include:
– inspecting the agreement for the forward contract and the supporting documentation to
ensure that the agreement occurred (at 31 December 20X7 only) and confirming that
the situation has not changed subsequently;
– inspecting documentation for evidence of the purchase price (at 31 December 20X7
only); and
– obtaining evidence collaborating the fair value of the forward contract; for example
quoted market prices.
(c) I would check that the following IFRS 7 disclosures have been made.
 The accounting policy for financial instruments including forwards, especially how fair value is
measured
 Net gains to be recorded in profit or loss (£500,000 for year ending 31 December 20X7) and
net losses (£100,000 for year ending 31 December 20X8)
 The fair value of the asset category which includes the forward contract. The disclosure should
be such that it permits the information to be compared with the corresponding carrying
amount
 The nature and extent of risks arising from financial instruments, including forward contracts.
The disclosures should be both qualitative and quantitative

1 Hedging
The futures contract was entered into to protect the company from a fall in oil prices and hedge
the value of the inventories. It is therefore a fair value hedge.
The inventories should be recorded at their cost of $2,600,000 (100,000 barrels at $26) on
1 July 20X2.
The futures contract has a zero value at the date it is entered into, so no entry is made in the
Tutorial note
However, the existence of the contract and associated risk would be disclosed from that date in
accordance with IFRS 7.
At the year end the inventories should be measured at the lower of cost and net realisable value.
Hence they should be measured at $2,250,000 (100,000 barrels at $22.50) and a loss of $350,000
However, a gain has been made on the futures contract:
$
The company has a contract to sell 100,000 barrels on
31 March 20X3 at $27.50 2,750,000
A contract entered into at the year end would sell these
barrels at $23.25 on 31 March 20X3 2,325,000
Gain (= the value the contract could be sold on for to a
third party) 425,000
The gain on the futures contract should also be recognised in profit or loss:
DEBIT Future contract asset $425,000
CREDIT Profit or loss $425,000
The net effect on profit or loss is a gain of $75,000 ($425,000 less $350,000) whereas without the
hedging contract there would have been a loss of $350,000.
Note: If the fair value of the inventories had increased, the carrying amount of the inventories
should have been increased by the same amount and this gain also recognised in profit or loss
(normally gains on inventories are not recognised until the goods are sold). A loss would have
occurred on the futures contract, which should also have been recognised in profit or loss.
2 Columba
A gain of £3,000 should be recognised in profit or loss.
The ineffective portion of the gain or loss on the hedging instrument should be recognised in profit
or loss. In a cash flow hedge the amount to be recognised in other comprehensive income is the
lower of:
 the cumulative gain/loss on the hedging instrument ie, £20,000; and
 the cumulative change in fair value of the hedged item ie, £17,000.
So £17,000. This leaves £3,000 of the increase in the fair value of the cap to be recognised in profit
or loss.
3 Pula
The hedging relationship may be designated either a fair value hedge or a cash flow hedge.
The contract to sell the bulldozer represents a firm commitment with Roadmans, not merely a
proposed transaction, and it is expressed in a currency other than Pula's functional currency. A
hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value
hedge or as a cash flow hedge.

4 Macgorrie
Statement (a) is false.
Macgorrie has only attempted to protect itself against price increases relating to 90 tonnes of the
silver it needs to purchase. IAS 39.AG107A permits the hedged item to be designated as the
hedged amount of the exposure in determining effectiveness. The unhedged 20 tonnes can
therefore be ignored. Hedge effectiveness is reduced as the forward contract is not perfectly
matched against the underlying commodity price.
Statement (b) is true.
The change in value of the derivative per tonne is £2,835/90 = £31.50.
The effective element is (£31.50 change in derivative value per tonne/£35 change in spot price per
tonne)% = 90%, which falls within the specified range. C
H
5 Tried & Tested plc A
P
1 Audit and assurance issues T
E
Assessment of proposed swap
R
 The hedging relationship qualifies for hedge accounting only if all the following
conditions are met:
17
(a) At the inception of the hedge there is formal designation and documentation of the
hedging relationship and the entity's risk management objective and strategy for
undertaking the hedge. That documentation shall include identification of the
hedging instrument, the hedged item or transaction, the nature of the risk being
hedged and how the entity will assess the hedging instrument's effectiveness in
offsetting the exposure to changes in the hedged item's fair value or cash flows
attributable to the hedged risk.
(b) The hedge is expected to be highly effective in achieving offsetting changes in fair
value or cash flows attributable to the hedged risk, consistently with the originally
documented risk management strategy for that particular hedging relationship.
(c) For cash flow hedges, a forecast transaction that is the subject of the hedge must be
highly probable and must present an exposure to variations in cash flows that could
ultimately affect profit or loss.
(d) The effectiveness of the hedge can be reliably measured ie, the fair value or cash
flows of the hedged item that are attributable to the hedged risk and the fair value
of the hedging instrument can be reliably measured.
(e) The hedge is assessed on an ongoing basis and determined actually to have been
highly effective throughout the financial reporting periods for which the hedge was
designated.
 The designated instrument must be a derivative.
It appears to be a derivative in this case because there is no initial net investment.
Furthermore, under the terms of the swap, settlements are made in cash, not by delivery
of a financial instrument on a regular-way basis.
 The effectiveness of the hedge.
This is indicated below in the calculations (see (3)). It is likely that T&T may designate
the transaction as part of the hedging relationship since there is a 20% reduction in
interest costs. If the change in fair value caused by the interest rate reduction is of similar
magnitude at about 20%, then this would be an effective hedge.
 In general terms a hedge can be a fair value or cash flow hedge. A pay-variable receive-
fixed swap can only be a fair value hedge as the entity's exposure to changes in fair value
is hedged (rather than a hedge of the variability in the entity's cash flows).

Other audit and assurance issues
 This is a relatively complex transaction which will increase audit risk, particularly as the
finance director has had little experience of this type of transaction before.
 T&T is exposed to interest rate risk if the swap goes ahead. T&T has changed its fixed
interest commitments to variable commitments. It is possible that interest rates will rise,
particularly as interest rates are said to be uncertain.
 Since T&T has a better credit rating it is possible that it may face risk of default from LP
on the loan payments under the swap agreement.
 The finance director is concerned about the level of gearing within the company. While
steps are being taken to deal with the situation, this issue will need to be considered as
part of the going concern review.
 The extent to which the bank will be expecting to place reliance on financial information
as part of the process of agreeing the swap and any specific assurances which we might
be required to provide.
2 Control structure
 Control structure should be appropriate in relation to the risks faced.
 Proper assessment should be performed and documented.
 Organisation should consider and document its 'appetite for risk' or its degree of
acceptability of exposure.
 Authorisation controls should be in place with different levels of authorisation depending
on the risk profile of the instrument.
 Documentation of the way in which risks are identified, monitored and reported with
lines of responsibility clearly specified.
3 Reduction in annual interest costs
Variable rate interest liabilities and income for T&T
%
Interest on fixed loan currently paid 8.5
Received from LP under swap agreement (8.8)
Difference (0.3)
Payment by T&T to LP under swap agreement (LIBOR + 1) 6 + 1.0
Total variable payments by T&T 6.7
This is a 0.3% reduction on its LIBOR facilities.

£ £
T&T currently pays – fixed (8.5% × £2.5m) 212,500
Will pay
Interest (6.7% × £2.5m) 167,500
Bank charge (0.04% × £2.5m) 1,000
(168,500)
Net annual saving 44,000
6 Anew plc
(a) Key risks from derivatives trading
There are a number of concerns that an auditor of Anew should address in connection with
this new division while planning the audit of Anew. One of those is the risk inherent in one of
the division's main activities, derivatives trading. There will be risks arising from trading
activities as well as those arising from hedging activities.
 Credit risk is the risk that a customer or counterparty will not settle an obligation for full
value. This risk will arise from the potential for a counterparty to default on its
contractual obligations and it is limited to the positive fair value of instruments that are
favourable to the company.

 Legal risk relates to losses resulting from a legal or regulatory action that invalidates or
otherwise precludes performance by the end user or its counterparty under the terms of
the contract or related netting agreements.
 Market risk relates to economic losses due to adverse changes in the fair value of the
derivative. These movements could be in the interest rates, the foreign exchange rates or
equity prices.
 Settlement risk relates to one side of a transaction settling without value being received
from the counterparty.
 Solvency risk is the risk that the entity would not have the funds to honour cash outflow
commitments as they fall due. It is sometimes referred to as liquidity risk. This risk may be
caused by market disruptions or a credit downgrade which may cause certain sources of
funding to dry up immediately. C
(b) Necessary general controls and application controls H
A
P
T
Tutorial note E
R
This answer assumes that a computer system is used in processing trades involving derivatives.
General controls 17
A number of general controls may be relevant in this case, for example the following:
 For credit risk, general controls may include ensuring that off-market derivative contracts
are only entered into with counterparties from a specific list and establishing credit limits
for all customers.
 For legal risk, a general control may be to ensure that all transactions are reviewed by
properly qualified lawyers and regulation specialists.
 For market risk, a general control may be to set strict investment acceptance criteria and
ensure that these are adhered to.
 For settlement risk, a general control may be to set up a third party through whom
settlement takes place, ensuring that the third party is instructed not to give value until
value has been received.
 For solvency (liquidity) risk, general controls may include having diversified funding
sources, managing assets with liquidity in mind, monitoring liquidity positions, and
maintaining a healthy cash and cash equivalents balance.
Application controls
These include the following:
 A computer application may identify the credit risk. In this case an appropriate control
may be monitoring credit exposure, limiting transactions with an identified counterparty
and stopping any further risk-increasing transactions with that counterparty.
 For legal risk, an application control may be the system insisting that it will not process a
transaction/trade until an authorised person has signed into the system to give the
authority. Such an authorised person may be different depending on the nature and type
of transaction. In some cases it may be the company specialist solicitor; yet in other cases
it may just be the dealer's supervisor.
 For market risk, an application control may carry out mark to market activity frequently
and the production of timely exception management reports.
 For settlement risk, an application control may be a computer settlement system refusing
to release funds/assets until the counterparty's value has been received or an authorised
person has confirmed to the system that there is evidence that value will be received.
 For solvency risk, an application control may be that the system will produce a report for
management informing management that there needs to be a specific amount of funds
available on a given date to settle the trades coming in for settlement on that date.

(c) Memorandum
To Melanie
From Jane Chadge
Date 12 November 20X7
Subject Briefing note on all manner of things derivative
Thank you for your recent email asking me to explain how to distinguish derivatives activity
for trading purposes from derivatives activity for hedging purposes. In the same email you
asked me to explain how these instruments are accounted for and audited within the
international accounting and auditing framework. In this briefing note, I am assuming that
your reference to international accounting and auditing framework is to IFRSs/IASs
(International Financial Reporting Standards/International Accounting Standards) and ISAs
(International Standards on Auditing UK) for Accounting and Auditing respectively. I am also
assuming that '… for trading purposes …' refers to engagement in derivatives activity for
speculative purposes.
(i) Derivative instruments
 These are financial contracts between two parties where payments are dependent
on movements in price in one or more underlying financial instruments, reference
rates or indices.
 They are financial instruments or other contracts within the scope of relevant
accounting standards. IAS 32, IAS 39 (/IFRS 9) and IFRS 7 deal with the accounting
and disclosure requirements for derivatives.
 IAS 39 requires that derivatives be measured at fair value in the statement of
financial position unless they are linked to and must be settled by an investment in
an unquoted equity instrument that cannot be reliably measured at fair value.
 In general, derivatives can be used either for speculation (trading) or for hedging
(offsetting risk). How the derivative is accounted for and disclosed will depend on
whether it is for speculative or hedging purposes.
 Generally a derivative instrument can be any instrument that has the three
characteristics stated in IAS 39. Derivative instruments include swaps, options,
swaptions, forwards and futures. A derivative instrument can be embedded in
another (non-derivative) instrument; for example, a company issuing a bond whose
interest is linked to the US$ price of crude oil, such that the interest payments
increase and decrease with this price.
(ii) Use of derivatives for trading purposes
 Speculators may trade with other speculators as well as with hedgers. In most
financial derivatives markets, the value of speculative trading is far higher than the
value of true hedge trading.
 As well as outright speculation, derivatives traders may look for arbitrage
opportunities between different derivatives on identical or closely related underlying
securities.
 Derivatives such as options, futures or swaps generally offer the greatest possible
reward for betting on whether the price of an underlying asset will go up or down.
For example, a person may believe that an oil company may find more oil reserves
in the next year. If the person bought the stock (share) for £10, and it went to £20
after the discovery was announced, the person would have made a profit and have
a return on his investment.
 Other uses of derivatives are to gain an economic exposure to an underlying
security in situations where direct ownership of the underlying security is too costly
or is prohibited by legal or regulatory restrictions, or to create a synthetic short
position. In addition to directional plays (ie, simply betting on the direction of the
underlying security), speculators can use derivatives to place bets on the volatility of
the underlying security. This technique is commonly used when speculating with
traded options.

(iii) Use of derivatives for hedging purposes
 Hedging is a risk management technique that involves using one or more
derivatives or other hedging instruments to offset changes in fair value or cash flows
of one or more assets, liabilities or future transactions. Risk can be transferred.
 One use of derivatives is as a tool to transfer risk by taking an equal but opposite
position in the futures market against the underlying commodity. For example, a
sheep breeder will sell/buy futures contracts on sheep from/to a speculator before
the sheep trading season since the breeder intends to eventually sell his sheep after
the harvest. By taking a position in the futures market, the breeder minimises his risk
from price fluctuations.
(iv) The audit of derivative instruments
C
 For many entities the use of derivatives has reduced exposure to changes in H
exchange rates, interest rates and commodity prices and other risks. A
P
 The inherent characteristics of derivatives usually result in increased financial risk in T
turn increasing audit risk and presenting the auditor with new challenges. E
R
 To audit derivatives adequately, the auditor needs to:
– have specialist skills and knowledge. In the case of Anew the auditor will need
to understand the operating characteristics and risk profile of the industry in 17
which Anew operates, the characteristics of the specific derivative used, Anew's
derivatives information system, how Anew values derivatives and reporting
requirements of IAS 39 (IFRS 9) and IFRS 7;
– know the business including industrial sector issues, political, economic,
sociocultural and technological factors, the strengths and weaknesses of Anew
(eg, experience of management and those charged with governance), and the
reasons for using specific derivatives (in this case both speculative and risk
management);
– identify the key risks (as already identified in part (a));
– assess the risk and the internal controls in accordance with ISA (UK) 315
(Revised June 2016) Identifying and Assessing the Risks of Material Misstatement
through Understanding of the Entity and Its Environment;
– identify internal controls (as done in part (b)) and test those controls identified
to check if they are 'fit for purpose';
– carry out substantive procedures to ensure that key assertions, as identified in
ISA 315, are met. These key assertions relate to existence and occurrence,
rights and obligations, completeness, accuracy, valuation and allocation, and
presentation. These would have to be considered for all material derivatives;
and
– handle non-standard derivatives according to the circumstances ensuring that
control and substantive tests have been carried out as appropriate.
I trust that the above points have provided you with the information you require. Please do
not hesitate to seek further clarification on any of these points.

7 Terent Property plc
Points raised by MM
Reporting
An enhanced interest convertible has a dual nominal rate, with the higher rate payable in the latter
part of the term.
The advantage to TP is that it delays the larger cash interest payments to match, presumably, the
cash inflows it will have from its long-term projects (given that a seven-year horizon is envisaged).
Compound instruments have both a liability and an equity element. In that case, IAS 32 Financial
Instruments: Presentation requires that the component parts be split, with each part accounted for
and presented separately according to its substance. A convertible bond is an example that has a
debt element and the value that might be ascribed to the right to purchase future equity. The right
has value otherwise it would not be packaged into a convertible bond and issued to investors.
IAS 32 requires both liability and equity elements to be disclosed, and suggests some measurement
methods, although it should be realised that these are likely to be approximations.
An example of one measurement method is that the issuer of a bond convertible into ordinary shares,
for example, first determines the carrying amount of the liability component by measuring the fair
value of a similar liability that does not have an associated conversion element. The carrying amount
of the equity option to convert into ordinary shares is then determined by deducting the fair value of
the financial liability from the fair value of the compound financial instrument as a whole.
The financial liability element has a stepped or enhanced interest feature. As such, the payments
required by the debt should be apportioned between a finance charge at a constant rate on the
outstanding obligation, and a reduction of the carrying amount. The effect of this accounting on a
stepped interest loan is that an overall effective interest cost will be charged in each accounting
period; an accrual will be made in addition to the cash payments in earlier periods and will reverse
in later periods.
The requirement is that the financing costs are allocated over the term of the loan at a constant
average rate.
For the loan proposal in question, the following would appear in the financial statements over the
term of the loan.
The implicit interest rate before tax is that which solves the following.
10m
11m  0.288m  (0.49m  AF2@k )  (1.51m  AF3-7 @k ) 
d d (1  k d )7
Try 10% as it is between the two nominal rates

3.791
= (0.49m  1.736)  (1.51m  )  5.132m
1.12
= 0.851m + 4.729m + 5.132m
= 10.712m
Thus 10% is the correct rate.
(Note: If rates other than 10% had been used, then trial and error/linear interpolation might have
been necessary.)
Finance cost Closing
Year Bal b/d (10%) Cash paid balance
£'000 £'000 £'000 £'000
1 10,712 1,071 (490) 11,293
2 11,293 1,129 (490) 11,932
3 11,932 1,193 (1,510) 11,615
4 11,615 1,162 (1,510) 11,267
5 11,267 1,127 (1,510) 10,884
6 10,884 1,088 (1,510) 10,462
7 10,462 1,046 (1,510) 9,998
(rounding error of £2,000)

The effect given in the financial statements is that of smoothing the costs relating to the debt, with
costs greater than interest actually paid in early years and lower in later years.
The above calculations assume that there is no value attributable to equity conversion rights. The
split accounting treatment in IAS 32 should really use the interest rate on similar bonds without
conversion rights, rather than the 10% rate above, to determine the value of the liability. A
constant rate would apply to all seven years.
Investment criteria
Assuming that the debt is held to redemption, then the cost of debt (yield to redemption) after tax
is found by trial and error. As an initial guess, the cost of debt is likely to be between 15.1% and
4.9% and less than the 10% calculated above because of the tax relief on interest, say 8%.
By trial and error therefore:
C
10m H
10.712m  (1  0.23)(0.49m  AF2@k )  (1  0.23)(1.51m  AF3-7 @k )  A
d d (1  k d )7 P
T
Try 8%: E
R
3.993
RHS = (0.77  0.49m  1.783) + (0.77  1.51m  ) + 5.835m
1.082
= 0.673m + 3.980m + 5.835m 17
= 10.488m
Discounted too much, therefore decrease rate.
Try 7%:
4.1
RHS = (0.77  0.49m  1.808) + (0.77  1.51m  ) + 6.227m
1.072
= 0.682m + 4.164m + 6.227m
= 11.073m
The actual value of 10.712 million is approximately 40% between the two values and thus the
after-tax cost of debt is approximately 7.6%, ie, substituting kd = 7.6% confirms that this is the IRR
or cost of debt after tax.
The impact on WACC, the cost of capital for the company, can then be determined.
The current (growth-adjusted) cost of equity of the company can be found by inverting the P/E
ratio. Thus:
1
= 12.5%
8
The current pre-tax cost of debt is taken as the SOFP value at 11%. Therefore the current WACC is
as follows.
Current MV of equity = £12.48  10m
= £124.8m
Current value of debt plus equity = £(124.8 + 8.2)m
= £133m
12.5%  124.8 (1  0.23)  11%  8.2
WACC = 
133 133
= 12.25%

Since the cost of debt of the convertibles is lower, WACC will fall to
12.25%  133  7.6%  10.712
Revised WACC =
133  10.712
= 11.90%
which is below the company's current cost of capital.
However, it is important to appreciate that we have not taken into account any increases in the
cost of equity that might arise as a result of increased financial risk. This is likely to increase, but will
be marginal given that the company's overall gearing is low.
Without details of cash flow increases from the project we cannot determine by how much the cost
of equity might increase.
Assurance issues
Given that the company had difficulty in raising a rights issue last year, there may be some doubt
that the company can raise debt.
In any case, if the company wishes to finance projects that add to the company's risk profile, it
should be prepared to accept more relaxed financing criteria than it currently adopts.
We need to assess the additional burden on profitability that the new debt issue will impose. As
mentioned, during the course of our audit, it would be worthwhile seeing the projections relating
to the net cash inflows arising from the proposed developments.
It will be important to assess interest cover relating to the overall debt charges to ensure that the
company is not overexposing itself.
There will be a large redemption in seven years and we should make sure that the company
establishes a sinking fund for this. This will be an additional drain on cash resources.
We will need to verify if there are any covenants on the existing debt. The company may well be in
breach of these should it undertake to develop and finance it in the way proposed.
Once the property development begins we will have to take professional advice on year by year
valuations of the assets.
We will need to review the status of the debt issue for redemptions. Any redemptions will alter
subsequent interest calculations. This will depend on the details of redemption dates in the debt
contract and the likely value of the future share price of the company, which is unknowable at this
time.
It will be important to determine the nature of the cash flows arising from the new development
since there is a substantial increase in interest costs relating to the new debt after the second year.
Presumably the structuring of the debt agreement in this way matches the projected income flows
from the future developments. We should review this to ensure that the company has the
appropriate cash capacity to deal with these levels of outflows.
I have assumed a tax rate of 23%, although this may change in the future and the conclusions of
this report may alter accordingly. As part of our audit it may well be worthwhile conducting some
sensitivity analysis of the cash projects from the new developments to obtain some idea of the
degree of risk to which the company is exposed.
Fair value
The assurance relating to fair value is dealt with in ISA (UK) 540 (Revised June 2016) Auditing
Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures, and the
auditors will almost certainly seek to conduct their audit in relation to this standard. In particular,
they will obtain audit evidence that fair value measurements and disclosures are in accordance with
the entity's applicable financial reporting framework including IFRS 13. This will involve gaining an
understanding of the entity's process for determining fair value measurements and disclosures and
of the relevant control activities.

In understanding the processes used to measure fair value the auditor might look to obtain
assurance on the following:
 Relevant control activities over the process used to measure fair value
 The expertise and experience of those persons determining the fair value measurements
 The precise role that information technology has in the process
 The types of accounts or transactions requiring fair value measurements or disclosures (for
example, whether the accounts arise from the recording of routine and recurring transactions
or whether they arise from non-routine or unusual transactions)
 The extent to which the entity's process relies on a service organisation to provide fair value
measurements or the data that supports the measurement. When an entity uses a service
organisation, the auditor complies with the requirements of ISA (UK) 402 Audit Considerations C
H
Relating to an Entity Using a Service Organisation A
P
 The extent to which the entity uses the work of experts in determining fair value
T
measurements and disclosures E
R
 The valuation techniques adopted (ie, Level 1, 2 or 3)
 The valuation approach adopted (income approach, market approach, cost approach)
17
 The significant management assumptions used in determining fair value (particularly if Level 3
unobservable inputs are used)
 The documentation supporting management's assumptions
 The methods used to develop and apply management assumptions and to monitor changes
in those assumptions
 The integrity of change controls and security procedures for valuation models and relevant
information systems, including approval processes
 The controls over the consistency, timeliness and reliability of the data used in valuation
models
After obtaining an understanding of the processes, the auditor is likely to identify and assess the
risks of material misstatement at the assertion level related to the fair value measurements and
disclosures in the financial statements to determine the nature, timing and extent of the further
audit procedures.
Finally, the auditor will check our disclosures against the financial reporting framework, including
the requirements of IFRS 13.

CHAPTER 18
Employee benefits
Introduction
Topic List
1 Objectives and scope of IAS 19 Employee Benefits
2 Short-term employee benefits
3 Post-employment benefits overview
4 Defined contribution plans
5 Defined benefit plans – recognition and measurement
6 Defined benefit plans – other matters
7 Defined benefit plans – disclosure
8 Other long-term employee benefits
9 Termination benefits
10 IAS 26 Accounting and Reporting by Retirement Benefit Plans
11 Audit focus
Technical reference
897
Introduction
 Explain how different methods of providing remuneration for employees may impact
upon reported performance and position
 Explain and appraise accounting standards that relate to employee remuneration which
include different forms of short-term and long-term employee compensation; retirement
benefits; and share-based payment
of details
Specific syllabus references for this chapter are: 5(a), 5(b), 14(c), 14(d), 14(f)

1 Objectives and scope of IAS 19 Employee Benefits
Section overview
IAS 19 considers the following employee benefits:
 Short-term employee benefits
 Post-employment benefits
 Other long-term employee benefits
 Termination benefits
IAS 19 Employee Benefits should be applied by all entities in accounting for the provision of all employee
benefits, except those benefits which are equity based and to which IFRS 2 Share-based Payment applies.
The standard applies regardless of whether the benefits have been provided as part of a formal contract
or an informal arrangement.
Employee benefits are all forms of consideration, for example cash bonuses, retirement benefits and
private health care, given to an employee by an entity in exchange for the employee's services.
A number of accounting issues arise due to:
 the valuation problems linked to some forms of employee benefits; and
 the timing of benefits, which may not always be provided in the same period as the one in which
the employee's services are provided.
IAS 19 is structured by considering the following employee benefits: C
H
 Short-term employee benefits; such as wages, salaries, bonuses and paid holidays A
 Post-employment benefits; such as pensions and post-retirement health cover P
T
 Other long-term employee benefits; such as sabbatical and long-service leave
E
 Termination benefits; such as redundancy and severance pay R
IAS 19 was extensively revised in 2011.
18
2 Short-term employee benefits
Section overview
Short-term employee benefits are those that fall due within 12 months from the end of the period in
which the employees provide their services. The required accounting treatment is to recognise the
benefits to be paid in exchange for the employee's services in the period on an accruals basis.
2.1 All short-term benefits
Definition
Short-term employee benefits: Short-term employee benefits are employee benefits (other than
termination benefits) that fall due within twelve months from the end of the period in which the
employees provide their services.
Short-term employee benefits include the following:

(a) Wages, salaries and social security contributions
(b) Short-term absences where the employee continues to be paid, for example paid annual vacation,
paid sick leave and paid maternity/paternity leave. To fall within the definition, the absences should
be expected to occur within 12 months of the end of the period in which the employee services
were provided
Employee benefits 899

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

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

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

An entity has a contractual agreement to pay a total of 4% of its net profit each year as a bonus. The
bonus is divided between the employees who are with the entity at its year end. The following data is
relevant:
Net profit £120,000
Average employees 5
Employees at start of year 6
Employees at end of year 4
Requirement
How should the expense be recognised?
Solution
C
An expense should be recognised for the year in which the profits were made and therefore the H
employees' services were provided, for: A
P
£120,000 × 4% = £4,800 T
E
Each of the four employees remaining with the entity at the year end is entitled to £1,200. A liability of R
£4,800 should be recognised if the bonuses remain unpaid at the year end.
18
Conditions may be attached to such bonus payments; commonly, the employee must still be in the
entity's employment when the bonus becomes payable. An estimate should be made based on the
expectation of the level of bonuses that will ultimately be paid. IAS 19 sets out that a reliable estimate
for bonus or profit-sharing arrangements can be made only when:
 there are formal terms setting out determination of the amount of the benefit;
 the amount payable is determined by the entity before the financial statements are authorised for
issue; or
 past practice provides clear evidence of the amount of a constructive obligation.
Worked example: Annual bonus

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

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

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

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

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

H
These are defined by IAS 19 as all plans other than defined contribution plans. A
P
Characteristics of a defined benefit plan are as follows: T
E
 The amount of pension paid to retirees is defined by reference to factors such as length of service R
and salary levels (ie, it is guaranteed).
 Contributions into the plan are therefore variable depending on how the plan is performing in
relation to the expected future obligation (ie, if there is a shortfall, contributions will increase and 18
vice versa).
Variables – returns on investments, mortality rates, etc
Time
(therefore) defined
variable benefits
contributions
Contribution levels
The actuary advises the company on contributions necessary to produce the defined benefits ('the
funding plan'). It cannot be certain in advance that contributions plus returns on investments will equal
benefits to be paid.
Formal actuarial valuations will be performed periodically (eg, every three years) to reveal any surplus or
deficit on the scheme at a given date. Contributions may be varied as a result; for example, the actuary
may recommend a contribution holiday (a period during which no contributions are made) to eliminate
a surplus.
Risk associated with defined benefit schemes
As the employer is obliged to make up any shortfall in the plan, it is effectively underwriting the
investment and actuarial risk associated with the plan. Thus in a defined benefit plan, the employer
carries both the investment and the actuarial risk.

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

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

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

Scenario 1 – Entity ABC has a separately constituted retirement benefit plan for its employees which sets
out that both ABC and its employees contribute 7% of annual salaries into the plan; contributions in
respect of an individual employee create a right to a specified proportion of the plan assets, which on
retirement is then used to buy the employee an annuity.
This is a defined contribution plan, because there appears to be no obligation on the part of ABC, other
than to pay its annual 7% contribution.
Scenario 2 – Entity DEF has a separately constituted retirement benefit plan for its employees; the plan
is the same as the ABC plan, set out above, except that DEF has a contractual obligation to top up the
plan assets if the return (calculated according to the rules) on these assets in any year is below 5%.

This is a defined benefit plan, because DEF has provided a guarantee over and above its obligation to
make contributions.
Scenario 3 – Entity GHI has a separately constituted retirement benefit plan for its employees; the plan
is the same as the ABC plan, set out above. For some years GHI has made additional payments directly
to retired ex-employees if the increase in the general price index exceeds 7% in any year. Such
payments are at the discretion of GHI.
This is a defined benefit plan, because over and above its obligation to make contributions GHI has a
past practice of increasing benefits in payment over and above the level due from the plan. This creates
a constructive obligation that the entity will continue to do so.
4 Defined contribution plans
Section overview
Accounting for defined contribution plans is straightforward, as the obligation is determined by the
amount paid into the plan in each period.
4.1 Recognition and measurement

Contributions into a defined contribution plan by an employer are made in return for services provided
C
by an employee during the period. The employer has no further obligation for the value of the assets of H
the plan or the benefits payable. A
P
 The entity should recognise contributions payable as an expense in the period in which the T
employee provides services (except to the extent that labour costs may be included within the cost E
of assets). R
 A liability should be recognised where contributions arise in relation to an employee's service, but
remain unpaid at the period end. 18
In the unusual situation where contributions are not payable during the period (or within 12 months of
the end of the period) in which the employee provides his or her services on which they accrue, the
amount recognised should be discounted to reflect the time value of money.
 Any excess contributions paid should be recognised as an asset (prepaid expenses) but only to the
extent that the prepayment will lead to a reduction in future payments or a cash refund.
Worked example: Defined contribution plan

Mouse Co agrees to contribute 5% of employees' total remuneration into a post-employment plan each
period.
In the year ended 31 December 20X9, the company paid total salaries of £10.5 million. A bonus of
£3 million based on the income for the period was paid to the employees in March 20Y0.
The company had paid £510,000 into the plan by 31 December 20X9.
Requirement
Calculate the total expense for post-employment benefits for the year and the accrual which will appear
in the statement of financial position at 31 December 20X9.
Solution
£
Salaries 10,500,000
Bonus 3,000,000
13,500,000 × 5% = £675,000

£ £
DEBIT Staff costs expense 675,000
CREDIT Cash 510,000
CREDIT Accruals 165,000
4.2 Disclosure requirements

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

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

IAS 19 instead requires that the defined benefit plan is recognised in the sponsoring entity's statement
of financial position as either a liability or asset depending on whether the plan is in deficit or surplus.
The value of the pension plan is calculated in its simplest form as:
£
Present value of the defined benefit obligation at the reporting date X
Fair value of plan assets at the reporting date (X)
Plan deficit/surplus X/(X)
5.2.1 Present value of the defined benefit obligation
Definition
Defined benefit obligation: The defined benefit obligation is the present value of all expected future
payments required to settle the obligation resulting from employee service in the current and prior
periods.

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

18
Definition
Plan assets: Plan assets are defined as those assets held by a long-term benefit fund and those insurance
policies which are held by an entity, where the fund/entity is legally separate from the employer and
assets/policies can only be used to fund employee benefits.
Investments owned by the employer which have been earmarked for employee benefits but which the
employer could use for different purposes are not plan assets.
Definition
Fair value: Fair value is the price that would be received to sell an asset in an orderly transaction
between market participants at the measurement date. (IFRS 13)
Guidance on fair value is given in IFRS 13 Fair Value Measurement (see Chapter 2, section 4). Under
IFRS 13, fair value is a market-based measurement, not an entity-specific measurement. It focuses on
assets and liabilities and on exit (selling) prices. It also takes into account market conditions at the
measurement date.
IFRS 13 states that valuation techniques must be those which are appropriate and for which sufficient
data are available. Entities should maximise the use of relevant observable inputs and minimise the use
of unobservable inputs.

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

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

There is a four-step method for recognising and measuring the expenses and liability of a defined
benefit pension plan.
An outline of the method used by an employer to account for the expenses and obligation of a defined
benefit plan is given below. The stages will be explained in more detail later.
Step 1 Measure the deficit or surplus:

(a) An actuarial technique (the projected unit credit method) should be used to make
a reliable estimate of the amount of future benefits employees have earned from
service in relation to the current and prior years. The entity must determine how
much benefit should be attributed to service performed by employees in the current
period, and in prior periods. Assumptions include, for example, levels of employee
turnover, mortality rates and future increases in salaries (if these will affect the
eventual size of future benefits such as pension payments).
(b) The benefit should be discounted to arrive at the present value of the defined benefit
obligation and the current service cost.
(c) The fair value of any plan assets should be deducted from the present value of the
defined benefit obligation.

Step 2 The surplus or deficit measured in Step 1 may have to be adjusted if a net benefit asset has
to be restricted by the asset ceiling (see section 6.2).
Step 3 Determine the amounts to be recognised in profit or loss:

(a) Current service cost
(b) Any past service cost and gain or loss on settlement
(c) Net interest on the net defined benefit liability (asset)
Step 4 Determine the remeasurements of the net defined benefit liability (asset), to be recognised
in other comprehensive income (items that will not be reclassified to profit or loss):
(a) Actuarial gains and losses
(b) Return on plan assets (excluding amounts included in net interest on the net defined
benefit liability (asset))
(c) Any change in the effect of the asset ceiling (excluding amounts included in net
interest on the net defined benefit liability (asset))
5.5.1 Retirement benefits paid out

During an accounting year, some of the plan assets will be paid out to retirees, thus discharging part of
the benefit obligation. This is accounted for by:
DEBIT PV of defined benefit obligation X
CREDIT FV of plan assets X
Note that there is no cash entry, as the pension plan itself rather than the sponsoring employer pays the C
money out. H
A
P
5.5.2 Contributions paid into plan T
E
Contributions will be made into the plan as advised by the actuary. This is accounted for by: R
DEBIT FV of plan assets X
CREDIT Cash X
18
5.5.3 Return on plan assets
Definition
The return on plan assets is defined as interest, dividends and other revenue derived from plan assets
together with realised and unrealised gains or losses on the plan assets, less any costs of administering
the plan and less any tax payable by the plan itself.
Accounting for the return on plan assets is explained in more detail below.
5.6 The statement of financial position

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

5.7 Plan assets
Plan assets are:
(a) assets such as stocks and shares, held by a fund that is legally separate from the reporting entity,
which exists solely to pay employee benefits; and
(b) insurance policies, issued by an insurer that is not a related party, the proceeds of which can only
be used to pay employee benefits.
Investments which may be used for purposes other than to pay employee benefits are not plan assets.
The standard requires that the plan assets are measured at fair value, as 'the price that would be
received to sell an asset in an orderly transaction between market participants at the measurement date'.
This is consistent with IFRS 13 Fair Value Measurement (see Chapter 2).
IAS 19 includes the following specific requirements:
(a) The plan assets should exclude any contributions due from the employer but not yet paid.
(b) Plan assets are reduced by any liabilities of the fund that do not relate to employee benefits, such
as trade and other payables.
5.8 The statement of profit or loss and other comprehensive income

All the gains and losses that affect the plan obligation and plan assets must be recognised. The
components of defined benefit cost must be recognised as follows in the statement of profit or loss
and other comprehensive income:
Component Recognised in
(a) Service cost Profit or loss

(b) Net interest on the net defined benefit liability Profit or loss
(c) Remeasurements of the net defined benefit Other comprehensive income (not
liability reclassified to profit or loss)
5.9 Service costs

These comprise the following:
(a) Current service cost; this is the increase in the present value of the defined benefit obligation
resulting from employee services during the period. The measurement and recognition of this cost
was introduced in section 5.5.
(b) Past service cost; this is the change in the obligation relating to service in prior periods. This
results from amendments or curtailments to the pension plan, and
(c) Any gain or loss on settlement.
The detail relating to points (b) and (c) above will be covered in a later section. First, we will continue
with the basic elements of accounting for defined benefit pension costs.
5.10 Net interest on the net defined benefit liability (asset)

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

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

The calculation is as follows:
Net defined Discount

benefit balance × rate
The net defined benefit liability/(asset) should be measured as at the start of the accounting period,
taking account of changes during the period as a result of contributions paid into the scheme and
benefits paid out.
Many exam questions include the assumption that all payments into and out of the scheme take place
at the end of the year, so that the interest calculations can be based on the opening balances.
5.10.2 Discount rate

The discount rate adopted should be determined by reference to market yields on high-quality fixed-
rate corporate bonds. In the absence of a 'deep' market in such bonds, the yields on comparable
government bonds should be used as reference instead. The maturity of the corporate bonds that are
used to determine a discount rate should have a term to maturity that is consistent with the expected
maturity of the post-employment benefit obligations, although a single weighted average discount rate
is sufficient.
Worked example: Interest cost

In 20X8, an employee leaves a company after working there for 24 years. The employee chooses to
leave his accrued benefits in the pension scheme until he retires in seven years' time (he now works for C
another company). H
A
At the time of his departure, the actuary calculates that it is necessary at that date to have a fund of P
T
£296,000 to pay the expected pensions to the ex-employee when he retires.
E
At the start of the year, the yield on high quality corporate debt was 8%, and remained the same R
throughout the year and the following year.
Requirement 18
Calculate the interest cost to be debited to profit or loss in Years 1 and 2.
Solution
£
Year 1: Discounted cost b/f 296,000
Interest cost (profit or loss) (8% × £296,000) 23,680
Obligation c/f (statement of financial position) 319,680
Year 2: Interest cost (profit or loss) (8% × £319,680) 25,574
Obligation c/f (statement of financial position) 345,254
5.11 Remeasurements of the net defined benefit liability

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

5.11.1 Actuarial gains and losses
Actuarial gains and losses arise for several reasons, and IAS 19 requires these to be recognised in full in
At the end of each accounting period, a new valuation, using updated assumptions, should be carried
out on the obligation. Actuarial gains or losses arise because of the following.
 Actual events (eg, employee turnover, salary increases) differ from the actuarial assumptions that
were made to estimate the defined benefit obligations
 The effect of changes to assumptions concerning benefit payment options
 Estimates are revised (eg, different assumptions are made about future employee turnover,
salary rises, mortality rates, and so on)
 The effect of changes to the discount rate
Actuarial gains and losses are recognised in other comprehensive income. They are not reclassified to
profit or loss under the 2011 revision to IAS 1 (see Chapter 9).
5.11.2 Return on plan assets

The return on plan assets must be calculated.
A new valuation of the plan assets is carried out at each period end, using current fair values. Any
difference between the new value, and what has been recognised up to that date (normally the opening
balance, interest, and any cash payments into or out of the plan) is treated as a 'remeasurement' and
Note: In the examples in this chapter, it is assumed that cash from contributions is received and
pensions paid out at the end of the year, as no interest arises on it. In practice, it is more likely that
contributions would be paid in part way through the year, and pensions paid out part way through the
year or evenly over the year.
Worked example: Remeasurement of the net defined benefit liability

At 1 January 20X2 the fair value of the assets of a defined benefit plan was £1,100,000 and the present
value of the defined benefit obligation was £1,250,000. On 31 December 20X2, the plan received
contributions from the employer of £490,000 and paid out benefits of £190,000.
The current service cost for the year was £360,000 and a discount rate of 6% is to be applied to the net
liability/(asset).
After these transactions, the fair value of the plan's assets at 31 December 20X2 was £1.5 million. The
present value of the defined benefit obligation was £1,553,600.
Requirement
Calculate the gains or losses on remeasurement through other comprehensive income (OCI) and the
return on plan assets and illustrate how this pension plan will be treated in the statement of profit or loss
and other comprehensive income and statement of financial position for the year ended 31 December
20X2.
Solution
It is always useful to set up a working reconciling the assets and obligation:
Assets Obligation
£ £
Fair value/present value at 1.1.X2 1,100,000 1,250,000
Interest (1,100,000 × 6%)/(1,250,000 × 6%) 66,000 75,000
Current service cost 360,000
Contributions received 490,000
Benefits paid (190,000) (190,000)
Return on plan assets excluding amounts in net interest (balancing 34,000 –
figure) (OCI)
Loss on remeasurement (balancing figure) (OCI) – 58,600
1,500,000 1,553,600

The following accounting treatment is required.
(a) In the statement of profit or loss and other comprehensive income, the following amounts will
be recognised.
In profit or loss:
£
Net interest on net defined benefit liability (75,000 – 66,000) 9,000
In other comprehensive income (34,000 – 58,600) 24,600

(b) In the statement of financial position, the net defined benefit liability of £53,600 (1,553,600 –
1,500,000) will be recognised.
5.12 Section summary

The recognition and measurement of defined benefit plan costs are complex issues.
 Learn and understand the definitions of the various elements of a defined benefit pension plan
 Learn the outline of the method of accounting (see paragraph 5.5)
 Learn the recognition method for the:
– statement of financial position
– statement of profit or loss and other comprehensive income
C
H
A
6 Defined benefit plans – other matters P
T
E
Section overview R
We have now covered the basics of accounting for defined benefit plans. This section looks at the
special circumstances of: 18
 past service costs

 curtailments
 settlements
 asset ceiling test
6.1 Past service cost and gains and losses on settlement

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

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

6.1.2 Gains and losses on settlement
A settlement occurs when an employer enters into a transaction to eliminate part or all of its post-
employment benefit obligations (other than a payment of benefits to or on behalf of employees under
the terms of the plan and included in the actuarial assumptions).
A curtailment and settlement might happen together, for example when an employer brings a defined
benefit plan to an end by settling the obligation with a one-off lump-sum payment and then scrapping
the plan.
The gain or loss on a settlement is the difference between:
(a) the present value of the defined benefit obligation being settled, as valued on the date of the
settlement; and
(b) the settlement price, including any plan assets transferred and any payments made by the entity
directly in connection with the settlement.
6.1.3 Accounting for past service cost and gains and losses on settlement
An entity should remeasure the obligation (and the related plan assets, if any) using current actuarial
assumptions, before determining past service cost or a gain or loss on settlement.
The rules for recognition for these items are as follows.
Past service costs are recognised at the earlier of the following dates:
(a) When the plan amendment or curtailment occurs
(b) When the entity recognises related restructuring costs (in accordance with IAS 37, see Chapter 13)
or termination benefits
All gains and losses arising from past service costs or settlements must be recognised immediately in
profit or loss.
6.2 Asset ceiling test

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

A net defined benefit asset may arise if the plan has been overfunded or if actuarial gains have arisen.
This meets the definition of an asset (as stated in the Conceptual Framework) because all the following
apply.
(a) The entity controls a resource (the ability to use the surplus to generate future benefits).
(b) That control is the result of past events (contributions paid by the entity and service rendered by
the employee).
(c) Future benefits are available to the entity in the form of a reduction in future contributions or a
cash refund, either directly or indirectly to another plan in deficit.
The asset ceiling is the present value of those future benefits. The discount rate used is the same as
that used to calculate the net interest on the net defined benefit liability/(asset). The net defined benefit
asset would be reduced to the asset ceiling threshold. Any related write-down would be treated as a
remeasurement and recognised in other comprehensive income.
If the asset ceiling adjustment was needed in a subsequent year, the changes in its value would be
treated as follows:
(a) Interest (as it is a discounted amount) recognised in profit or loss as part of the net interest
amount
(b) Other changes recognised in profit or loss

6.4 Other issues
6.4.1 Multiple plans and offsetting
Where a sponsoring employer runs more than one defined benefit scheme, each must be accounted for
separately and a plan deficit in one cannot be set off against a plan surplus in another unless there is a
legal right of offset and the entity intends to settle on a net basis.
6.4.2 Projected unit credit method

The projected unit credit method is the method required by IAS 19 to be used in determining the
present value of the defined benefit obligation and current service cost.
This method sees each period of service giving rise to an additional unit of benefit entitlement (ie, for
each extra year worked by an employee, their pension increases).
Each of these units is measured separately and the total of all units to date (both current year and
previous years) is the final obligation under the plan.
The total of the current year units is the current service cost.
Attribution of benefit to period of service
In order to apply the projected unit credit method, a unit, or amount of future benefit, must be
attributed to each period of service.
Worked example: Projected unit credit method 1

C
A defined benefit plan provides a lump-sum benefit of £100 per year of service payable on retirement. H
A
Requirement P
How is this benefit attributed to periods of service and how is the resulting current service cost and T
E
defined benefit obligation calculated? R
Solution
A benefit of £100 is attributed to each year. 18
The current service cost = the present value of £100.

The present value of the defined benefit obligation = the present value of £100 × number of years of
service to reporting date.
Worked example: Projected unit credit method 2

A company operates a defined benefit scheme that pays a lump-sum benefit equal to £500 for each year
of service.
An employee joins the company at the beginning of Year 1 and is due to retire after five years of service.
For the sake of simplicity ignore the possibility of the employee leaving the company before the
expected date.
The discount rate is 10%.
Requirement
Calculate the current service cost to be debited to profit or loss in Years 1 to 5, and the present value of
the defined benefit obligation in each of these years.

Solution
Year 1 2 3 4 5
£ £ £ £ £
Current year benefit 500 500 500 500 500
500 500 500 500
Current service cost
(1.1) 4 (1.1)3 (1.1)2 1.1 0
= 342 = 376 = 413 = 455 500
PV of defined benefit obligation 342 376 × 2 413 × 3 455 × 4 500 × 5
= 752 = 1,239 = 1,820 = 2,500
Note:
Previously we have said that the present value of the obligation moves from year to year due to:
 payments out to retirees
 the unwinding of one year's discount
 the current service cost
This can be applied to Year 2 as follows:
£
PV of defined benefit obligation b/f 342
Unwinding of discount (342  10%) 34
Current service cost 376
PV of defined benefit obligation c/f 752
6.5 Suggested approach

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

1 Record opening figures:
 Asset
 Obligation
2 Interest cost on obligation DEBIT Interest cost (P/L)
 Based on discount rate and PV (x%  b/d obligation)
obligation at start of period. CREDIT PV defined benefit obligation (SOFP)
 Should also reflect any changes in
obligation during period.
3 Interest on plan assets DEBIT Plan assets (SOFP)
 Based on discount rate and asset CREDIT Interest cost (P/L)
value at start of period. (x%  b/d assets)
 Technically, this interest is also time
apportioned on contributions less
benefits paid in the period.
4 Current service cost
 Increase in the present value of the DEBIT Current service cost (P/L)
obligation resulting from employee CREDIT PV defined benefit obligation (SOFP)
service in the current period.
5 Contributions DEBIT Plan assets (SOFP)
 As advised by actuary. CREDIT Company cash

Step Item Recognition
6 Benefits DEBIT PV defined benefit obligation (SOFP)
 Actual pension payments made. CREDIT Plan assets (SOFP)
7 Past service cost Positive (increase in obligation):
 Increase/decrease in PV obligation as DEBIT Past service cost (P/L)
a result of introduction or CREDIT PV defined benefit obligation (SOFP)
improvement of benefits.
Negative (decrease in obligation):
DEBIT PV defined benefit obligation (SOFP)
CREDIT Past service cost (P/L)
8 Gains and losses on settlement Gain
 Difference between the value of the DEBIT PV defined benefit obligation (SOFP)
obligation being settled and the CREDIT Service cost (P/L)
settlement price.
Loss
DEBIT Service cost (P/L)
CREDIT PV defined benefit obligation (SOFP)
9 Remeasurements: actuarial gains and Gain
losses DEBIT PV defined benefit obligation (SOFP)
 Arising from annual valuations of CREDIT Other comprehensive income
obligation.
Loss C
 On obligation, differences between H
actuarial assumptions and actual DEBIT Other comprehensive income A
experience during the period, or CREDIT PV defined benefit obligation (SOFP) P
changes in actuarial assumptions. T
E
10 Remeasurements: return on assets Gain R
(excluding amounts in net interest) DEBIT FV plan assets (SOFP)
 Arising from annual valuations of CREDIT Other comprehensive income
plan assets 18
Loss
DEBIT Other comprehensive income
CREDIT FV plan assets (SOFP)
11 Disclose in accordance with the See section 7.
standard
Interactive question 1: Defined benefit plan 1

For the sake of simplicity and clarity, all transactions are assumed to occur at the year end.
The following data applies to the post-employment defined benefit compensation scheme of BCD Co.
Discount rate: 10% (each year)
Present value of obligation at start of 20X2: £1m
Market value of plan assets at start of 20X2: £1m
The following figures are relevant.
20X2 20X3 20X4
£'000 £'000 £'000
Current service cost 140 150 150
Benefits paid out 120 140 150
Contributions paid by entity 110 120 120
Present value of obligation at year end 1,200 1,650 1,700
Fair value of plan assets at year end 1,250 1,450 1,610

Additional information:
(1) At the end of 20X3, a division of the company was sold. As a result of this, a number of the
employees of that division opted to transfer their accumulated pension entitlement to their new
employer's plan. Assets with a fair value of £48,000 were transferred to the other company's plan
and the actuary has calculated that the reduction in BCD's defined benefit liability is £50,000. The
year-end valuations in the table above were carried out before this transfer was recorded.
(2) At the end of 20X4, a decision was taken to make a one-off additional payment to former
employees currently receiving pensions from the plan. This was announced to the former
employees before the year end. This payment was not allowed for in the original terms of the
scheme. The actuarial valuation of the obligation in the table above includes the additional liability
of £40,000 relating to this additional payment.
Requirement
Show how the reporting entity should account for this defined benefit plan in each of years 20X2, 20X3
and 20X4.

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

The defined benefit pension plan of Leadworth plc was formed on 1 January 20X3. The following details
relate to the scheme at 31 December 20X3.
£m
Present value of obligation 208
Fair value of plan assets 200
Current service cost for the year 176
Contributions paid 160
Interest cost on obligation for the year 32
Interest on plan assets for the year 16

The directors are aware that IAS 19 has been revised but are unsure how to treat any gain or loss on
remeasurement of the plan asset or liability.
Requirement
Show how the defined benefit pension plan should be dealt with in the financial statements for the year

Baseline plc has a defined benefit pension scheme and wishes to recognise the full deficit in its
statement of financial position.
Requirement
Using the information below, prepare extracts from the statement of financial position and the
statement of comprehensive income, together with a reconciliation of scheme movements for the year
ended 31 January 20X8. Ignore taxation.
(a) The opening scheme assets were £3.6 million on 1 February 20X7 and scheme liabilities at this
date were £4.3 million.
(b) Company contributions to the scheme during the year amounted to £550,000.
(c) Pensions paid to former employees amounted to £330,000 in the year. C
H
(d) The yield on high-quality corporate bonds was 8% and the actual return on plan assets was A
£295,000. P
T
(e) During the year, five staff were made redundant, and an extra £58,000 in total was added to the E
R
value of their pensions.
(f) Current service costs as provided by the actuary are £275,000.
(g) The actuary valued the plan liabilities at 31 January 20X8 as £4.54 million. 18
7 Defined benefit plans – disclosure
Section overview
The disclosure requirements for defined benefit plans are extensive and detailed in order to enable
users to understand the plan and the nature and extent of the entity's commitment.
Detailed disclosure requirements are set out in IAS 19 in relation to defined benefit plans, to provide
users of the financial statements with information that enables an evaluation of the nature of the plan
and the financial effect of any changes in the plan during the period.
Amended requirements for disclosures include a description of the plan, a reconciliation of the fair value
of plan assets from the opening to closing position, the actual return on plan assets, a reconciliation of
movements in the present value of the defined benefit obligation during the period, an analysis of the
total expense recognised in profit or loss, and the principal actuarial assumptions made.
Additional disclosures set out in the amendment to IAS 19 include:
 an analysis of the defined benefit obligation between amounts relating to unfunded and funded plans;
 a reconciliation of the present value of the defined benefit obligation between the opening and
closing statement of financial position, separately identifying each component in the reconciliation;

 a reconciliation of the present value of the defined benefit obligation and the fair value of the plan
assets to the pension asset or liability recognised in the statement of financial position;
 a breakdown of plan assets for the entity's own financial instruments, for example an equity interest
in the employing entity held by the pension plan and any property occupied by the entity or other
assets used by the entity;
 for each major category of plan assets the percentage or amount that it represents of the total fair
value of plan assets;
 the effect of a one percentage point increase or decrease in the assumed medical cost trend rate on
amounts recognised during the period, such as service cost and the pension obligation relating to
medical costs;
 amounts for the current annual period and the previous four annual periods of the present value of
the defined benefit obligation, fair value of plan assets and the resulting pension surplus or deficit,
and experience adjustments on the plan liabilities and assets in percentage or value terms; and
 an estimate of the level of future contributions to be made in the following reporting period.
8 Other long-term employee benefits
Section overview
The accounting treatment for other long-term employee benefits is a simplified version of that adopted
for defined benefit plans.
Definition
Other long-term employee benefits: Employee benefits (other than post-retirement benefit plans and
termination benefits) which do not fall due wholly within 12 months after the end of the period in
which the employees render the service.
Examples of other long-term employee benefits include long-term disability benefits and paid
sabbatical leave.
Although such long-term benefits have many of the attributes of a defined benefit pension plan, they
are not subject to the same level of uncertainty. Furthermore, the introduction of such benefits or
changes to these benefits rarely causes a material amount of past service cost. As a consequence, the
accounting treatment adopted is a simplified version of that for a defined benefit plan. The only
difference is that all actuarial gains and losses are recognised immediately in profit or loss.
9 Termination benefits
Section overview
Termination benefits are recognised as an expense when the entity is committed to either:
 terminating the employment before normal retirement date; or
 providing termination benefits in order to encourage voluntary redundancy.
Definition
Termination benefits: Employee benefits payable on the termination of employment, through
voluntary redundancy or as a result of a decision made by the employer to terminate employment
before the normal retirement date.

Where voluntary redundancy has been offered, the entity should measure the benefits based on an
expected level of take-up. If, however, there is uncertainty about the number of employees who will
accept the offer, then there may be a contingent liability, requiring disclosure under IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
An entity should recognise a termination benefit when it has made a firm commitment to end the
employment. Such a commitment will exist where, for example, the entity has a detailed formal plan for
the termination and it cannot realistically withdraw from that commitment.
Where termination benefits fall due more than 12 months after the reporting date they should be
discounted.
Worked example: Termination benefits

The directors of an entity met on 23 July 20X3 to discuss the need to decrease costs by reducing the
number of employees. On 17 August 20X3 they met again to agree a plan. On 6 September 20X3 other
members of the management team were informed of the plan. On 7 October 20X3 the plan was
announced to the employees affected and implementation of the formalised plan began.
Requirement
When should the entity recognise the liability?
Solution
The entity should only recognise the liability for the termination benefits when it is demonstrably
committed to terminating the employment of those affected. This occurred on 7 October 20X3 when C
the formal plan was announced and it is at this date that there is no realistic chance of withdrawal. H
A
P
T
10 IAS 26 Accounting and Reporting by Retirement Benefit Plans E
R
Section overview
18
IAS 26 applies to the preparation of financial reports by retirement benefit plans which are either set up
as separate entities and run by trustees or held within the employing entity.
10.1 Objectives, scope and definitions of IAS 26

The objective of IAS 26 is to provide useful and consistently produced information on retirement benefit
plans for members of the plans and other interested parties.
IAS 26 should be applied in the preparation of financial reports by retirement benefit plans.
Although it is commonplace for a retirement benefit plan to be set up as a separate legal entity run by
independent trustees, plan assets may be held within the entity employing the plan's members. IAS 26
applies in both sets of circumstances. In the latter case IAS 26 still regards the retirement benefit plan as
a reporting entity separate from the employing entity.
The preparation of a retirement benefit plan's financial report should be in accordance with not only
IAS 26 but also all other international standards to the extent that they are not overridden by IAS 26.
IAS 26 does not cover:
 the preparation of reports to individual participants about their retirement benefit rights; or
 the determination of the cost of retirement benefits in the financial statements of the employer
having pension plans for its employees and providing other employee benefits.

Definition
Retirement benefit plans: Arrangements whereby an entity provides benefits for its employees on or
after termination of service (either in the form of an annual income or as a lump sum), when such
benefits, or the employer's contributions towards them, can be determined or estimated in advance of
retirement from the provisions of a document or from the entity's practices.
There are two main types of retirement benefit plan, both discussed in section 3 of this chapter.
1 Defined contribution plans (sometimes called 'money purchase schemes'). These are retirement
plans under which payments into the plan are fixed. Subsequent payments out of the plan to
retired members will therefore be determined by the value of the investments made from the
contributions that have been made into the plan and the investment returns reinvested.
2 Defined benefit plans (sometimes called 'final salary schemes'). These are retirement plans under
which the amount that a retired member will receive from the plan during retirement is fixed.
Contributions are paid into the scheme based on an estimate of what will have to be paid out
under the plan.
Interactive question 5: Scope

To which of the following does IAS 26 Accounting and Reporting by Retirement Benefit Plans apply?
(a) The general purpose financial reports of pension schemes
(b) The cost to companies of employee retirement benefits
(c) The financial statements relating to an actuarial business
(d) Reports to individuals of their future retirement benefits
10.2 Key concepts

'Funding' represents the employer's contributions paid to the fund in order to meet the future
obligations under the plan for the payment of retirement benefits.
'Participants' are those employees who will benefit under the plan (ie, employees and retired
employees).
The 'net assets available for benefits' are the assets less liabilities of the plan that are available to
generate future investment income that will increase the plan's assets. These net assets are calculated
before the deduction of the actuarial assessment of promised retirement benefits.
10.3 Defined contribution plans

A defined contribution plan is where the annual pension payable to retired employees (ie, participants)
is based on the accumulated value of the assets in the employee's fund.
The assets in the pension plan are funded by contributions made into the plan and investment returns
on those assets. Contributions may be made by the employer, the employee or both parties.
Financial report for a defined contribution plan
A financial report prepared for a defined contribution plan should contain:
(a) a statement of the net assets in the plan that are available to meet the benefits payable under the
plan; and
(b) a description of the funding policy of the plan.
The objective of the plan's financial report is to provide information about the plan itself, for example
that it is being run with the members' best interest in mind, and to set out the performance of the
investments in the plan. The performance of the investments will directly affect the retirement benefits

that are paid out under the plan and hence such information will be of particular interest to the
participants of the plan.
A defined contribution plan report will typically include the following:
 A description of the significant activities for the reporting period, along with details of any changes
that have been made to the plan and the effect of these changes on the plan
 A description of the plan's membership, terms and conditions
 Financial statements containing information on the transactions and investment performance for
the period as well as presenting the financial position of the plan at the end of the period
 A description of the investment policies
10.4 Defined benefit plans

Under defined benefit plans the annual pensions payable to retired employees (ie, the participants)
are based on a formula, for example using the number of years' service and the employee's final
salary.
The amount of payments ultimately to be paid out of the fund is uncertain, as they depend on such
factors as life expectancy and future salary levels. The expertise of an actuary is used to estimate these
uncertain future events to ensure that, based on the assets in the plan and the expected future
contributions to be made, the pension scheme is adequately funded to meet its future obligations. The
future obligations are measured as the actuarial present value of promised retirement benefits, which is
more precisely defined as being the present value of the expected payments by a retirement benefit
C
plan to existing and past employees, attributable to the service already rendered. H
A related concept is 'vested benefits' which are benefits payable regardless of whether the participants in A
P
the plan continue in the entity's employment. T
E
If the estimated expected obligations payable under a plan exceed the assets (ie, there is a deficit), then
R
the employer may have to make additional contributions to ensure the retirement plan is adequately
funded. If assets exceed obligations (ie, there is a surplus), then the employer may be able to reduce its
future contributions payable.
18
Financial report for a defined benefit plan
A defined benefit plan report should contain a statement showing the net assets that are available for
the payment of benefits, the actuarial present value of promised retirement benefits, identifying which
of these benefits are vested and which are not, and the resulting surplus or deficit in the plan. This
information may alternatively be presented by providing a statement of the net assets of the fund that
are available to pay future benefits, together with a note disclosing the actuarial present value of
promised retirement benefits and those benefits which are vested and those which are not. This
actuarial present value information may be contained in an accompanying actuarial report, rather than
in the statement of net assets.
A defined benefit plan's report should provide participants with information about the relationship
between the future obligations under the plan and the resources within the plan that are available to
meet those obligations. A typical report will therefore include the following:
(a) A description of significant activities for the reporting period along with details of any changes that
have been made to the plan and the effect of the changes on the plan
(b) A description of the plan's membership, terms and conditions
(c) Financial statements containing information on the transactions and investment performance for
the period as well as presenting the financial position of the plan at the end of the period
(d) Actuarial information, including the present value of the promised retirement benefits under the
plan and a description of the significant actuarial assumptions made in making those estimates
(e) A description of the investment policies

10.5 All retirement plans
10.5.1 Valuation of assets
Retirement benefit plan investments should be carried at fair value, which for marketable securities is
market value. Where an estimate of fair value is not possible, for example where the plan has total
ownership of another entity, disclosure should be made of the reason why fair value is not used.
10.6 Key requirements

The following summarises the key requirements of IAS 26.
Key requirements Defined Defined All

contribution benefit retirement
plans plans plans
Investments to be carried at fair value wherever Yes

possible
Recognition of the actuarial present value of promised Yes
retirement benefits
A statement of changes in net assets available for Yes
benefits
No requirement for an actuarial report Yes
10.7 Disclosure
The report of all retirement benefit plans should include the following information.
 A statement of changes in the net assets that are available in the fund to provide future benefits
 A summary of the plan's significant accounting policies
The statement of changes in the net assets available to provide future benefits should disclose a full
reconciliation showing movements during the period, for example contributions made to the plan split
between employee and employer, investment income, expenses and benefits paid out.
Information should be provided on the plan's funding policy, the basis of valuation for the assets in the
fund and details of significant investments that exceed a 5% threshold of net assets in the fund available
for benefits. Any liabilities that the plan has other than those of the actuarially calculated figure for
future benefits payable and details of any investment in the employing entity should also be disclosed.
General information should be included about the plan, such as the names of the employing entities,
the groups of employees that are members of the plan, the number of participants receiving benefits
under the plan and the nature of the plan ie, defined contribution or defined benefit. If employees
contribute to the plan, this should be disclosed along with an explanation of how the promised benefits
are calculated and details of any termination terms of the plan. If there have been changes in any of the
information disclosed then this fact should be explained.

11 Audit focus
Section overview
 The estimation of pension costs, particularly those for defined benefit pension schemes, involves a
high level of uncertainty.
 The auditor must evaluate the appropriateness of the fair value measurements.
Fair value accounting applies to pension costs, so auditors must be aware of the issues around auditing
fair value when auditing this area. Please refer back to Chapter 17 for further details on the IAASB's
guidance on auditing fair value.
11.1 Auditing pension costs

The table below summarises the areas of audit focus, and the audit evidence required, when auditing
pension costs.
Issue Evidence
Scheme assets (including  Ask directors to reconcile the scheme assets valuation at the
quoted and unquoted securities, scheme year-end date with the assets valuation at the reporting
debt instruments, properties) entity's date being used for IAS 19 purposes.
 Obtain direct confirmation of the scheme assets from the C
investment custodian. H
A
 Consider requiring scheme auditors to perform procedures. P
T
Scheme liabilities  Auditors must follow the principles relating to work done by a E
management's expert as defined in ISA (UK) 500 Audit Evidence R
(and covered in Chapter 6) to assess whether it is appropriate to
rely on the actuary's work.
 Specific matters would include: 18
– the source data used;

– the assumptions and methods used; and
– the results of actuaries' work in the light of auditors'
knowledge of the business and results of other audit
procedures.
Actuarial source data is likely to include:
 scheme member data (for example, classes of member and
contribution details); and
 scheme asset information (for example, values and income and
expenditure items).

Issue Evidence
Actuarial assumptions (for Auditors will not have the same expertise as actuaries and are
example, mortality rates, unlikely to be able to challenge the appropriateness and
termination rates, retirement reasonableness of the assumptions. They should nevertheless
age and changes in salary and ascertain the qualifications and experience of the actuaries.
benefit levels) Auditors can, also, through discussion with directors and actuaries:
 obtain a general understanding of the assumptions and review
the process used to develop them;
 consider whether assumptions comply with IAS 19 requirements
ie, are unbiased and based on market expectations at the year
end, over the period during which obligations will be settled;
 compare the assumptions with those which directors have used
in prior years;
 consider whether, based on their knowledge of the reporting
entity and the scheme, and on the results of other audit
procedures, the assumptions appear to be reasonable and
compatible with those used elsewhere in the preparation of the
entity's financial statements; and
 obtain written representations from directors confirming that
the assumptions are consistent with their knowledge of the
business.
Items charged to profit or loss  Discuss with directors and actuaries the factors affecting current
(current service cost, past service cost (for example, a scheme closed to new entrants may
service cost, gains and losses on see an increase year on year as a percentage of pay with the
settlements and curtailments) average age of the workforce increasing).
 Confirm that net interest cost has been based on the discount
rate determined by reference to market yields on high-quality
fixed-rate corporate bonds.
Items recognised in other  Check basis of updated assumptions used to calculate actuarial
comprehensive income gains/losses.
 Check basis of calculation of return on plan assets ie, using
current fair values. Fair values must be measured in accordance
with IFRS 13.
Contributions paid into plan  Agree cash payments to cash book/bank statements.
(Retirement benefits paid out
are paid by the pension plan
itself so there is no cash entry in
the entity's books)
Where the results of auditors' work are inconsistent with the directors' and actuaries', additional
procedures, such as requesting directors to obtain evidence from another actuary, may help in resolving
the inconsistency.

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

benefits benefits benefits benefits
Same principles as Recognise only if

Accruals Defined Defined defined benefit plans firm commitment
basis contribution benefit except all gains / losses to pay
are recognised in profit
or loss
Payable within 12
Disclosure Recognition months of reporting
date
C
Yes No
– Amount H
recognised as
Contributions an A
expense
expense, and P
– A description
– Unpaid contributions Accruals Benefits T
a liability basis discounted E
of the plan
– Excess contributions R
an asset if these will
reduce future liability
Disclosure Recognition
18
See next page
Profit or loss Statement of
financial position
Current service cost
Present value
Net interest of the defined
benefit obligation
at reporting date
Past service cost
LESS
Other Fair value of
comprehensive plan assets
income
Remeasurement
gains / losses

Disclosure
Narrative Components of Defined benefit Reconciliation Other standards

disclosure total expense obligation
IAS 24
IAS 37
– Description of the plan Opening and IAS 1
Arising closing balances
– Actuarial assumptions
from
Funded Unfunded
Plan assets plans plans
Actual return
Fair value of plan assets Present value of
on plan assets Fair value of
– For each category defined benefit
plan assets
of entity's own obligation
instruments
– For property or
asset used by entity
– By main categories
of instruments
in percentage terms Reconciliation of above
to assets and liabilities
in statement of
financial position
IAS 26 Accounting and Reporting

by Retirement Benefit Plans
Defined Defined
benefit contribution
plans plans
Actuarial present value of

promised retirement
benefits
Valuation
of plan
assets

Self-test
IAS 19 Employee Benefits
1 Employee benefits
Under which category of employee benefits should the following items be accounted for according
to IAS 19 Employee Benefits?
(a) Paid annual leave
(b) Lump-sum benefit of 1% of the final salary for each year of service
(c) Actuarial gains
2 Lampard
The Lampard company operates two major benefit plans on behalf of its employees under which
the amounts of benefit payable depend on a number of factors, the most important of which is
length of service. The plans are:
(a) Plan Deben, a post-retirement defined benefit plan
(b) Plan Limen, a long-term disability benefits plan
Changes to the terms of these plans coming into effect from 31 December 20X7 will result in past
service cost attributable to unvested benefits, to the extent of £500,000 on Plan Deben and
£220,000 on Plan Limen. Within each plan the average period until benefits become vested is five
years. There are no past service costs brought forward on either plan.
Requirement C
H
Under IAS 19 Employee Benefits, what is the total amount of past service costs which must be A
recognised by Lampard in the year ended 31 December 20X7? P
T
3 Tiger E
R
The Tiger company operates a post-retirement defined benefit plan under which post-retirement
benefits are payable to ex-employees and their partners.
18
For all the years this plan has been in operation, Tiger has used the market yield on its own
corporate bonds as the rate at which it has discounted its defined obligation, because the yield on
its own bonds has been the same as that on high-quality corporate bonds. In the current year Tiger
has experienced a sharp downgrading in its credit rating, such that the yield on its own bonds at
the year end is 8% while that on high-quality corporate bonds is 6%. Tiger is proposing to use the
yield on its own bonds as the discount rate, to reflect the greater risk.
Requirement
Indicate whether Tiger's approach is correct according to IAS 19 Employee Benefits.
4 Interest
An entity's defined benefit net liability at 31 December 20X4 and 20X5 is measured as follows.
20X4 20X5
£ £
Defined benefit obligation 950,000 1,150,000
The discount rates used for calculating the defined benefit obligation were 6.5% at 31 December
20X4 and 6% at 31 December 20X5.
Requirements
(a) Calculate the interest cost to be charged to profit or loss for 20X5.
(b) How should the discount factor that is used to discount post-employment benefit obligations
be determined?
(c) What elements should the discount rate specifically not reflect according to IAS 19?

5 Straw Holdings plc
John Cork, financial director of Straw Holdings plc, your audit client, has recently written to you for
advice on pension scheme accounting.
The company's defined benefit pension scheme has net assets valued at £20.2 million. Scheme
assets of £19.4 million at the beginning of the year were expected to be enhanced by a cash
contribution to the scheme of £0.4 million greater than payments to pensioners. An appropriate
discount rate of 10% has been identified.
Based on these figures Mr Cork has prepared the following reconciliation.
Assets at 31 December 20X1
£m
Opening scheme net assets 19.40
Add interest on assets @ 10% 1.94
Net contributions received 0.40
Less actuarial deficit (balancing figure) (1.54)
Closing scheme net assets 20.20
The deficit of £1.54 million has come as a surprise to Mr Cork. He is unsure how to treat this deficit
in the financial statements and is concerned about the impact it will have on the company's profits.
Requirements
(a) Explain the impact of the actuarial valuation of the scheme's assets and the resultant deficit on
the financial statements of Straw Holdings plc for the year ended 31 December 20X1.
(b) Identify two benefits to Straw Holdings plc of moving from a defined benefit to a defined
contribution scheme.
IAS 26 Accounting and Reporting by Retirement Benefit Plans
6 IAS 26
Answer the following questions in accordance with IAS 26 Accounting and Reporting by Retirement
Benefit Plans.
(a) How should a defined contribution retirement benefit plan carry property, plant and
equipment used in the operation of the fund?
(b) Is a defined contribution retirement benefit plan permitted to use a constant rate redemption
yield to measure any securities with a fixed redemption value which are acquired to match the
obligations of the plan?
(c) Does IAS 26 specify a minimum frequency of actuarial valuations?
7 Commercial Properties plc
Commercial Properties plc is a construction company based in Leeds which specialises in the
construction of manufacturing units and warehouses. You are conducting the audit for the year
ended 31 December 20X8 and have obtained the following information.
The company has two warehouses which it lets to commercial tenants, one located in York and the
other in Huddersfield. The property in York has been held for a number of years while construction
of the property in Huddersfield was completed on 1 January 20X8 and then subsequently let.
The policy of the company in respect of investment properties is to carry them in the statement of
financial position at open market value. They are revalued annually on the advice of professional
surveyors at eight times the aggregate rental income.
In March 20X9 a rent review on the warehouse in York was implemented. The directors intend to
base the valuation of this warehouse for the year ended 31 December 20X8 on this revised figure
on the basis that this represents a more up to date assessment of the market value of the property.
The property in Huddersfield has been let on special terms to another company in which one of
the directors holds an interest.
Commercial Properties plc also operates a defined benefit pension scheme on behalf of its
employees. The actuary has performed an annual review of funding and based on these figures the

statement of financial position is showing the pension fund as a net liability. There is an actuarial
surplus on liabilities of £375,000 and a deficit on assets of £525,000. The discount rate determined
by reference to market yields on high-quality fixed-rate corporate bonds is 12%.
Requirements
(a) Identify and explain the audit issues regarding the two investment properties.
(b) List the audit procedures you would perform to confirm the valuation of the properties.
(c) List the audit procedures relating to the above pension scheme to be carried out as part of the
20X8 audit.
C
H
A
P
T
E
R
18

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

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

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

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

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

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

benefit employees earned in current and prior periods
– Discount benefit using projected unit credit method
C
– Determine fair value of plan assets
H
– Determine total amount of remeasurement gains and losses to be A
P
recognised
T
– Where plan introduced or changed determine resulting past service cost E
R
– Where plan has been curtailed or settled calculate resulting gain or loss
Defined benefit scheme
18
 Recognised in statement of financial position as the net of: IAS 19.54
– Present value of defined benefit obligation at reporting date, minus

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

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

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

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

 Arises when entity introduces defined benefit plan or changes benefit under IAS 19.97
an existing defined benefit plan
 Entity shall recognise past service cost as an expense in profit or loss IAS 19.96
IAS 19.104A
Reimbursements
 An entity shall recognise its right to reimbursement as a separate asset only
when it is virtually certain that another party will reimburse some or all of the
expenditure required to settle a defined benefit obligation
IAS 19.108
Business combinations
 In a business combination (see IFRS 3 Business Combinations) an entity shall
recognise assets and liabilities arising from post-employment benefits at the:
– Present value of the obligation, less
– Fair value of any plan assets
 The present value of the obligation includes all of the following even if not
recognised by acquiree:
– All actuarial gains and losses
– Past service cost before acquisition date
– Amounts not recognised under transitional provisions
Other long-term employee benefits
 Examples include sabbatical leave and long-term disability benefits IAS 19.126
 Amount recognised as a liability is the net of the following: IAS 19.128
– Present value of the defined benefit obligation at the reporting date,

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

Scope IAS 26.1
Definitions IAS 26.8
Defined contribution plans IAS 26.13
Defined benefit plans IAS 26.17–19
Frequency of actuarial valuations IAS 26.27
Financial statement content IAS 26.28–31
All plans:
Valuation of plan assets IAS 26.32
Disclosure IAS 26.34
C
H
A
P
T
E
R
18


The actuarial gain or loss is established as a balancing figure in the calculations, as follows.
Present value of obligation
20X2 20X3 20X4
£'000 £'000 £'000
PV of obligation at start of year 1,000 1,200 1,600
Interest cost (10%) 100 120 160
Past service cost – – 40
Benefits paid (120) (140) (150)
Settlements – (50) –
Actuarial (gain)/loss on obligation: balancing figure 80 320 (100)
PV of obligation at end of year 1,200 1,600 * 1,700
* (1,650 – 50)
Market value of plan assets
20X2 20X3 20X4
£'000 £'000 £'000
Market value of plan assets at start of year 1,000 1,250 1,402
Interest on plan assets (10%) 100 125 140
Contributions 110 120 120
Benefits paid (120) (140) (150)
Settlements – (48) –
Gain on remeasurement through OCI: balancing
figure 160 95 98
Market value of plan assets at year end 1,250 1,402* 1,610
* (1,450 – 48)
In the statement of financial position, the liability that is recognised is calculated as follows.
20X2 20X3 20X4
£'000 £'000 £'000
Present value of obligation 1,200 1,600 1,700
Market value of plan assets 1,250 1,402 1,610
Liability/(asset) in statement of financial position (50) 198 90
The following will be recognised in profit or loss for the year:

20X2 20X3 20X4
£'000 £'000 £'000
Past service cost – – 40
Net interest on defined benefit liability (asset) – (5) 20
Gain on settlement of defined benefit liability – (2) –
Expense recognised in profit or loss 140 143 210
The following remeasurements will be recognised in other comprehensive income for the year:
20X2 20X3 20X4
£'000 £'000 £'000
Actuarial (gain)/loss on obligation 80 320 (100)
Return on plan assets (excluding amounts in net
interest) (160) (95) (98)

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

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

The defined benefit pension plan is treated in accordance with IAS 19 Employee Benefits, as revised in
2011.
C
The pension plan has a deficit of liabilities over assets. H
£m A
Fair value of plan assets 200 P
Less present value of obligation (208) T
E
(8)
R
The deficit is reported as a liability in the statement of financial position.
Profit or loss for the year includes: 18
£m
Net interest on net defined benefit liability (32 – 16) 16
192
The company is required by the revised IAS 19 to recognise the £24,000,000 remeasurement gain (see
working) immediately in other comprehensive income.
WORKING
PV of FV of plan
obligation assets
£m £m
b/f Nil Nil
Contributions paid 160
Interest on plan assets 16
Interest cost on obligation 32
Actuarial difference (bal fig) – 24
c/f 208 200

Statement of financial position extract £'000

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

Charged to profit or loss
Net interest on net defined benefit liability (344 – 288) 56
Curtailment cost 58
389
Actuarial gain on obligation 107
Return on plan assets (excluding amounts in net interest) 7
Reconciliation of pension plan movement £'000

Plan deficit at 1 Feb 20X7 (3,600 – 4,300) (700)
Company contributions 550
Profit or loss total (389)
Other comprehensive income total (107 + 7) 114
Plan deficit at 31 Jan 20X8 (4,115 – 4,540) (425)
Changes in the present value of the defined benefit obligation £'000

Defined benefit obligation at 1 Feb 20X7 4,300
Interest cost @ 8% 344
Pensions paid (330)
Curtailment 58
Actuarial gain (residual) (107)
Defined benefit obligation at 31 Jan 20X8 4,540
Changes in the fair value of plan assets £'000

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

IAS 26 applies to the general purpose financial reports of pension schemes.


1 Employee benefits
(a) Short-term employee benefits
(b) Defined benefit plans
(c) Defined benefit plans
IAS 19.9 highlights paid annual leave as a short-term benefit.
The actuarial gains and the lump-sum benefit relate to defined benefit plans (per IAS 19.24–27 and 54).
2 Lampard
£720,000 (£500,000 + £220,000)
Under IAS 19 Employee Benefits (revised 2011), past service cost attributable to all benefits, whether
vested or not within a post-retirement defined benefit plan, must be recognised immediately in
profit or loss. Similarly, past service cost attributable to all benefits, whether vested or not, within a
long-term disability benefits plan must be recognised immediately in profit or loss, so the full
£720,000 must be recognised.
3 Tiger
C
Tiger should not be using 8% as its discount rate. H
A
Under IAS 19.78 the yield on high-quality corporate bonds must be used as the discount rate for P
the defined benefit obligation. (Using a higher rate would result in a lower obligation, which would T
not reflect greater risk.) E
R
4 Interest
(a) The interest cost for 20X5 is calculated by multiplying the defined benefit obligation at the
start of the period by the discount rate at the start of the period, so: 18
£950,000 × 6.5% = £61,750.

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

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

6 IAS 26
(a) Under IAS 26.33 all types of retirement benefit plan should account for assets used in the
operation of the plan under the applicable standards. IAS 16 is applicable in this case and
either the cost model or the revaluation model may be used.
(b) All types of retirement plan are permitted by IAS 26.33 to use this method of measuring such
securities.
(c) No minimum frequency of actuarial valuation is specified in IAS 26.27 or elsewhere.
7 Commercial Properties plc
Tutorial note
This question contains a revision of the audit of investment properties, covered in Chapter 12.
(a) Audit issues

 Whether the two warehouses fall within the IAS 40 Investment Property definition of an
investment property
Based on the following evidence, it would appear that the definition is satisfied:
– Both properties are held for the purposes of generating rental income
– They are not owner occupied but let to third parties
 Whether the initial recognition of the newly completed warehouse is in accordance with
IAS 40
The property would normally be measured at cost during the period of construction
(although IAS 40 does allow construction cost to be measured at fair value if it can be
measured reliably).
 Whether the accounting treatment adopted for the subsequent measurement of the
investment properties is in accordance with IAS 40
Under IAS 40, a company may choose to adopt the cost model or the fair value model.
Commercial Properties plc has adopted the fair value model. As a result of this, no

depreciation should be charged and any changes in fair value should be recognised in
profit or loss for the period.
 Whether the basis used as fair value is appropriate
Rental income has been used as a basis of calculating an estimated fair value. This is a
suitable basis, provided rentals are an indication of the market-based exit value at the
measurement date.
IFRS 13 states that fair value should reflect market conditions at the measurement date.
The use of the revised rentals following the rent review therefore does not seem to be
appropriate. This is because the rent reviews took place after the year-end date and, at
the end of the reporting period, would not have been guaranteed. As a result, they could
not have been reflected in a fair value at 31 December 20X8.
In accordance with IFRS 13, the market-based current exit price is based on the concept
that an exchange between unrelated knowledgeable and willing parties has taken place.
The warehouse in Huddersfield is being let to another company with which a director is
associated. As a result of the relationship between the two parties the rent may not
reflect market conditions and therefore may not be a suitable estimation of fair value.
 Whether there is a related party relationship
The relationship between the director and the company leasing the warehouse in
Huddersfield may constitute a related party transaction, which may require disclosure in
the financial statements.
 Materiality
C
The materiality of any adjustments required as a result of any changes to the fair values H
of the investment properties will need to be considered. As any changes in fair value are A
reflected in the statement of profit or loss and other comprehensive income, materiality P
T
will need to be assessed both in terms of the impact on the statement of financial
E
position and on the statement of profit or loss and other comprehensive income. R
(b) Audit procedures: investment properties
 Obtain the report produced by the professional surveyors to confirm their valuation at
18
eight times aggregate rental income, and to support the assumption that rentals provide
an indication of an appropriate exit value in accordance with IFRS 13.
 Consider the extent to which their expertise can be relied on eg, reputable firm,
experience etc.
 Obtain a copy of the rental agreement for the warehouse in York both before and after
the rent review. Confirm that the year-end value has been based on the revised rent and
calculate the adjustment which would be required if based on the initial agreement.
 Discuss the nature of the special terms on which the warehouse in Huddersfield has been
let and the nature of the relationship between the director and the entity.
 Compare fair values as calculated by the directors with current prices for similar
properties in similar locations.
 Where cash flows have been discounted, review whether any assumptions built in to the
calculation are reasonable eg, discount rates used.
 Compare any proposed adjustments with materiality levels set for the audit.
(c) Audit procedures: pension scheme
 Obtain the client's permission to liaise with the actuary, and review the actuary's
professional qualification.
 Agree the validity and accuracy of the actuarial valuation.
– Agree that the actuarial valuation method satisfies the accounting objectives of
IAS 19.
– Confirm that net interest cost has been based on the discount rate determined by
reference to market yields on high-quality fixed-rate bonds.

 Agree the completeness of the actuarial valuation.
– Identify major events that should have been taken into account.
– Scrutinise relevant correspondence eg, between the client, the actuary, the solicitor.
– Review minutes of board meetings.
 Agree opening balances to last year's working papers.
 Reconcile closing balance provision to opening statement of financial position.
 Agree contributions paid to the cash book and to the funding rate recommended by the
actuary in the most recent actuarial valuation.
 Check that disclosures comply with the requirements of IAS 19.

CHAPTER 19
Share-based payment
Introduction
Topic List
1 Background
2 Objective and scope of IFRS 2 Share-based Payment
3 Share-based transaction terminology
4 Equity-settled share-based payment transactions
5 Cash-settled share-based payment transactions
6 Share-based payment with a choice of settlement
7 Group and treasury share transactions
8 Disclosure
9 Distributable profits and purchase of own shares
10 Audit focus
Technical reference
943
Introduction
 Appraise corporate reporting regulations, and related legal requirements, with respect to
presentation, disclosure, recognition and measurement
 Explain how different methods of providing remuneration for employees may impact
upon reported performance and position
 Explain and appraise accounting standards that relate to employee remuneration which
include different forms of short-term and long-term employee compensation; retirement
benefits; and share-based payment
of details
Specific syllabus references for this chapter are: 1(b), 5(a), 5(b), 14(c), 14(d), 14(f)

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

Pre-IFRS 2
Before the publication of IFRS 2 Share-based Payment there appeared to be an anomaly to the extent
that if a company paid its employees in cash, an expense was recognised in profit or loss, but if the
payment was in share options, no expense was recognised.
IFRS 2 requirements
As will be seen throughout the chapter, IFRS 2 requires an expense to be recognised in profit or loss in
relation to share-based payments.
The publication of IFRS 2 in 2004 and introduction of this requirement to recognise an expense caused
huge controversy, with opposition especially strong among high tech companies. The arguments over
expensing share-based payments polarised opinion, especially in the US.
 The main argument against recording an expense was that no cash changes hands as part of such
transactions, and it is claimed therefore that there is no true expense. C
H
 The main argument for was that share-based payments are simply another form of compensation A
that should go into the calculation of earnings for the sake of transparency for investors and the P
business community. It was also argued that recording an expense better reflects the accruals basis T
of financial statement preparation. E
R
Practical application of IFRS 2
In practice, the implementation of IFRS 2 has resulted in earnings being reduced, sometimes
19
significantly. It is generally agreed that as a result of this standard companies focus more on the
earnings effect of different rewards policies.
Following the adoption of IFRS 2, some companies have admitted that they are re-evaluating the use of
share options as part of employee remuneration.
Illustration: GlaxoSmithKline plc

The effect of IFRS 2 on reported performance can be substantial even in mature businesses.
GlaxoSmithKline plc (GSK), a company listed on both the London and New York Stock Exchanges,
operating in the pharmaceutical industry, adopted IFRS 2 in 2004 and restated its 2003 results. In line
with IFRS 2, GSK recognised a charge of £226 million in 2006 (£236 million in 2005 and £333 million in
2004). The IFRS 2 adjustment to restate pre-tax profits for 2003 was £369 million which represented
5.8% of pre-tax profits.
Share-based payment 945

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

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

Payment for goods or services received by an entity within a group may be made in the form of
granting equity instruments of the parent company, or equity instruments of another group company.
IFRS 2.3 states that this type of transaction qualifies as a share-based payment transaction within the
scope of IFRS 2.

In 2009, the standard was amended to clarify that it applies to the following arrangements:
 Where the entity's suppliers (including employees) will receive cash payments that are linked to the
price of the equity instruments of the entity
 Where the entity's suppliers (including employees) will receive cash payments that are linked to the
price of the equity instruments of the entity's parent
Under either arrangement, the entity's parent had an obligation to make the required cash payments to
the entity's suppliers. The entity itself did not have any obligation to make such payments. IFRS 2 applies
to arrangements such as those described above even if the entity that receives goods or services from its
suppliers has no obligation to make the required share-based cash payments.
2.2 Transactions outside the scope of IFRS 2

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

Scenario 1: Entity A grants share warrants and its own equity to its external consultants. The warrants
become exercisable once an initial public offering (IPO) is made and on condition that the consultants
continue to provide agreed services to Entity A until the date the IPO is made.
This transaction is a share-based payment within the scope of IFRS 2.
Scenario 2: Entity B buys back some of its own shares from employees in their capacity as shareholders
for the market value of those shares.
This transaction is a simple purchase of treasury shares and is outside the scope of IFRS 2, being
governed instead by IAS 32. C
H
Scenario 3: Entity C buys back some of its own shares but pays an amount in excess of their market A
value only to shareholders who are employees. P
T
The excess over market value to employees only would be considered as a compensation expense E
within the scope of IFRS 2. R
Scenario 4: Entity D enters into a contract to buy a commodity for use in its business for cash, at a price
equal to the value of 1,000 shares of Entity D at the date the commodity is delivered. Although Entity D
19
can settle the contract net, it does not intend to do so, nor does it have a past practice of doing so.
This transaction is within the scope of IFRS 2, as it meets the definition of a cash-settled share-based
payment transaction. Entity D will be acquiring goods in exchange for a payment, the amount of which
will be based on the value of its shares.
If, however, Entity D has a practice of settling these contracts net, or did not intend to take physical
delivery, then the forward contract would be within the scope of IAS 32 and IAS 39 and outside the
scope of IFRS 2.

3 Share-based transaction terminology
Section overview
Share-based transactions are agreed between an entity and counterparty at the grant date; the
counterparty becomes entitled to the payment at the vesting date.
Before considering the accounting treatment of share-based payment transactions, it is important to

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

IFRS 2 recognises two types of vesting conditions:
Non market based vesting conditions
These are conditions other than those relating to the market value of the entity's shares. Examples
include vesting dependent on:
 the employee completing a minimum period of service (also referred to as a service condition)
 achievement of minimum sales or earnings target
 achievement of a specific increase in profit or earnings per share
 successful completion of a flotation
 completion of a particular project
Market-based vesting conditions
Market-based performance or vesting conditions are conditions linked to the market price of the shares in
some way. Examples include vesting dependent on achieving:
 a minimum increase in the share price of the entity
 a minimum increase in shareholder return
 a specified target share price relative to an index of market prices

The definition of vesting conditions:
 is restricted to service conditions and performance conditions; and
 excludes other features such as a requirement for employees to make regular contributions into a
savings scheme.
4 Equity-settled share-based payment transactions
Section overview
 Where payment for goods or services is in the form of shares or share options, the fair value of the
transaction is recognised in profit or loss, spread over the vesting period.
4.1 Introduction
If goods or services are received in exchange for shares or share options, the transaction is accounted for
by:
£ £
DEBIT Expense/Asset X
CREDIT Equity X
IFRS 2 does not stipulate which equity account the credit entry is made to. It is normal practice to credit
a separate component of equity, although an increasing number of UK companies are crediting retained
earnings.
We must next consider:
(a) Measurement of the total expense taken to profit or loss
(b) When this expense should be recorded
4.2 Measurement
When considering the total expense to profit or loss, the basic principle is that equity-settled share-
based transactions are measured at fair value.
C
Definition H
A
Fair value: The amount for which an asset could be exchanged, a liability settled, or an equity P
instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length T
transaction. E
R
(Note that this definition is still applicable, rather than the definition in IFRS 13, because IFRS 13 does
not apply to transactions within the scope of IFRS 2.)
19
Fair value will depend on who the transaction is with:

(a) There is a rebuttable presumption that the fair value of goods/services received from a third party
can be measured reliably.
(b) It is not normally possible to measure services received when the shares or share options form part
of the remuneration package of employees.

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

measured reliably?
N
Y
Measure at fair value of the goods/ Measure at the fair value of the equity
services on the date they were received instruments granted at grant date
= direct method = indirect method
Figure 19.1: Measurement of Equity-Settled Share-Based Transactions
4.3 Allocation of expense to financial years

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

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

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

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

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

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

19
4.5.1 Immediate vesting

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

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

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

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

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

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

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

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

On 1 January 20X4 an entity granted options over 10,000 of its shares to Sally, one of its senior
employees. One of the conditions of the share option scheme was that Sally must work for the entity for
three years. Sally continued to be employed by the entity during 20X4, 20X5 and 20X6.
A second condition for vesting is that the costs for which Sally is responsible should reduce by 10% per
annum compound over the three-year period. At the date of grant, the fair value of each share option
was estimated at £21.
At 31 December 20X4 Sally's costs had reduced by 15% and therefore it was estimated that the C
H
performance condition would be achieved. A
P
Due to a particularly tough year of trading for the year ended 31 December 20X5 Sally had only
T
reduced costs by 3% and it was thought at that time that she would not meet the cost reduction target E
by 31 December 20X6. R
At 31 December 20X6, the end of the performance period, Sally did meet the overall cost reduction
target of 10% per annum compound.
19
Requirement
How should the transaction be recognised?
Solution
The cost reduction target is a non market performance condition which is taken into account in
estimating whether the options will vest. The expense recognised in profit or loss in each of the three
years is:
Cumulative Charge in the year
£ £
20X4 (10,000  £21)/3 years 70,000 70,000
20X5 Assumed performance would not be achieved 0 (70,000)
20X6 10,000  £21 210,000 210,000

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

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

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

Company B issued 100 share options to certain employees, that will vest once revenues reach
£1 billion and its share price equals £50. The employee will have to be employed with Company B at
the time the share options vest in order to receive the options. The share options had a fair value of £20
at the grant date and will expire in 10 years.

Requirement
How should the expense be recorded under each of the following different scenarios?
(a) All options vest.
(b) Revenues have reached £1 billion, all employees are still employed and the share price is £49.
(c) The share price has reached £50, all employees are still employed but revenues have not yet
reached £1 billion.
(d) Revenues have reached £1 billion, the share price has reached £50 and half the employees who
received options left the company before the vesting date.
4.7 Other issues

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

Yarex plc is proposing to award share options to directors and senior employees during the accounting
year ending 31 December 20X6.
The proposal is to issue 100,000 options to each of the 50 directors and senior managers on
1 November 20X6.
The exercise price of the options would be £5 per share. The scheme participants will need to have been
with the company for at least three years before being able to exercise their options.
It is estimated that 75% of the current directors and senior managers will remain with the company for
three years or more.
1 November 20X6 Average 20X6 31 December 20X6
£ £ £
Price per share 5.00 5.50 5.80 (estimated)
Fair value of each option 2.00 2.40 3.80 (estimated) C
H
Requirement A
P
Show how the proposed scheme would be reflected in the financial statements on 31 December 20X6 T
and 31 December 20X7. Ignore taxation. E
R
Solution
The three-year service condition specified by the options contract is a non-market vesting condition 19
which should be taken into account when estimating the number of options which will vest at the end
of each period. Therefore the proportion of directors expected to remain with the company is relevant
in determining the remuneration charge arising from the options.
The fair value for the options used is the fair value at the grant date ie, the fair value of £2 on
1 November 20X6.
The remuneration expense in respect of the options for the year ended 31 December 20X6 is calculated
as follows:
Fair value of options expected to vest at grant date:
(75% × 50 employees) × 100,000 options × £2 = £7,500,000
Annual charge to profit or loss therefore £7.5m/3 years = £2.5m
Charge to profit or loss for y/e 31 December 20X6 = £2.5m × 2/12 months = £416,667

The accounting entry for the year ending 31 December 20X6 is:
£ £
DEBIT Remuneration expense 416,667
In 20X7 the remuneration charge is for the whole year. Assuming there is no change in the estimated
retention rate for employees, the accounting entry is:
£ £
DEBIT Remuneration expense 2,500,000
CREDIT Equity 2,500,000
4.7.2 Vested options not exercised

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

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

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

4.7.4 Modifications and repricing
Equity instruments may be modified before they vest.
Eg, a downturn in the equity market may mean that the original option exercise price set is no longer
attractive. Therefore the exercise price is reduced (the option is 'repriced') to make it valuable again.
Such modifications will often affect the fair value of the instrument and therefore the amount
The accounting treatment of modifications and repricing is as follows:
(a) Continue to recognise the original fair value of the instrument in the normal way (even where the
modification has reduced the fair value).
(b) Recognise any increase in fair value at the modification date (or any increase in the number of
instruments granted as a result of modification) spread over the period between the modification
date and vesting date.
(c) If modification occurs after the vesting date, then the additional fair value must be recognised
immediately unless there is, for example, an additional service period, in which case the difference
is spread over this period.
Worked example: Repricing of share options

An entity granted 1,000 share options at an exercise price of £50 to each of its 30 key management
personnel on 1 January 20X4. The options only vest if the managers were still employed on
31 December 20X7. The fair value of the share options was estimated at £20 and the entity estimated
that the options would vest with 20 managers. This estimate was confirmed on 31 December 20X4.
The entity's share price collapsed early in 20X5. On 1 July 20X5 the entity modified the share options
scheme by reducing the exercise price to £15. It estimated that the fair value of an option was £2
immediately before the price reduction and £11 immediately after. It retained its estimate that options
would vest with 20 managers.
Requirement
How should the modification be recognised?
Solution
The total cost to the entity of the original option scheme was:
C
1,000 shares × 20 managers × £20 = £400,000 H
A
This was being recognised at the rate of £100,000 each year. P
T
The cost of the modification is: E
R
1,000 × 20 managers × (£11 – £2) = £180,000
This additional cost should be recognised over 30 months, being the remaining period up to vesting, so
£6,000 a month. 19
The total cost to the entity in the year ended 31 December 20X5 is:
£100,000 + (£6,000 × 6) = £136,000.
Interactive question 5: Repricing of share options

At the beginning of Year 1, an entity grants 100 share options to each of its 500 employees. Each grant
is conditional upon the employee remaining in service over the next three years. The entity estimates
that the fair value of each option is £15. On the basis of a weighted average probability, the entity
estimates that 100 employees will leave during the three-year period and therefore forfeit their rights to
the share options.
During the first year 40 employees leave. By the end of the first year, the entity's share price has dropped,
and the entity reprices its share options. The repriced share options vest at the end of Year 3. The entity
estimates that a further 70 employees will leave during Years 2 and 3, and hence the total expected

employee departures over the three-year vesting period is 110 employees. During Year 2 a further
35 employees leave, and the entity estimates that a further 30 employees will leave during Year 3, to bring
the total expected employee departures over the three-year vesting period to 105 employees. During
Year 3, a total of 28 employees leave, and hence a total of 103 employees ceased employment during the
vesting period. For the remaining 397 employees, the share options vested at the end of Year 3.
The entity estimates that, at the date of repricing, the fair value of each of the original share options
granted (ie, before taking into account the repricing) is £5 and that the fair value of each repriced share
option is £8.
Requirement
What are the amounts that should be recognised in the financial statements for Years 1 to 3?
4.7.5 Cancellations and settlements

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

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

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

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

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

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

Share options granted to employees do not generally have a readily obtainable market price because
the conditions attached to the options usually make them different from other options that an entity C
may trade on the open market. H
A
Where there is no readily obtainable market price an entity should use an option pricing model to P
calculate fair value. The type of option pricing model should reflect the nature of the options. Employee T
E
options often have long lives and are generally exercisable between the vesting date and the end of the
R
life of the option; the model used should allow for such circumstances.
All option pricing models take into account a number of factors as set out below.
19
(a) The exercise price of the option – a known amount.
(b) The life of the option – although the maximum life of the option is a known quantity, this input
requires an estimate of the expected life of the individual option. Employee options, for example,
are typically exercised soon after vesting date, as this is generally the only way that an employee
can crystallise any gain.
(c) The current price of the underlying shares – this is generally a known amount (the listed market
value of the shares).
(d) The expected volatility of the share price – volatility is typically expressed in annualised terms for
ease of comparability. The expected annualised volatility of a share is expressed in terms of the
compounded annual rate of return that is expected to arise approximately two-thirds of the time.
Volatility (also discussed in detail in your Strategic Business Management Study Manual) is a measure
of the amount by which a share price is expected to fluctuate during a period. For example, a share
worth £100 with a volatility of 40% would suggest that it will be worth between £60 and £140
approximately two-thirds of the time between the grant date and the exercise of the options.

(e) The dividend expected on the shares – this should only be included where the employee is not
entitled to dividends on the underlying options granted.
(f) The risk-free interest rate for the life of the option – this is typically 'the implied yield currently
available on zero-coupon government issues of the country in whose currency the exercise price is
expressed'.
Factors which are typically used to assess volatility include the historical volatility of the entity's share
price and the length of time that the shares have been publicly traded.
4.8.2 Which valuation model?

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

Monte-Carlo simulation
Monte-Carlo simulation extends the Binomial model by undertaking thousands of simulations of
potential future outcomes for key assumptions and calculating the option value under each scenario.
Monte-Carlo models can incorporate very complex performance conditions and exercise patterns. They
are generally considered the best type of model for valuing employee share-based payments, although
they are also affected by the subjectivity of probabilities.
5 Cash-settled share-based payment transactions
Section overview
 The credit entry in respect of a cash-settled share-based payment transaction is reported as a
liability.
 The fair value of the liability should be remeasured at each reporting date until settled. Changes in
the fair value are recognised in profit or loss.
5.1 Introduction
Cash-settled share-based payment transactions are transactions where the amount of cash paid for
goods and services is based on the value of an entity's equity instruments.
Examples of this type of transaction include:
(a) share appreciation rights (SARs): the employees become entitled to a future cash payment (rather
than an equity instrument), based on the increase in the entity's share price from a specified level
over a specified period of time; or
(b) an entity might grant to its employees a right to receive a future cash payment by granting to
them a right to shares that are redeemable.

If goods or services are received in exchange for cash amounts linked to the value of shares, the
transaction is accounted for by: C
H
£ £
A
DEBIT Expense/Asset X P
CREDIT Liability X T
E
Allocation of expense to financial years R
The expense should be recognised as services are provided. For example, if share appreciation rights do
not vest until the employees have completed a specified period of service, the entity should recognise
the services received and the related liability, over that period. 19
Measurement
The goods or services acquired and the liability incurred are measured at the fair value of the liability.
The entity should remeasure the fair value of the liability at each reporting date and at the date of
settlement. Any changes in fair value are recognised in profit or loss for the period.
Vesting conditions
Vesting conditions should be taken into account in a similar way as for equity-settled transactions when
determining the number of rights to payment that will vest.

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

Interactive question 6: Share-based payment
J&B granted 200 options on its £1 ordinary shares to each of its 800 employees on 1 January 20X1.
Each grant is conditional upon the employee being employed by J&B until 31 December 20X3.
J&B estimated at 1 January 20X1 that:
 the fair value of each option was £4 (before adjustment for the possibility of forfeiture); and
 approximately 50 employees would leave during 20X1, 40 during 20X2 and 30 during 20X3
thereby forfeiting their rights to receive the options. The departures were expected to be evenly
spread within each year.
The exercise price of the options was £1.50 and the market value of a J&B share on 1 January 20X1 was £3.
In the event, only 40 employees left during 20X1 (and the estimate of total departures was revised down
to 95 at 31 December 20X1), 20 during 20X2 (and the estimate of total departures was revised to 70 at
31 December 20X2) and none left during 20X3. The departures were spread evenly during each year.
Requirements
The directors of J&B have asked you to illustrate how the scheme is accounted for under IFRS 2 Share-
based Payment.
(a) Show the double entries for the charge to profit or loss for employee services over the three years
and for the share issue, assuming all employees entitled to benefit from the scheme exercised their
rights and the shares were issued on 31 December 20X3.
(b) Explain how your solution would differ had J&B offered its employees cash, based on the share
value rather than share options.
See Answers at the end of this chapter.
6 Share-based payment with a choice of settlement
Section overview
Accounting for share-based transactions with a choice of settlement depends on which party has the C
choice. H
A
 Where the counterparty has a choice of settlement, a liability component and an equity P
component are identified. T
E
 Where the entity has a choice of settlement, the whole transaction is treated either as cash-settled R
or as equity-settled, depending on whether the entity has an obligation to settle in cash.
19
6.1 Counterparty has the choice
Where the counterparty or recipient, rather than the issuing entity, has the right to choose the form
settlement will take, IFRS 2 regards the transaction as a compound financial instrument to which split
accounting must be applied.
This means that the entity has issued an instrument with a debt component in so far as the recipient
may demand cash and an equity component to the extent that the recipient may demand settlement in
equity instruments.

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

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

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

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

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

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

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

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

Woodley plc is one of your assurance clients, and has asked you to advise on how to apply IFRS 2 to its
new share option scheme. The company's reporting period is to 31 December.
The scheme is open to all 450 employees and all options are granted on 1 January 20X7. The fair value
of each option is £15 on 1 January 20X7. The company estimates that this fair value will rise by
approximately £5 per year. Each employee is given 100 options.
The vesting of the share option depends on achieving two independent targets. The first target is that
the share price must have increased by a total of at least 10% in order for the options to vest.
The second target is that shares can vest when profits increase by 15% in any year, or by an average of
C
12% in any two years. The scheme will be cancelled after four years.
H
In 20X7, profits increase by 10% and the share price has risen by 5%. The shares do not vest, but at A
31 December 20X7 the forecast increase in profits for 20X8 is 14%, and the forecast increase in share P
T
price for 20X8 is 5%. It is therefore anticipated the shares will vest in 20X8.
E
30 employees leave in 20X7 and it is estimated that a further 25 will leave before the options vest. R
In 20X8, profits increase by 13% so the shares do not vest, although the share price target has now
been achieved. 15 employees left during the year and it is anticipated that a further 26 will leave before
19
the scheme is expected to vest in 20X9 (forecast profit increase for 20X9 is 12%).
In 20X9, profits increased by the forecast 12%, so the options vest. 390 employees ultimately received
their options.
Requirements
(a) Explain the principles of how this scheme should be measured and recognised. Calculate the IFRS 2
expense and set out the double entries required for 20X7, 20X8 and 20X9.
(b) Describe how your answer would be different if in 20Y0, 100 employees allowed their vested share
options to lapse.
(c) How would your answer to (a) be different if the actual increase in profits for the year to
31 December 20X9 was 10% and, at that date, it was forecast that profits for 20Y0 were to
increase by 15%, but the actual increase achieved in 20Y0 was 9%? If the targets related to share
price and not profits, describe how to account for failing to meet the targets set.

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

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

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

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

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

IFRS 2 requires disclosure of information that enables users of the financial statements to understand
how the fair value of the goods or services received, or the fair value of the equity instruments granted,
during the period was determined.
For equity instruments the disclosure of fair value methodology applies to both:
 new instruments issued during the reporting period; and
 existing instruments modified during the reporting period. C
H
The entity must disclose the option pricing model used and the inputs to that model. These will include A
at least: P
T
 the weighted average share price E
R
 the exercise price
 the expected volatility of the share price
 the life of the option
19
 the expected dividends on the underlying share
 the risk-free interest rate over the life of the option
 the method used and the assumptions made to incorporate the effect of early exercise
8.4 Impact on earnings and financial position

Entities should also disclose information that enables users of the financial statements to understand the
effect of share-based payment transactions on the entity's profit or loss for the period and on its
financial position.
(a) The total expense recognised for the period arising from share-based payment transactions,
including separate disclosure of that portion of the total expense that arises from transactions
accounted for as equity-settled share-based payment transactions

(b) For liabilities arising from share-based payment transactions:
(i) The total carrying amount at the end of the period
(ii) The total intrinsic value at the end of the period of liabilities for which the counterparty's
right to cash or other assets had vested by the end of the period
The disclosure requirements of IFRS 2 are illustrated by an example below.
8.5 Model disclosures

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

IAS 33 Earnings per Share requires that for calculating diluted EPS all dilutive options need to be taken
into account. Employee share options with fixed terms and non-vested ordinary shares are treated as
options outstanding on grant date even though they may not have vested on the date the diluted EPS is
calculated. All awards which do not specify performance criteria are treated as options.
Employee share options contingent on performance-related conditions are treated as contingently
issuable shares and are dealt with in detail in Chapter 11.
9 Distributable profits and purchase of own shares
Section overview
Various rules have been created to ensure that dividends are only paid out of distributable profits.
Definition
Dividend: An amount payable to shareholders from profits or other distributable reserves.

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

No dividend may exceed the amount recommended by the directors who have an implied power in
their discretion to set aside profits as reserves.
The directors may declare such interim dividends as they consider justified.
Dividends are normally declared payable on the paid-up amount of share capital. For example, a £1
share which is fully paid will carry entitlement to twice as much dividend as a £1 share 50p paid.
A dividend may be paid otherwise than in cash.
Dividends may be paid by cheque or warrant sent through the post to the shareholder at his registered
address. If shares are held jointly, payment of dividend is made to the first-named joint holder on the
register.
Listed companies generally pay two dividends a year; an interim dividend based on interim profit
figures, and a final dividend based on the annual accounts and approved at the AGM.
A dividend becomes a debt when it is declared and due for payment. A shareholder is not entitled to
a dividend unless it is declared in accordance with the procedure prescribed by the articles and the
declared date for payment has arrived.
This is so even if the member holds preference shares carrying a priority entitlement to receive a
specified amount of dividend on a specified date in the year. The directors may decide to withhold
profits and cannot be compelled to recommend a dividend.
If the articles refer to 'payment' of dividends this means payment in cash. A power to pay dividends in
specie (otherwise than in cash) is not implied but may be expressly created. Scrip dividends are
dividends paid by the issue of additional shares.
Any provision of the articles for the declaration and payment of dividends is subject to the overriding
rule that no dividend may be paid except out of profits distributable by law.
C
H
9.2 Distributable profits A
P
T
Section overview E
R
Distributable profits may be defined as 'accumulated realised profits ... less accumulated realised losses'.
'Accumulated' means that any losses of previous years must be included in reckoning the current
distributable surplus. 'Realised' profits are determined in accordance with generally accepted
19
accounting principles.
Definition
Profits available for distribution: Accumulated realised profits (which have not been distributed or
capitalised) less accumulated realised losses (which have not been previously written off in a reduction
or reorganisation of capital).
The word 'accumulated' requires that any losses of previous years must be included in reckoning the
current distributable surplus.
A profit or loss is deemed to be realised if it is treated as realised in accordance with generally accepted
accounting principles (GAAP). Hence, financial reporting and accounting standards in issue, plus GAAP,
should be taken into account when determining realised profits and losses.

Depreciation must be treated as a realised loss, and debited against profit, in determining the amount
of distributable profit remaining.
However, a revalued asset will have depreciation charged on its historical cost and the increase in the
value in the asset. The Companies Act allows the depreciation provision on the valuation increase to be
treated also as a realised profit.
Effectively there is a cancelling out, and at the end only depreciation that relates to historical cost
will affect dividends.
Illustration: Depreciation charge

Suppose that an asset purchased for £20,000 has a 10-year life. Provision is made for depreciation on a
straight-line basis. This means the annual depreciation charge of £2,000 must be deducted in reckoning
the company's realised profit less realised loss.
Suppose now that after five years the asset is revalued to £50,000 and in consequence the annual
depreciation charge is raised to £10,000 (over each of the five remaining years of the asset's life).
The effect of the Act is that £8,000 of this amount may be reclassified as a realised profit. The net effect
is that realised profits are reduced by only £2,000 in respect of depreciation, as before.
If, on a general revaluation of all fixed assets, it appears that there is a diminution in value of any one or
more assets, then any related provision(s) need not be treated as a realised loss.
The Act states that if a company shows development expenditure as an asset in its accounts it must
usually be treated as a realised loss in the year it occurs. However, it can be carried forward in special
circumstances (generally taken to mean in accordance with accounting standards).
9.3 Dividends of public companies
Section overview
A public company may only make a distribution if its net assets are, at the time, not less than the
aggregate of its called-up share capital and undistributable reserves. It may only pay a dividend
which will leave its net assets at not less than that aggregate amount.
aggregate of its called-up share capital and undistributable reserves. The dividend which it may pay
is limited to such amount as will leave its net assets at not less than that aggregate amount.
Undistributable reserves are defined as follows:
(a) Share premium account
(b) Capital redemption reserve
(c) Any surplus of accumulated unrealised profits over accumulated unrealised losses (known as a
revaluation reserve). However, a deficit of accumulated unrealised profits compared with
accumulated unrealised losses must be treated as a realised loss
(d) Any reserve which the company is prohibited from distributing by statute or by its constitution or
any law
Worked example: Permissible dividend

Suppose that a public company has an issued share capital (fully paid) of £800,000 and £200,000 on
share premium account (which is an undistributable reserve). If its assets less liabilities are less than
£1 million it may not pay a dividend. However, if its net assets are, say, £1,250,000 it may pay a
dividend but only of such amount as will leave net assets of £1 million or more, so its maximum
permissible dividend is £250,000.

The dividend rules apply to every form of distribution of assets except the following:
 The issue of bonus shares whether fully or partly paid
 The redemption or purchase of the company's shares out of capital or profits
 A reduction of share capital
 A distribution of assets to members in a winding up
You must appreciate how the rules relating to public companies in this area are more stringent than the
rules for private companies.
Interactive question 8: Main rules

What are the main rules affecting a company's ability to distribute its profits as dividends?
9.4 Relevant accounts
Section overview
The profits available for distribution are generally determined from the last annual accounts to be
prepared.
Whether a company has profits from which to pay a dividend is determined by reference to its 'relevant
accounts', which are generally the last annual accounts to be prepared.
If the auditor has qualified their report on the accounts they must also state in writing whether, in their
opinion, the subject matter of their qualification is material in determining whether the dividend may
be paid. This statement must have been circulated to the members (for a private company) or
considered at a general meeting (for a public company).
A company may produce interim accounts if the latest annual accounts do not disclose a sufficient
distributable profit to cover the proposed dividend. It may also produce initial accounts if it proposes to
pay a dividend during its first accounting reference period or before its first accounts are laid before the
company in general meeting. These accounts may be unaudited, but they must suffice to permit a
proper judgement to be made of amounts of any of the relevant items.
If a public company has to produce initial or interim accounts, which is unusual, they must be full C
H
accounts such as the company is required to produce as final accounts at the end of the year. They need A
not be audited. However, the auditors must, in the case of initial accounts, satisfy themselves that the P
accounts have been 'properly prepared' to comply with the Act. A copy of any such accounts of a public T
company (with any auditors' statement) must be delivered to the Registrar for filing. E
R
9.5 Infringement of dividend rules

19
In certain situations the directors and members may be liable to make good to the company the
amount of an unlawful dividend.
If a dividend is paid otherwise than out of distributable profits the company, the directors and the
shareholders may be involved in making good the unlawful distribution.
The directors are held responsible since they either recommend to members in general meeting that a
dividend should be declared or they declare interim dividends.
(a) The directors are liable if they declare a dividend which they know is paid out of capital.
(b) The directors are liable if, without preparing any accounts, they declare or recommend a
dividend which proves to be paid out of capital. It is their duty to satisfy themselves that profits are
available.
(c) The directors are liable if they make some mistake of law or interpretation of the constitution
which leads them to recommend or declare an unlawful dividend. However, in such cases the
directors may well be entitled to relief, as their acts were performed 'honestly and reasonably'.

The directors may honestly rely on proper accounts which disclose an apparent distributable profit out
of which the dividend can properly be paid. They are not liable if it later appears that the assumptions
or estimates used in preparing the accounts, although reasonable at the time, were in fact unsound.
The position of members is as follows.
(a) A member may obtain an injunction to restrain a company from paying an unlawful dividend.
(b) Members voting in general meeting cannot authorise the payment of an unlawful dividend nor
release the directors from their liability to pay it back.
(c) The company can recover from members an unlawful dividend if the members knew or had
reasonable grounds to believe that it was unlawful.
(d) If the directors have to make good to the company an unlawful dividend they may claim
indemnity from members who at the time of receipt knew of the irregularity.
(e) Members knowingly receiving an unlawful dividend may not bring an action against the directors.
If an unlawful dividend is paid by reason of error in the accounts the company may be unable to claim
against either the directors or the members. The company might then have a claim against its auditors
if the undiscovered mistake was due to negligence on their part.
Re London & General Bank (No 2) 1895
The facts: The auditor had drawn the attention of the directors to the fact that certain loans to
associated companies were likely to prove irrecoverable. The directors refused to make any provision for
these potential losses. They persuaded the auditor to confine his comments in his audit report to the
uninformative statement that the value of assets shown in the statement of financial position 'is
dependent on realisation'. A dividend was paid in reliance on the apparent profits shown in the
accounts. The company went into liquidation and the liquidator claimed compensation from the auditor
for loss of capital due to his failure to report clearly to members what he well knew was affecting the
reliability of the accounts.
Decision: The auditor has a duty to report what he knows of the true financial position: otherwise his
audit is 'an idle farce'. He had failed in this duty and was liable.
9.6 Purchase of own shares
Section overview
You must be able to carry out simple calculations showing the amounts to be transferred to the
capital redemption reserve on purchase or redemption of own shares and how the amount of any
premium on redemption would be treated.
Any limited company is permitted without restriction to cancel unissued shares and in that way to
reduce its authorised share capital. That change does not alter its financial position.
Three factors need to be in place to give effect to a reduction of a company's issued share capital.
ARTICLES OF + SPECIAL + COURT

ASSOCIATION RESOLUTION ORDER
These must contain the A special resolution must Must be confirmed by
necessary authority. be passed. the court.
Articles usually contain the necessary power. If not, the company in general meeting would first pass a
special resolution to alter the articles appropriately and then proceed, as the second item on the agenda
of the meeting, to pass a special resolution to reduce the capital.
There are three basic methods of reducing share capital specified.
(a) Extinguish or reduce liability on partly paid shares. A company may have issued £1 (nominal)
shares 75p paid up. The outstanding liability of 25p per share may be eliminated altogether by
reducing each share to 75p (nominal) fully paid or some intermediate figure eg, 80p (nominal)

75p paid. Nothing is returned to the shareholders but the company gives up a claim against them
for money which it could call up whenever needed.
(b) Cancel paid-up share capital which has been lost or which is no longer represented by
available assets. Suppose that the issued shares are £1 (nominal) fully paid but the net assets now
represent a value of only 50p per share. The difference is probably matched by a debit balance on
retained earnings (or provision for fall in value of assets). The company could reduce the nominal
value of its £1 shares to 50p (or some intermediate figure) and apply the amount to write off the
debit balance or provision wholly or in part. It would then be able to resume payment of dividends
out of future profits without being obliged to make good past losses. The resources of the
company are not reduced by this procedure of part cancellation of nominal value of shares but it
avoids having to rebuild lost capital by retaining profits.
(c) Pay off part of the paid-up share capital out of surplus assets. The company might repay to
shareholders, say, 30p in cash per £1 share by reducing the nominal value of the share to 70p. This
reduces the assets of the company by 30p per share.
9.7 Share premium account

Whenever a company obtains for its shares a consideration in excess of their nominal value, it must
transfer the excess to a share premium account. The general rule is that the share premium account is
subject to the same restriction as share capital. However, a bonus issue can be made using the
share premium account (reducing share premium in order to increase issued share capital).
Following the decision in Shearer v Bercain 1980, there is an exemption from the general rules on setting
up a share premium account, in certain circumstances where new shares are issued as consideration for
the acquisition of shares in another company.
The other permitted uses of share premium are to pay the following:
(a) Capital expenses such as preliminary expenses of forming the company
(b) Discount on the issue of shares or debentures
(c) Premium (if any) paid on redemption of debentures
Private companies (but not public companies) may also use a share premium account in purchasing or
redeeming their own shares out of capital.
9.8 Practical reasons for purchase or redemption C

Companies may wish to repurchase or redeem their issued shares for a variety of reasons. H
A
(a) The company may have surplus funds for which it cannot identify sufficient attractive business P
opportunities. T
E
(b) A reduction in the number of issued shares helps to improve earnings per share (EPS) and return R
on capital employed (ROCE).
(c) Dividend payments may be reduced, allowing the cash to be used for other purposes: 19
 Funding operating activities
 Capital expenditure
 Repayment of debt
(d) The remaining shareholders' holdings will proportionately increase. Hence, even if the overall total
dividends might not increase, some shareholders could receive more cash individually.
(e) Problem or dissident shareholders in private companies can be paid off and leave the company
without spreading the membership of the company beyond the existing shareholders.
(f) It provides a potential exit route for venture capitalists who intend to be involved in the business
for a limited period.
(g) It provides an escape route for entrepreneurs who have taken their companies to market to take
them back into private ownership eg, Virgin, Amstrad and Harvey Nichols.

9.9 Purchase or redemption by a company of its own shares
There is a general prohibition against any voluntary acquisition by a company of its own shares, but
that prohibition is subject to exceptions.
A company may:
(a) purchase its own shares in compliance with an order of the court;
(b) issue redeemable shares and then redeem them;
(c) purchase its own shares under certain specified procedures; or
(d) forfeit or accept the surrender of its shares.
These restrictions relate to the purchase of shares: there is no objection to accepting a gift.
The conditions for the issue and redemption of redeemable shares are set out in the Companies Act
2006.
(a) The articles must give authority for the issue of redeemable shares. Articles do usually provide for it
but, if they do not, the articles must be altered before the shares are issued.
(b) Redeemable shares may only be issued if at the time of issue the company also has issued shares which
are not redeemable: a company's capital may not consist entirely of redeemable shares: s 684.
(c) Redeemable shares may only be redeemed if they are fully paid.
(d) The terms of redemption must provide for payment on redemption.
(e) The shares may be redeemed out of distributable profits, or the proceeds of a new issue of shares,
or capital (if it is a private company) in accordance with the relevant rules.
(f) Any premium payable on redemption must be provided out of distributable profits subject to an
exception described below.
The CA 2006 provides regulations which prevent companies from redeeming shares except by
transferring a sum equal to the nominal value of shares redeemed from distributable profit reserves to a
non-distributable 'capital redemption reserve'. This reduction in distributable reserves is an example of
the capitalisation of profits, where previously distributable profits become undistributable.
The purpose of these regulations is to prevent companies from reducing their share capital
investment so as to put creditors of the company at risk.
Note: Following IAS 32, redeemable preference shares are no longer classified as equity; they are
classified as financial liabilities.
Worked example: Capitalisation of profits

Suppose, for example, that Muffin Ltd decided to repurchase and cancel £100,000 of its ordinary share
capital. A statement of financial position of the company is currently as follows.
£
Assets
Cash 100,000
Other assets 300,000
400,000
Equity and liabilities
Ordinary shares 130,000
Retained earnings 150,000
Trade payables 120,000
400,000
Now if Muffin Ltd were able to repurchase the shares without making any transfer from the retained
earnings to a capital redemption reserve, the effect of the share redemption on the statement of
financial position would be as follows.

Net assets £
Non-cash assets 300,000
Less trade payables 120,000
180,000
Equity £
180,000
In this example, the company would still be able to pay dividends out of profits of up to £150,000. If it
did, the creditors of the company would be highly vulnerable, financing £120,000 out of a total of
£150,000 assets of the company.
The regulations in the Act are intended to prevent such extreme situations arising. On repurchase of the
shares, Muffin Ltd would have been required to transfer £100,000 from its retained earnings to a
non-distributable reserve, called a capital redemption reserve. The effect of the redemption of shares on
the statement of financial position would have been:
Net assets £ £
Non-cash assets 300,000
Less trade payables 120,000
180,000
Equity
Reserves
Distributable (retained earnings) 50,000
Non-distributable (capital redemption reserve) 100,000
150,000
180,000
The maximum distributable profits are now £50,000. If Muffin Ltd paid all these as a dividend, there
would still be £250,000 of assets left in the company, just over half of which would be financed by
non-distributable equity capital.
When a company redeems some shares, or purchases some of its own shares, they should be
redeemed:
(a) out of distributable profits; or C
(b) out of the proceeds of a new issue of shares. H
A
If there is any premium on redemption, the premium must be paid out of distributable profits, P
except that if the shares were issued at a premium, then any premium payable on their redemption may T
be paid out of the proceeds of a new share issue made for the purpose, up to an amount equal to the E
R
lesser of the following:
(a) The aggregate premiums received on issue of the shares
(b) The balance on the share premium account (including premium on issue of the new shares) 19
Worked example: Repurchase of shares

A numerical example might help to clarify this point. Suppose that Just Desserts Ltd intends to
repurchase 10,000 shares of £1 each at a premium of 5p per share. The redemption may be financed
out of:
(a) Distributable profits (10,000  £1.05 = £10,500).
(b) The proceeds of a new share issue (say, by issuing 10,000 new £1 shares at par). The premium of
£500 must be paid out of distributable profits.
(c) Combination of a new share issue and distributable profits.
(d) Out of the proceeds of a new share issue where the shares to be repurchased were issued at a
premium. For example, if the shares had been issued at a premium of 3p per share, then (assuming
that the balance on the share premium account after the new share issue was at least £300) £300
of the premium on redemption could be debited to the share premium account and only £200
need be debited to distributable profits.

Solution
(a) Where a company purchases its own shares wholly out of distributable profits, it must transfer to
the capital redemption reserve an amount equal to the nominal value of the shares repurchased.
In example (a) above the accounting entries would be:
£ £
DEBIT Share capital account 10,000
Retained earnings (premium on redemption) 500
CREDIT Cash 10,500
DEBIT Retained earnings 10,000
CREDIT Capital redemption reserve 10,000
(b) Where a company redeems shares or purchases its shares wholly or partly out of the proceeds of a
new share issue, it must transfer to the capital redemption reserve an amount by which the
nominal value of the shares redeemed exceeds the aggregate proceeds from the new issue
(ie, nominal value of new shares issued plus share premium).
(i) In example (b) the accounting entries would be:

£ £
DEBIT Share capital account (redeemed shares) 10,000
Retained earnings (premium) 500
CREDIT Cash (redemption of shares) 10,500
DEBIT Cash (from new issue) 10,000
CREDIT Share capital account 10,000
No credit to the capital redemption reserve is necessary because there is no decrease in the
creditors' buffer.
(ii) If the redemption in the same example were made by issuing 5,000 new £1 shares at par, and
paying £5,500 out of distributable profits:
£ £
Retained earnings (premium) 500
CREDIT Capital redemption reserve 5,000
(iii) In the example (d) above (assuming a new issue of 10,000 £1 shares at a premium of 8p per
share) the accounting entries would be:
£ £
Share premium account 800
Retained earnings 200
No capital redemption reserve is required, as in (i) above. The redemption is financed entirely
by a new issue of shares.

9.10 Commercial reasons for altering capital structure
 Greater security of finance
 Better image for third parties
 A 'neater' statement of financial position
 Borrowing repaid sooner
 Cost of borrowing reduced
Interactive question 9: Krumpet plc

Set out below is the summarised statement of financial position of Krumpet plc at 30 June 20X5.
£'000
Net assets 520
Equity
Called up share capital £1 ordinary shares 300
520
On 1 July 20X5 Krumpet plc purchased and cancelled 50,000 of its ordinary shares at £1.50 each.
The shares were originally issued at a premium of 20p. The redemption was partly financed by the issue
at par of 5,000 new shares of £1 each.
Requirement
Prepare the summarised statement of financial position of Krumpet plc at 1 July 20X5 immediately after
the above transactions have been effected.
10 Audit focus
Section overview
The auditor will need to evaluate whether the fair value of the share-based payment is appropriate. C
H
A
The auditor will require evidence in respect of all the components of the estimated amounts, as well as P
reperforming the calculation of the expense for the current year. T
E
Issue Evidence R
Number of employees in scheme/number of  Scheme details set out in contractual
instruments per employee/length of vesting period documentation
19
Number of employees estimated to benefit  Inquire of directors
 Compare to staffing numbers per forecasts and
prediction
Fair value of instruments  For equity-settled schemes check that fair value
is estimated at the grant date
 For cash-settled schemes check that the fair
value is recalculated at the end of the reporting
period and at the date of settlement
 Check that model used to estimate fair value is
in line with IFRS 2 and is appropriate to the
conditions. Consider obtaining expert advice
on the valuation if appropriate

Issue Evidence
General  Obtain representations from management
confirming their view that:
– the assumptions used in measuring the
expense are reasonable, and
– there are no share-based payment schemes
in existence that have not been disclosed to
the auditors
Interactive question 10: Share-based payments

You are the auditor of Russell plc. The draft financial statements for the year ending 31 December 20X5
show a profit before tax of £400,000. Russell plc provided four of its directors with 3,000 share options
each on 1 January 20X5 which vest on 31 December 20X7. The fair value of the options, determined by
use of the Black-Scholes model, is as follows:
£10 At the grant date
£12 On 1 January 20X6
£15 On 1 January 20X7
£13 On 31 December 20X7
The options are dependent on continued employment. All four directors are expected to remain. No
entry has been made in the financial statements of Russell plc in respect of the options on the basis that
they do not vest until 31 December 20X7.
Requirement
Identify the audit issues you would need to consider in respect of the share options.

Summary
Equity-settled Cash-settled
DEBIT Expense
DEBIT Expense CREDIT Liability
CREDIT Equity
C
H
A
P
T
E
R
19

Remain in employment
for a specified service
Achieve target period
Share price Achieve profit targets
Shareholder return Achieve earnings per
Price index share targets
Achieve flotation
Complete a particular
project

Modification to
equity instrument granted
Is the modification
beneficial?
Yes No
Increase Increase in
Decrease in Decrease in
in fair number of
fair value of number of
value of equity
equity instruments
equity instruments
instruments granted
instruments granted
Less likely
to vest
Amortise
the incremental Ignore the Treat as
fair value modification cancellation
over vesting
period
and
C
H
Revise A
vesting P
estimates T
E
R
19

Self-test
1 Which are the three types of share-based transactions covered by IFRS 2?
2 Which of the following transactions are not within the definition of a share-based payment under
IFRS 2?
(a) Employee share ownership plans (ESOPs)
(b) Transfers of equity instruments of the parent of the reporting entity to third parties that have
supplied goods or services to the reporting entity
(c) The acquisition of property, plant and equipment as part of a business combination
(d) Share appreciation rights (SARs)
(e) The raising of funds through a rights issue to all shareholders including those who are
employees
(f) Cash bonus to employees dependent on share price performance
(g) Employee share purchase plans
(h) Remuneration in non-equity shares
3 BCN Co grants 1,000 share options to each of its 300 staff to be exercised in two years' time at a
price of £6.10. The current fair value of the option is £1.40 and the expected fair value in two
years' time is £2.40 (adjusted for the possibility of forfeiture in both cases). Under IFRS 2 Share-
based Payment, how much expense would be recognised in profit or loss at the date of issue of the
options?
4 On 1 January 20X3 an entity grants 250 share options to each of its 200 employees. The only
condition attached to the grant is that the employees should continue to work for the entity until
31 December 20X6. Five employees leave during the year.
The market price of each option was £12 at 1 January 20X3 and £15 at 31 December 20X3.
Requirement
Show how this transaction will be reflected in the financial statements for the year ended
31 December 20X3.
5 On 1 July 20X4 company A granted 20 executives options to buy up to 10,000 shares each. The
options only vest if the executives are still in the service of the company on 1 July 20X6. It is
estimated that 90% of the executives will remain with the company for the duration of the vesting
period and exercise their options in full.
The following information is relevant.
 The exercise price of the option is £20 per share.
 The market value of each share was £15 on 1 July 20X4 and £18 on 30 June 20X5. It is £19
on 20 July 20X5, when the draft financial statements for the year to 30 June 20X5 are being
reviewed.
 The market value of the option is £3 on 1 July 20X4, £3.20 on 30 June 20X5, and £2.50 on
20 July 20X5.
Requirement
How should the transaction be accounted for in the financial statements for the year to
30 June 20X5?
6 An entity grants 100 share options on its £1 shares to each of its 500 employees on
1 January 20X5. Each grant is conditional upon the employee working for the entity over the next
three years. The fair value of each share option as at 1 January 20X5 is £15.
On the basis of a weighted average probability, the entity estimates on 1 January 20X5 that 20% of
employees will leave during the three-year period and therefore forfeit their rights to share options.

Requirement
Show the accounting entries which will be required over the three-year period in the event of the
following:
(a) 20 employees leave during 20X5 and the estimate of total employee departures over the
three-year period is revised to 15% (75 employees).
(b) 22 employees leave during 20X6 and the estimate of total employee departures over the
three-year period is revised to 12% (60 employees).
(c) 15 employees leave during 20X7, so a total of 57 employees left and forfeited their rights to
share options. A total of 44,300 share options (443 employees × 100 options) vested at the
end of 20X7.
7 On 1 January 20X4 an entity grants 100 cash share appreciation rights (SARs) to each of its 500
employees on condition that the employees remain in its employ for the next two years. The SARs
vest on 31 December 20X5 and may be exercised at any time up to 31 December 20X6. The fair
value of each SAR at the grant date is £7.40.
No. of
employees Estimated Intrinsic
exercising Outstanding further Fair value of value* (ie,
Year ended Leavers rights SARs leavers SARs cash paid)
£ £
31 December 50 – 450 60 8.00
20X4
31 December 50 100 300 – 8.50 8.10
20X5
31 December – 300 – – – 9.00
20X6
* Intrinsic value is the fair value of the shares less the exercise price
Requirement
Show the expense and liability which will appear in the financial statements in each of the three
years.
8 ZZX plc
C
ZZX plc has provided a share incentive scheme to a number of its employees on 1 January 20X4. H
This allows for a cash payment to be made to the individuals concerned equal to the share price at A
the end of a three-year period subject to the following conditions. P
T
(1) Vesting will be after three years. E
(2) The share price must exceed £2. R
(3) The employee must be with the company on 31 December 20X6.30
Each scheme issued will result in payment, subject to the conditions outlined, equal to the value of
19
10 shares at the end of the three-year period if the conditions are satisfied. The payments, once
earned, are irrevocable.
The finance director has been issued 20 such schemes.
The share prices over the next three years were as follows.
31 December 20X4 £2.20
Requirements
(a) Prepare the journal entries for the transactions of the share incentives issued to the finance
director.
(b) Assuming that on 1 January 20X4 nine other individuals were also granted equivalent rights to
the finance director and that on 1 January 20X5 two of those individuals left the company,
prepare the journal entries for the transactions relating to the incentive schemes.

9 Kapping
The directors of Kapping are adopting IFRS for the first time and are reviewing the impact of IFRS 2
Share-based Payment on the financial statements for the year ended 31 May 20X7. They require
you to do the following:
(a) Explain why share options, although having no cost to the company, should be reflected as
an expense in profit or loss.
(b) Discuss whether the expense arising from share options under IFRS 2 actually meets the
definition of an expense under the IASB's Conceptual Framework.
(c) Explain the impact of IFRS 2 on earnings per share, given that an expense is shown in profit or
loss and the impact of share options is recognised in the diluted earnings per share
calculation.
(d) Briefly discuss whether the requirements of IFRS 2 should lead them to reconsider their
remuneration policies.
10 Mayflower plc
Your firm has been working on a new audit assignment, Mayflower plc (Mayflower), a listed,
diversified group of companies. Its main business interests include construction, publishing, food
processing and a restaurant chain.
Mayflower's draft profit before tax for the year ended 31 March 20X8 is £17.5 million (20X7
£16.3 million) and its revenue is £234.5 million (20X7 £197.5 million).
The senior in charge of the audit for the year ended 31 March 20X8 has fallen ill towards the end
of the audit and you are now helping to complete it. There are several matters outstanding and
you will need to consider their impact on the financial statements and the audit. Your line manager
has asked to meet you to discuss the significant outstanding matters. He has asked you to prepare
briefing notes for the meeting, including your views on the impact on the financial statements and
any additional audit work that might be required, so that a way forward can be agreed.
On reviewing the previous senior's notes you find the following outstanding areas:
Forward contract
On 1 April 20X6 Mayflower entered into a forward contract to purchase a large quantity of sugar
on 1 April 20Y0. As far as we can tell, this was purely speculative based on the expectation that the
price of sugar would rise. Mayflower did not pay to enter this contract. The company has not
accounted for this contract in the years ended 31 March 20X7 or 20X8.
The finance manager of Mayflower has told us that at 31 March 20X7 the value of the contract had
risen to £800,000 and by 31 March 20X8 its fair value had risen further to £850,000.
Share options
On 1 April 20X5 Mayflower provided three of its directors with 4,000 share options each, which
vest on 1 April 20X8, assuming the directors remain in employment.
The fair values of each option were:
1 April £
20X5 12
20X6 15
20X7 17
20X8 16
We have established that no accounting entries have been made for the above.
Debenture issue
Mayflower issued a £5 million convertible debenture at par on 1 April 20X7. The debenture has an
annual nominal rate of interest of 4.5% and is redeemable on 1 April 20Y7 at par. Alternatively, the
holder has the option to convert the debenture to four million £1 shares in Mayflower.
The debenture is presented as a non-current liability at the net proceeds and this amount has not
changed since issue.

The directors have agreed to identify a suitable comparable debenture with an observable market
rate of interest, but they have not yet done so.
Properties
The audit has verified the following facts about properties held by Mayflower:
PROPERTY DESCRIPTION
Exeter House Used as the company's head office.

33–39 Reeves Road A warehouse held under a finance lease that, up to six
months ago, was used by Mayflower but has since been
rented out to a third party on a short-term lease.
41–51 Reeves Road A warehouse facility adjacent to the existing warehouse.
This was purchased in November 20X7 at a cost of
£3.8 million. Professional fees of £60,000 were also
incurred. It is currently empty and has been since
purchase, but a tenant is actively being sought.
Falcon House An office block owned by Mayflower for seven years. It is
currently all rented to a non-group company apart from
a couple of small rooms in the basement that are used
by Mayflower as an external store for some of its
records.
Mayflower has classified all these properties as investment properties and has adopted the fair value
model in accordance with IAS 40.
Since 31 March 20X8 property values have dropped by 2% on average.
We need to finalise their treatment as investment properties and verify their valuation.
Requirement
Prepare the required briefing notes on the financial reporting and auditing implications of each of
the outstanding areas for discussion with your line manager.
C
H
A
P
T
E
R
19

Technical reference
Three specific types of transactions

 Equity-settled share-based payment IFRS 2.2(a)
 Cash-settled share-based payment IFRS 2.2(b)
 Share-based payment transactions with a cash alternative IFRS 2.2(c)
Transactions excluded from scope

 Transactions with employees in their capacity as shareholders IFRS 2.4
 Issues of shares in a business combination IFRS 2.5
 Contracts that may be settled net in shares or rights to shares IFRS 2.6
Recognition
 Goods or services received in share-based transaction to be recognised as IFRS 2.8
expenses or assets
 Entity shall recognise corresponding increase in equity for equity-settled IFRS 2.7
transaction or a liability for cash-settled transactions
Equity-settled share-based transactions

 Goods or services received and corresponding increase in equity shall be IFRS 2.10
measured as fair value of goods or services received (direct method)
 If fair value of goods or services cannot be measured reliably, then measure at IFRS 2.10
fair value of instruments granted
 For transactions with third parties there is a presumption that the fair value of IFRS 2.13
the goods or services can be estimated reliably
 Fair value shall be measured at the date entity obtains the goods or IFRS 2.13
counterparty renders service
 If equity instruments vest immediately entity will recognise services received IFRS 2.14
and corresponding increase in equity immediately
 If equity instruments will be received in future, services and increase in equity IFRS 2.15
will be recognised during vesting period
 Fair value of equity instruments granted to be based on market prices if IFRS 2.16
available
 If market prices are not available a generally acceptable valuation technique IFRS 2.17
should be used
 Non-market vesting conditions shall be taken into account by adjusting the IFRS 2.19
number of equity instruments included in the measurement of the transactions
at each reporting date
 For non-market vesting conditions the amount ultimately recognised will be IFRS 2.19, 2.20
the number of equity instruments that actually vest
 For grants of equity instruments with market conditions the entity shall IFRS 2.21
recognise the goods or services from counterparty who satisfies all the other
vesting conditions irrespective of whether market conditions are satisfied
 Market conditions will be part of fair value at grant date. This should not be IFRS 2.21
revised at each reporting date and where options do not vest the charge
should not be reversed
 If vested equity instruments are forfeited, entity shall make no adjustment to IFRS 2.23
total equity except a transfer from one equity component to another

Cash-settled share-based payment transactions
 Goods or services acquired should be measured at fair value of liability IFRS 2.30
 Liability should be remeasured at each reporting date IFRS 2.30
Share-based payment transaction with cash alternative

 If counterparty has right to choose then entity has granted a compound IFRS 2.34
financial instrument with debt component and equity component
 For counterparties other than employees, the equity component is measured IFRS 2.35
as the difference between the fair value of the goods or services received and
the fair value of the debt component (the counterparty's right to demand
payment in cash)
 For transactions with employees, the entity shall measure the fair value of the IFRS 2.36, 2.37,
debt component and the fair value of the equity component separately and 2.38
account for the debt component as a cash-settled transaction and the equity
component as an equity-settled transaction
 At the date of settlement the entity shall remeasure the liability to its fair value IFRS 2.39
 Where equity instruments are paid instead of cash, the liability shall be IFRS 2.39
transferred to equity
 Where entity pays cash on settlement rather than equity, the payment is IFRS 2.40
applied to the liability. The equity components previously recognised will
remain in equity and entity can make a transfer from one component of equity
to another
 Where entity has the choice of settlement, if present obligation exists to IFRS 2.41
deliver cash, it should recognise and treat as cash-settled share-based payment
transaction
 If no present obligation exists to pay cash, entity should treat transaction as an IFRS 2.43
equity-settled transaction. On settlement if cash was paid, cash should be
treated as repurchase of equity by a deduction against equity
C
H
A
P
T
E
R
19


Fair value of options granted at grant date: 1,500 employees × 10 options × £20 = £300,000
This should be charged to profit or loss as employee remuneration evenly over the two-year period from
1 July 20X5 to 30 June 20X7.
£150,000 is recognised each year. A corresponding amount will be recognised as part of equity as the
services are recognised.

The remuneration expense for the year is based on the fair value of the options granted at the grant
date (1 January 20X3):
[400 employees – (10 leavers  4 years)] × 500 options × £10 = £1,800,000.
Therefore, the entity recognises a remuneration expense of £450,000 (£1.8m/4 years) in profit or loss
and a corresponding increase in equity of the same amount.

The total expense recorded over the expected vesting period would be as follows:
(a) All options vest: 100 options  £20 = £2,000 total expense
(b) All vesting conditions are met, except the market-based performance condition: 100 options × £20
= £2,000 total expense
(c) All vesting conditions are met, except the non market based performance condition: nil expense
(d) All vesting conditions are met, except half of the employees who received options left the company
befores the vesting date: 50 options  £20 = £1,000 total expense
Paragraph 21 of IFRS 2 states that the grant date fair value of the share-based payment with market-
based performance conditions that has met all its other vesting conditions should be recognised,
irrespective of whether that market condition is achieved. The company determines the grant date fair
value of the share-based payment excluding the non market based performance factor, but including
the market-based performance factor.

Equity
(per statement of
Expense financial position)
£ £
Year 1 660,000 660,000
Year 2 174,000 834,000
Year 3 423,000 1,257,000
WORKINGS
(1) Year 1
Equity: (440 employees × 100 options × £30)/2 years £660,000
(using original estimate of two-year period)

(2) Year 2
£
Equity c/d [(500 – 30 – 28 – 25) employees  100  £30  2/3] 834,000
(using revised estimate of three-year period)
Previously recognised (660,000)
 expense 174,000
(3) Year 3
£
Equity c/d [(500 – 30 – 28 – 23)  100  £30] 1,257,000
Previously recognised (834,000)
 expense 423,000

The incremental value is £3 per share option (£8 – £5). This amount is recognised over the remaining
two years of the vesting period, along with remuneration expense based on the original option value of
£15.
The amounts recognised in Years 1–3 are as follows.
Year £
1 Equity c/d [(500 – 110)  100  £15  1/3] 195,000
DEBIT Expenses £195,000
CREDIT Equity £195,000
2 Equity c/d [(500 – 105)  100  ((£15  2/3) + (£3  1/2 ))] 454,250
Less previously recognised (195,000)
259,250
3 Equity c/d [(500 – 103)  100  (£15 + £3)] 714,600

260,350
C
H
A
(a) Accounting entries P
T
31.12.X1 £ £ E
DEBIT Staff costs expense 188,000 R
CREDIT Equity reserve ((800 – 95)  200  £4  1/3) 188,000
31.12.X2
DEBIT Staff costs expense (W1) 201,333 19
CREDIT Equity reserve 201,333
31.12.X3
DEBIT Staff costs expense (W2) 202,667
CREDIT Equity reserve 202,667
Issue of shares:
DEBIT Cash ((800 – 40 – 20)  200  £1.50) 222,000
DEBIT Equity reserve 592,000
CREDIT Share capital (740  200  £1) 148,000
CREDIT Share premium (balancing figure) 666,000
WORKINGS
(1) Equity reserve at 31.12.X2
£
Equity c/d ((800 – 70)  200  £4  2/3) 389,333
 charge 201,333

(2) Equity reserve at 31.12.X3
£
Equity c/d ((800 – 40 – 20)  200  £4  3/3) 592,000
 charge 202,667
(b) Cash-settled share-based payment

If J&B had offered cash payments based on the value of the shares at vesting date rather than
options, in each of the three years an accrual would be shown in the statement of financial position
representing the expected amount payable based on the following:
No of employees  Number of  Fair value of each  Cumulative

estimated at the year rights each right at year end proportion
end to be entitled to of vesting
rights at the vesting period
date elapsed
The movement in the accrual would be charged to profit or loss representing further entitlements
received during the year and adjustments to expectations accrued in previous years.
The accrual would continue to be adjusted (resulting in an expense charge) for changes in the fair
value of the rights over the period between when the rights become fully vested and are
subsequently exercised. It would then be reduced for cash payments as the rights are exercised.

(a) Explanation
Employee services – no reliable fair value
Use fair value of the equity instrument
Fair value measured at grant date – and not subsequently changed
Expense in P/L over vesting period
If vesting period can vary as a result of non-market conditions, use best estimate of length of period
Best estimate of number that will vest
Credit entry to equity – separate component or retained earnings
20X7
Expense is at fair value £15 based on an expected two-year vesting period
450 employees – 30 leavers – 25 future leavers = 395 employees
Expense = 395  100 options  £15  1/2 years
= £296,250
20X8
450 employees – 30 left Year 1 – 15 left Year 2 – 26 future leavers = 379 employees
Expense is now spread over a three-year vesting period
Expense = £15  379  100  2/3 years £379,000
Less recognised in Year 1 £296,250
Year 2 expense £82,750
20X9
390  100  £15  3/3 years = £585,000
Less recognised previously £379,000
Expense in Year 3 £206,000
Double entries
£ £
20X7 DEBIT Employment costs 296,250

(b) 20Y0
If employees do not exercise their options, but allow them to lapse, the net expense recognised
does not change. As long as the options vest, an expense will appear in the accounts.
(c) In this case, the options would never vest. In 20X9, the expense would be extended to 20Y0
(effectively a four-year option scheme) before the scheme was cancelled in 20Y0 according to the
initial details of the scheme. If the non-market condition was not achieved in 20Y0, the net
expense recognised is reversed and a credit would appear in profit or loss for 20Y0 to the value of
the previous cumulative expense recognised (in 20X9 this was £585,000). A market condition not
being achieved would never affect the expense being recognised, as the share price movement is
called 'volatility' which is included in the £15 fair value.

Dividends may only be paid by a company out of profits available for the purpose. There is a detailed
code of statutory rules which determines what are distributable profits. The profits which may be
distributed as dividend are accumulated realised profits, so far as not previously used by distribution or
capitalisation, less accumulated realised losses, so far as not previously written off in a reduction or
reorganisation of capital duly made.
The word 'accumulated' requires that any losses of previous years must be included in reckoning the
current distributable surplus.
The word 'realised' presents more difficulties. It may prevent the distribution of an increase in the value
of a retained asset at fair value through profit or loss. However, it does not prevent a company from
transferring to retained earnings profit earned on an uncompleted contract, if it is in accordance with
generally accepted accounting principles. In view of the authority of accounting standards, it is unlikely
that profits determined in accordance with accounting standards would be considered unrealised. A
realised capital loss will reduce realised profits.
The above rules on distributable profits apply to all companies, private or public. A public company is
subject to an additional rule which may diminish but cannot increase its distributable profit as
determined under the above rules.
aggregate of its called-up share capital and undistributable reserves. The dividend which it may pay is
limited to such amount as will leave its net assets at not less than that aggregate amount.
C
H
Answer to interactive question 9 A
WORKINGS FOR KRUMPET PLC P
£ £ T
E
Cost of redemption (50,000  £1.50) 75,000 R
Premium on redemption (50,000  50p) 25,000

No premium arises on the new issue 19
Distributable profits
Retained earnings before redemption 160,000
Premium on redemption (25,000 – 5,000 charged to share
premium account) (20,000)
140,000
Remainder of redemption costs 50,000
Proceeds of new issue 5,000  £1 (5,000)
Remainder out of distributable profits (45,000)
Balance on retained earnings 95,000

Statement of financial position of Krumpet plc as at 1 July 20X5
£'000
Net assets (520 – 75 + 5) 450
Capital and reserves
Ordinary shares (300 – 50 + 5) 255
Share premium: 60,000 less 5,000
(10,000 allowable, being premium on original issue of 50,000 × 20p, restricted to
proceeds of new issue of 5,000) 55
Capital redemption reserve 45
355
Retained earnings (W) 95
450

Audit issues:
 Consider compliance with IFRS 2. Based on the fair value at grant date (as provided) the total
remuneration expense would be as follows:
4 × 3,000 × £10 = £120,000
The expense would then be recognised over the vesting period of three years. An amount of
£40,000 should be recognised in 20X5 as an expense in profit or loss for the year with a
corresponding credit in equity.
 The expense of £40,000 represents 10% of the profit before tax and is therefore likely to be
material to the financial statements.
 Whether the basis of valuing fair value is appropriate. Ideally fair value should be based on market
price if available. As the options have a relatively short life the valuation method used may provide
a reasonable approximation to fair value.
 Adequacy of disclosure in accordance with IFRS 2.

1 (1) Equity-settled share-based payment transactions

(2) Cash-settled share-based payment transactions
(3) Transactions with a choice of settlement
2 The following transactions are not within the definition of a share-based payment under IFRS 2:
(c) The acquisition of property, plant and equipment as part of a business combination.
This is within the scope of IFRS 3 Business Combinations.
(e) The raising of funds through a rights issue to all shareholders including those who are
employees.
IFRS 2 does not apply to transactions with employees in their capacity as shareholders.
(h) Remuneration in non-equity shares.
Payment in non-equity shares does not fall within the scope of IFRS 2 since it is a transaction
in which the entity receives goods and services in return for a financial liability.
3 No expense is recognised at the issue date of the options, but the expected benefit is accrued as a
cost over the life of the option:
300 employees × 1,000 options × £1.40 = £420,000
This is spread equally over the two-year period to vesting, resulting in an annual charge to profit or
loss of £210,000.
This would not be adjusted for any changes in expected benefit due to changes in expected share
price as the value is measured at grant date, but is adjusted for the numbers of employees entitled
to options at each reporting date.
4 The remuneration expense for the year is based on the fair value of the options granted at the
grant date (1 January 20X3). As five of the 200 employees left during the year it is reasonable to
assume that 20 employees will leave during the four-year vesting period and that therefore 45,000
options (250  180) will actually vest.
Statement of profit or loss and other comprehensive income C
H
Staff costs (45,000 × £12)/4 years £135,000 A
P
Statement of financial position T
E
Equity £135,000 R
5 IFRS 2 requires that share-based transactions made in return for goods or services are recognised in
the financial statements. The granting of options to the senior executives is a share-based payment
under IFRS 2 and will need to be recognised as a remuneration expense. The amount to be 19
charged as an expense is measured at the fair value of the goods or services provided as
consideration for the share-based payment or at the fair value of the share-based payment,
whichever can be more reliably measured.
In the case of employee share options, the market value of the options on the day these are
granted is used, as this can be measured more reliably. The market value of the share options at
the day these were granted, 1 July 20X4, was £3 each.
The exercise price for the option at £20 per share is above the market price on the date of issue on
1 July 20X4. This, however, does not mean that the option has zero market value. It has no intrinsic
value, but it has what is referred to as time value relating to expectations of a share price increase
over time.
The options vest at the end of the two-year period. The company expects that 90% of the options
will vest, as it is estimated that 90% of the executives will remain in employment for the two-year
period and thus be able to exercise their options in full.

The remuneration expense will be 10,000 × £3  20 × 90% = £540,000 and, as this vests over a
two-year period, the entry to income for the current year to 30 June 20X5 will relate to half that
amount: 1/2  £540,000 = £270,000.
£ £
DEBIT Share-based payment remuneration expense 270,000
CREDIT Equity share-based payment reserve 270,000
When the shares are issued a transfer will be made from that reserve together with any further proceeds
(if any) of the shares and will be credited to the share capital and share premium accounts.
6
£
(a) 20X5 Equity c/d (500 × 85%  100  £15  1/3) = 212,500

£
(b) 20X6 Equity c/d (500 × 88% × 100 × £15 × 2/3) = 440,000
227,500
£
(c) 20X7 Equity c/d (443 × 100 × £15) = 664,500
224,500
7
£
Year ended 31 December 20X4
Expense and liability ((450 – 60) × 100 × £8.00 × 1/2) 156,000
Liability c/d (300 × 100 × £8.50) 255,000
Less b/d liability (156,000)
99,000
Plus cash paid on exercise of SARs by employees
(100 × 100 × £8.10) 81,000
Expense 180,000
Liability c/d –
Less b/d liability (255,000)
(255,000)
Plus cash paid on exercise of SARs by employees
(300 × 100 × £9.00) 270,000
Expense 15,000
8 ZZX plc
(a) Journal entries for transactions: finance director
The transactions are settled in cash and hence liabilities are created.
DEBIT Expense 147
CREDIT Liability 147
It is assumed that the current share price is the best estimate of the final share price.
(Calculation note: 20  10  £2.20  1/3)
DEBIT Liability 147
CREDIT Expense 147

Reverses entries for 20X4 as share price is less than minimum
DEBIT Expense 480
CREDIT Liability 480
DEBIT Liability 480
CREDIT Cash 480
(20  10  £2.40  3/3)
(b) Journal entries for transactions: other individuals
DEBIT Expense 1,467
CREDIT Liability 1,467
(Calculation note: 20  10  10  £2.20  1/3)
DEBIT Liability 1,467
CREDIT Expense 1,467
31 December 20X6
DEBIT Expense 3,840
CREDIT Liability 3,840
DEBIT Liability 3,840
CREDIT Cash 3,840
(Calculation note: 20  10  8  £2.40  3/3)
9 Kapping
(a) When shares are issued for cash or in a business combination, an accounting entry is needed
to recognise the receipt of cash (or other resources) as consideration for the issue. Share
options (the right to receive shares in future) are also issued in consideration for resources:
services rendered by directors or employees. These resources are consumed by the company
and it would be inconsistent not to recognise an expense.
(b) The Framework defines an expense as a decrease in economic benefits in the form of outflows
of assets or incurrences of liabilities. It is not immediately obvious that employee services meet
the definition of an asset and therefore it can be argued that consumption of those services
does not meet the definition of an expense. However, share options are issued for
consideration in the form of employee services so that arguably there is an asset, although it is C
consumed at the same time that it is received. Therefore the recognition of an expense H
A
relating to share-based payment is consistent with the Framework.
P
(c) It can be argued that to recognise an expense in profit or loss would have the effect of T
distorting diluted earnings per share as diluted earnings per share would then take the E
R
expense into account twice. This is not a valid argument. There are two events involved:
issuing the options and consuming the resources (the directors' service) received as
consideration.
19
The diluted earnings per share calculation only reflects the issue of the options; there is no
adjustment to basic earnings. Recognising an expense reflects the consumption of services.
There is no 'double counting'.
(d) It is true that accounting for share-based payment reduces earnings. However, it improves the
information provided in the financial statements, as these now make users aware of the true
economic consequences of issuing share options as remuneration. The economic
consequences are the reason why share option schemes may be discontinued. IFRS 2 simply
enables management and shareholders to reach an informed decision on the best method of
remuneration, weighing the advantages of granting these and their potential beneficial effect
on motivation and corporate performance against the disadvantages of the impact on
earnings.

10 Mayflower plc
Tutorial note
This question includes a revision of the audit of financial instruments and investment properties.
(a) Forward contract

Accounting issues
 At 31 March 20X7 there was an increase in the value of the derivative asset of £800,000
and this gain should have been included in profit or loss for the year ended 31 March
20X7.
 A prior year adjustment is needed in respect of the error of £800,000 not recognised in
the opening balance. In accordance with IAS 8 this will be adjusted directly through
reserves. The amount is likely to be material. Also the comparatives would need to be
restated.
 The derivative will therefore be shown as an asset in the statement of financial position at
£800,000 and £850,000 in the two years ended 31 March 20X7 and 20X8 respectively.
Audit procedures
 Review terms of the contract to determine the appropriate treatment ie, as a derivative
financial asset
 The reason for the non-recognition of the fair value last year should be established and
the systems for identifying and measuring forward contracts with zero initial values
should be established
 General checks:
– Obtain an understanding of the factors which affect the entity's derivative activities
– Assess level of audit risk re the forward contract (and ensure audit procedures
reduce the risk to an acceptable level)
– Understand systems for dealing with forward contracts – ensure they cover
authorisations, checking for completeness and accuracy, appropriate accounting for
changes in values, ongoing monitoring, how errors are prevented and detected
– Ensure data is secure
– Check if there have been any margin settlements made
 Check the amounts at the year ends:
– Inspect contract and confirm that Mayflower did not pay to enter the contract
– Confirm no changes in contract
– Assess the expertise and experience of the finance manager in determining the fair
values and confirm that these have been derived in accordance with IFRS 13
(ie, Level 1 or Level 2 inputs)
– Review documentation supporting information used by management including any
assumptions made
– Inquire whether management experts have been used to measure fair value and
determine disclosures
– Look for evidence of year-end fair values (quoted market price). The fair values of
the forward contract would need to be attested. As sugar is traded on an active
international market there should be sufficient publicly available information to
observe the fair value of equivalent futures trades in an open market ie, in the
principal market
– Recalculate the value of the derivative asset
– Obtain written representations from management

– Review events after the year end which may provide evidence about valuation at
the period end
 Check IFRS 7 and IFRS 13 disclosure:
– Accounting policy for financial instruments and how fair value is measured
(valuation technique and inputs used)
– Appropriate gains recognised in profit or loss for the year
– Fair value ensuring the information can be compared with prior year
– Nature and extent of risks arising
(b) Share options
Accounting issues
 IFRS 2 deals with this area.
 The total remuneration expense, based on the fair value at the grant date, would be:
3  4,000  £12 = £144,000. This should have been spread evenly over the vesting period of
three years assuming that there were no changes in assessment of when the directors would
leave the company (and assuming that none of them have left). If there have been any
variations over time as to the likelihood of the three directors being in post at vesting then
there may be an adjustment to the amounts below (in particular if there was any change in
numbers of shares vesting between last year and this year).
 This will necessitate a prior period adjustment of £144,000  2/3 = £96,000 which would be
debited to retained earnings and credited to a share option reserve (or other appropriate
reserve). As the standard only requires the credit to be posted to equity it is possible for no
double entry to be posted at all (as retained earnings may substitute for a share option
reserve). Regardless of how the accounting is reflected, the comparatives will need to be
adjusted.
 The current year expense of £48,000 will be treated in the same way as above except that it
will be included in profit or loss for the current year – most appropriately as a staff cost.
Audit procedures
 View documentation to verify option terms such as exercise price and term to vesting date.
 Ensure relevant directors are still employed. C
H
 Investigate whether there was any indication that they might leave in the past, as this could A
affect the estimation basis of the prior period adjustment. P
T
 Determine the basis on which the fair value of the options has been calculated – should be E
based on appropriate valuation based on market prices wherever possible. If an option pricing R
model has been used, determine which method has been adopted and whether it is
appropriate and reflects the nature of the options.
19
 Confirm that the fair value is calculated as at the grant date and that this is when offer and
acceptance has taken place.
 Recalculate the fair value using the same inputs and consider obtaining expert advice if
appropriate.
 Check volatility to published statistics.
 Agree share price at issue to market price on that date.
 Agree risk-free rate appropriate at time of granting options.
 Assess whether there are any terms of the share option which give the directors a choice of
exercise through cash receipt as opposed to exercising the share options.
 Recalculate the expense spread over the vesting period.

 Obtain written representations from management confirming their view that any assumptions
they have used in measuring fair value are reasonable and that there are no further share-
based payment schemes in existence that have not been disclosed.
 Check disclosure is in accordance with IFRS 2.
(c) Debenture
Accounting issues
 The current treatment of leaving the debenture at the value of the net proceeds does not
comply with IAS 39 and IAS 32, as there has been no accounting for the post-issue finance
costs and the fact that the instrument is a hybrid instrument which needs to be split into
liability and equity components.
 Calculate the liability element as the present value of the cash flows of the debenture,
discounted at the market rate of interest for comparable borrowings with no conversion
rights. This will require some attention on our part, to ensure that an appropriate interest rate
has been selected.
 Classify as equity the remainder of the proceeds representing the fair value of the right to
convert.
 The market rate of interest should then be used to unwind the discounting for the current
year which will bring the liability closer to the final redemption value and allocate an
appropriate finance charge to profit or loss. The annual interest payment will also be recorded
as a cash flow and will reduce the liability.
Audit procedures
 Review debenture deed and agree nominal interest rates and conversion terms.
 Review calculation of the fair value of the liability at the date of issue.
 Confirm appropriate discount rate used by reference to external market while considering if
market rates are representative of the instrument issued.
 We should discuss and assess the reasons for the selection of the rate by management and the
assumptions made.
 We should review interest rates associated with companies in the industries which make up
Mayflower's core interests and also some conglomerates (even though the mix is highly
unlikely to be anything like Mayflower's) and compare these with the rate selected by
management. We could also perform a sensitivity analysis, if a material risk is identified, in
order to quantify the effect of changing the interest rate.
 Agree calculation of amortised cost after it has been performed by the directors.
 Agree initial proceeds and interest payments to records and bank statement.
 Review disclosures and ensure in accordance with IAS 32, IAS 39, IFRS 7 and IFRS 13.
(d) Properties
Accounting issues
Classification as investment property:
Exeter House This property does not fall within the definition of investment
property in accordance with IAS 40, as it is owner occupied. It
should be accounted for as property, plant and equipment
under IAS 16.
33–39 Reeves Road Although this property is not legally owned, it is held under a
finance lease and can be treated as an investment property
from the date of renting out to a third party.
41–51 Reeves Road Although vacant it can be classified as an investment property
as it is held for investment purposes.

Falcon House This property is owned by Mayflower and the vast majority of
it is let out to third parties. It appears unlikely that the two
parts of the property (that rented to a third party and that
used by Mayflower) could be sold or leased separately,
particularly the part used by Mayflower, as it is a couple of
small rooms in the basement. It is therefore inappropriate to
treat the two parts separately as investment property and
property, plant and equipment respectively. As the part used
by Mayflower appears to be an insignificant portion of the
whole, the whole property can be treated as an investment
property.
Valuation
Exeter House This should be valued according to IAS 16 (at cost or revalued
amount less depreciation).
33–39 Reeves Road This should have been recognised at the inception of the lease
at the lower of the fair value and the present value of the
minimum lease payments. On being rented out it would be
valued at fair value in accordance with company policy in
respect of investment properties. The revaluation to fair value
on transfer to investment properties is accounted for under IAS
16. Thereafter changes in fair value are recognised in profit or
loss.
41–51 Reeves Road This should be initially recognised at cost, including transaction
costs. As the fair value model is being adopted the asset should
be subsequently recognised at fair value. Changes in fair value
are recognised in profit or loss.
Falcon House Recognised at fair value, changes in fair value are recognised in
profit or loss, as above.
IAS 40 requires that the fair value of the investment properties should be measured in accordance
with IFRS 13.
Audit procedures
C
 Confirm that all investment properties are classified in accordance with IAS 40 definitions H
(see above). A
P
 Ensure that Exeter House is reclassified as property, plant and equipment. T
E
 Assess useful life of Exeter House and residual value in order to recalculate and agree R
depreciation charged.
 Determine the valuation policy to be used for Exeter House ie, cost or valuation and ensure
19
that the policy is correctly applied.
 Evaluate the process by which Mayflower establishes fair values of investment properties and
the control environment around such procedures.
 Determine basis for calculation of fair values (per IAS 40 (40) fair value must reflect rental
income from current leases and other assumptions that market participants would use when
pricing investment property under current market conditions). Look for best evidence of fair
value (for example, year-end prices in an active market for similar properties in the same
location and condition).
 If external valuers have been used agree valuation to valuer's certificate and assess the extent
that they can be relied on in accordance with ISA 620.
 If fair values have been based on discounted cash flows, ie, future rentals, determine whether
this is the most appropriate estimate of a market-based exit value. Compare predicted cash
flows with rental agreements. Review the basis of the interest rate applied.

 Review documentation to support method used.
 Recalculate the gain or loss on change in fair value and agree to amount recognised in profit
or loss.
 If fair value cannot be measured reliably confirm use of cost model.
 Agree disclosure is in accordance with IAS 40 and IFRS 13.

CHAPTER 20
Groups: types of investment

and business combination
Introduction
Topic List
1 Summary and categorisation of investments
2 IFRS 10 Consolidated Financial Statements
3 IFRS 3 (Revised) Business Combinations
4 IFRS 13 Fair Value Measurement (business combination aspects)
5 IAS 28 Investments in Associates and Joint Ventures
6 IFRS 11 Joint Arrangements
7 Question technique and practice
8 IFRS 12 Disclosure of Interests in Other Entities
9 Step acquisitions
10 Disposals
11 Consolidated statements of cash flows
12 Audit focus: group audits
13 Auditing global enterprises
Technical reference
1001
Introduction
 Identify and show the criteria used to determine whether and how different types of
investment are recognised and measured as business combinations
 Calculate and disclose, from financial and other data, the amounts to be included in an
entity's consolidated financial statements in respect of its new, continuing and
discontinued interests (which include situations when acquisitions occur in stages and in
partial disposals) in subsidiaries, associates and joint ventures
of details
 Appraise and evaluate cash flow measures and disclosures in single entities and groups
Specific syllabus references for this chapter are: 4(b), 6(a), 6(b), 14(c), 14(d), 14(f)

1 Summary and categorisation of investments
Section overview
 This chapter revises IFRS 3 Business Combinations, which was covered at Professional Level. It also
covers the following standards:
– IFRS 13 Fair Value Measurement (business combination aspects)
– IFRS 10 Consolidated Financial Statements
– IAS 28 Investments in Associates and Joint Ventures
– IFRS 11 Joint Arrangements
– IFRS 12 Disclosure of Interests in Other Entities
 Some of the above standards, or the topics to which they relate, were covered at Professional
Level, but a deeper knowledge is needed at Advanced Level.
A summary of the different types of investment and the required accounting for them is as follows.
Investment Criteria Required treatment in group accounts
Subsidiary Control Full consolidation (IFRS 10)

Associate Significant influence Equity accounting (IAS 28)
Joint venture Contractual arrangement Equity accounting (IAS 28), distinguish from
joint operation (IFRS 11)
Investment which is Asset held for accretion of As for single company accounts (per IAS 39)
none of the above wealth
1.1 Investments in subsidiaries

The important point here is control. In most cases, this will involve the parent company owning a
majority of the ordinary shares in the subsidiary (to which normal voting rights are attached). There are
circumstances, however, when the parent may own only a minority of the voting power in the
subsidiary, but the parent still has control.
IFRS 10 Consolidated Financial Statements, issued in 2011, retains control as the key concept underlying
the parent/subsidiary relationship but it has broadened the definition and clarified its application. This
will be covered in more detail in section 2 below.
IFRS 10 states that an investor controls an investee if and only if it has all of the following.
(a) Power over the investee
(b) Exposure, or rights, to variable returns from its involvement with the investee (see section 2)
(c) The ability to use its power over the investee to affect the amount of the investor's returns (see
section 2)
1.2 Investments in associates

C
The key criterion here is significant influence. This is defined as the 'power to participate', but not to H
'control' (which would make the investment a subsidiary). A
P
Significant influence is presumed to exist if an investor holds 20% or more of the voting power of the T
investee, unless it can be clearly shown that this is not the case. E
R
However, the existence of significant influence can also be evidenced in other ways.
 Representation on the board of directors of the investee
20
 Participation in the policy making process
 Material transactions between investor and investee
 Interchange of management personnel
 Provision of essential technical information
Groups: types of investment and business combination 1003

IAS 28 Investments in Associates and Joint Ventures requires the use of the equity method of accounting
for investments in associates. This method will be explained in section 5.
1.3 Accounting for investments in joint arrangements

IFRS 11 classes joint arrangements as either joint operations or joint ventures. The classification of a
joint arrangement as a joint operation or a joint venture depends on the rights and obligations of the
parties to the arrangement.
The detail of how to distinguish between joint operations and joint ventures will be considered in
section 6.
1.3.1 Accounting treatment in group accounts

IFRS 11 requires that a joint operator recognises line by line the following in relation to its interest in a
joint operation:
 Its (the joint operation's) assets, including its (the investor's) share of any jointly held assets
 Its liabilities, including its share of any jointly incurred liabilities
 Its revenue from the sale of its share of the output arising from the joint operation
 Its share of the revenue from the sale of the output by the joint operation
 Its expenses, including its share of any expenses incurred jointly
This treatment is applicable in both the separate and consolidated financial statements of the joint
operator.
In its consolidated financial statements, IFRS 11 requires that a joint venturer recognises its interest in a
joint venture as an investment and accounts for that investment using the equity method in
accordance with IAS 28 Investments in Associates and Joint Ventures unless the entity is exempted from
applying the equity method (see section 5).
In its separate financial statements, a joint venturer should account for its interest in a joint venture in
accordance with IAS 27 (2011) Separate Financial Statements, namely:
 at cost;
 in accordance with IAS 39 Financial Instruments: Recognition and Measurement; or
 using the equity method specified in IAS 28.
1.4 Other investments

Investments which do not meet the definitions of any of the above should be accounted for according
to IAS 39 Financial Instruments: Recognition and Measurement. An example of such an investment would
be a 15% shareholding in a company with no significant influence.
2 IFRS 10 Consolidated Financial Statements
Section overview
IFRS 10 covers the basic definitions and consolidation requirements and the rules on exemptions from
preparing group accounts. The standard requires a parent to present consolidated financial
statements, consolidating all subsidiaries, both foreign and domestic. The most important aspect is
control.
2.1 Introduction
When a parent issues consolidated financial statements, it should consolidate all subsidiaries, both
foreign and domestic. The first step in any consolidation is to identify the subsidiaries present in the
group.

Definition
Consolidated financial statements: The financial statements of a group presented as those of a single
economic entity. (IFRS 10)
You should make sure that you understand the various ways in which control can arise, as this is
something that you may be asked to discuss in the context of a scenario in the exam.
2.1.1 Power
Power is defined as existing rights that give the current ability to direct the relevant activities of
the investee. There is no requirement for that power to have been exercised.
Relevant activities may include:
 selling and purchasing goods or services
 managing financial assets
 selecting, acquiring and disposing of assets
 researching and developing new products and processes
 determining a funding structure or obtaining funding
In some cases assessing power is straightforward; for example, where power is obtained directly and
solely from having the majority of voting rights or potential voting rights, and as a result the ability to
direct relevant activities.
In other cases, assessment is more complex and more than one factor must be considered. IFRS 10 gives
the following examples of rights, other than voting or potential voting rights, which individually, or
alone, can give an investor power.
 Rights to appoint, reassign or remove key management personnel who can direct the relevant
activities
 Rights to appoint or remove another entity that directs the relevant activities
 Rights to direct the investee to enter into, or veto changes to, transactions for the benefit of the
investor
 Other rights, such as those specified in a management contract
Voting rights in combination with other rights may give an investor the current ability to direct the
relevant activities. For example, this is likely to be the case when an investor holds 40% of the voting
rights of an investee and holds substantive rights arising from options to acquire a further 20% of the
voting rights.
IFRS 10 suggests that the ability rather than contractual right to achieve the above may also indicate
that an investor has power over an investee.
An investor can have power over an investee even where other entities have significant influence or
other ability to participate in the direction of relevant activities.
2.1.2 Returns
An investor must have exposure, or rights, to variable returns from its involvement with the investee in
order to establish control. C
H
This is the case where the investor's returns from its involvement have the potential to vary as a result of A
the investee's performance. P
T
Returns may include the following: E
R
 Dividends
 Remuneration for servicing an investee's assets or liabilities
20
 Fees and exposure to loss from providing credit support
 Returns as a result of achieving synergies or economies of scale through an investor combining use
of their assets with use of the investee's assets

2.1.3 Link between power and returns
In order to establish control, an investor must be able to use its power to affect its returns from its
involvement with the investee. This is the case even where the investor delegates its decision-making
powers to an agent.
Worked examples: Control

(a) Twist holds 40% of the voting rights of Oliver and twelve other investors each hold 5% of the
voting rights of Oliver. A shareholder agreement grants Twist the right to appoint, remove and set
the remuneration of management responsible for directing the relevant activities. To change the
agreement, a two-thirds majority vote of the shareholders is required. To date, Twist has not
exercised its rights with regard to the management or activities of Oliver.
Requirement
Explain whether Twist should consolidate Oliver in accordance with IFRS 10.
(b) Copperfield holds 45% of the voting rights of Spenlow. Murdstone and Steerforth each hold 26%
of the voting rights of Spenlow. The remaining voting rights are held by three other shareholders,
each holding 1%. There are no other arrangements that affect decision-making.
Requirement
Explain whether Copperfield should consolidate Spenlow in accordance with IFRS 10.
(c) Scrooge holds 70% of the voting rights of Cratchett. Marley has 30% of the voting rights of
Cratchett. Marley also has an option to acquire half of Scrooge's voting rights, which is exercisable
for the next two years, but at a fixed price that is deeply out of the money (and is expected to
remain so for that two-year period).
Requirement
Explain whether either of Scrooge or Marley should consolidate Cratchett in accordance with
IFRS 10.
Solution
(a)
Twist
12 others × 5% = 60%
Shareholder
agreement 40%
Oliver
The absolute size of Twist's holding and the relative size of the other shareholdings alone are not
conclusive in determining whether the investor has rights sufficient to give it power. However, the
fact that Twist has a contractual right to appoint, remove and set the remuneration of
management is sufficient to conclude that it has power over Oliver. The fact that Twist has not
exercised this right is not a determining factor when assessing whether Twist has power. In
conclusion, Twist does control Oliver, and should consolidate it.

(b)
Copperfield Murdstone Steerforth 3 others × 1%
= 3%
45% 26% 26%
Spenlow
In this case, the size of Copperfield's voting interest and its size relative to the other shareholdings
are sufficient to conclude that Copperfield does not have power. Only two other investors,
Murdstone and Steerforth, would need to co-operate to be able to prevent Copperfield from
directing the relevant activities of Spenlow.
(c)
Scrooge Marley
35% + 35% ??
= 70% 30%
Option
Cratchett
Scrooge holds a majority of the current voting rights of Cratchett, so is likely to meet the power
criterion because it appears to have the current ability to direct the relevant activities. Although
Marley has currently exercisable options to purchase additional voting rights (that, if exercised,
would give it a majority of the voting rights in Cratchett), the terms and conditions associated with
those options are such that the options are not considered substantive.
Thus voting rights, even combined with potential voting rights, may not be the deciding factor.
Scrooge should consolidate Cratchett.
2.2 Exemption from preparing group accounts

A parent need not present consolidated financial statements if and only if all of the following hold:
(a) The parent is itself a wholly owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been informed
about, and do not object to, the parent not presenting consolidated financial statements.
(b) Its debt or equity instruments are not publicly traded.
C
(c) It is not in the process of issuing securities in public securities markets. H
A
(d) The ultimate or intermediate parent publishes consolidated financial statements that comply P
with International Financial Reporting Standards. T
E
A parent that does not present consolidated financial statements must comply with the IAS 27 rules on
R
separate financial statements.
Although a parent may not have to prepare consolidated financial statements, it may wish to provide
qualitative information about the nature and size of ownership of un-consolidated subsidiaries as this 20
could be beneficial to the users of the financial statements.

2.3 Potential voting rights
An entity may own share warrants, share call options or other similar instruments that are convertible
into ordinary shares in another entity. If these are exercised or converted they may give the entity
voting power or reduce another party's voting power over the financial and operating policies of the
other entity (potential voting rights). The existence and effect of potential voting rights, including
potential voting rights held by another entity, should be considered when assessing whether an entity
has control over another entity (and therefore has a subsidiary). Potential voting rights are considered
only if the rights are substantive (meaning that the holder must have the practical ability to exercise the
right).
In assessing whether potential voting rights give rise to control, the investor should consider the
purpose and design of the instrument. This includes an assessment of the various terms and
conditions of the instrument as well as the investor's apparent expectations, motives and reasons for
agreeing to those terms and conditions.
2.4 Exclusion of a subsidiary from consolidation

Where a parent controls one or more subsidiaries, IFRS 10 requires that consolidated financial
statements are prepared to include all subsidiaries, both foreign and domestic, other than:
 those held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued
Operations; and
 those held under such long-term restrictions that control cannot be operated.
The rules on exclusion of subsidiaries from consolidation are necessarily strict, because this is a common
method used by entities to manipulate their results. If a subsidiary which carries a large amount of debt
can be excluded, then the gearing of the group as a whole will be improved. In other words, this is a
way of taking debt out of the consolidated statement of financial position.
IFRS 10 is clear that a subsidiary should not be excluded from consolidation simply because it is loss
making or its business activities are dissimilar from those of the group as a whole. IFRS 10 rejects the
latter argument: exclusion on these grounds is not justified because better information can be provided
about such subsidiaries by consolidating their results and then giving additional information about the
different business activities of the subsidiary, eg, under IFRS 8 Operating Segments.
2.5 Other matters

Different reporting dates
Where one or more subsidiaries prepare accounts to a different reporting date from the parent and the
bulk of other subsidiaries in the group:
(a) the subsidiary may prepare additional statements to the reporting date of the rest of the group, for
consolidation purposes; or
(b) if this is not possible, the subsidiary's accounts may still be used for consolidation provided that
the gap between the reporting dates is three months or less and that adjustments are made for
the effects of significant transactions or other events that occur between that date and the parent's
reporting date.
Uniform accounting policies
Uniform accounting policies should be used and adjustments must be made where the subsidiary's
policies differ from those of the parent.
Date of inclusion/exclusion
The results of subsidiary undertakings are included in the consolidated financial statements from:
(a) the date of 'acquisition' ie, the date on which the investor obtains control; to
(b) the date of 'disposal' ie, the date when the investor loses control.
Once an investment is no longer a subsidiary, it should be treated as an associate under IAS 28
(if applicable) or as an investment under IAS 39.

Accounting for subsidiaries and associates in the parent's separate financial statements
A parent company will usually produce its own single company financial statements. In these
statements, governed by IAS 27 Separate Financial Statements, investments in subsidiaries and associates
included in the consolidated financial statements should be either:
 accounted for at cost;
 in accordance with IAS 39; or
 using the equity method specified in IAS 28 (this follows an August 2014 amendment to IAS 27).
Where subsidiaries are classified as held for sale in accordance with IFRS 5 they should be accounted
for in accordance with IFRS 5.
Non-controlling interest (NCI)
Within the statement of profit or loss and other comprehensive income, profit for the year and total
comprehensive income must be split between the shareholders of the parent and the non-controlling
interest.
IFRS 10 requires an entity to attribute their share of total comprehensive income to the non-controlling
interest, even if this results in a negative (debit) NCI balance.
Acquisitions and disposals which do not result in a change of control
Acquisitions of further shares in an existing subsidiary or disposals of shares by a parent which do not
result in a loss of control are accounted for within shareholders' equity.
No gain or loss is recognised and goodwill is not remeasured.
This is explained further within sections 9 and 10 of this chapter.
Loss of control
Where a parent loses control of a subsidiary:
 assets, liabilities and the non-controlling interest must be derecognised;
 any interest retained is recognised at fair value at the date of loss of control; and
 a gain or loss on loss of control is recognised in profit or loss.
This is explained further within section 10 of this chapter.
3 IFRS 3 (Revised) Business Combinations
Section overview
 IFRS 3 refers to business combinations as 'transactions or events in which an acquirer obtains
control of one or more businesses'. In a straightforward business combination one entity acquires
another, resulting in a parent/subsidiary relationship.
 Business combinations are accounted for using the acquisition method.
3.1 The acquisition method C

H
All business combinations should be recognised using the acquisition method which involves the A
following steps. P
T
(1) Identifying an acquirer – which obtains control of the other entity. If this cannot be established E
from shareholdings and other factors listed in IFRS 10 (see section 2.1 above), IFRS 3 provides R
additional indicators, such as the fact that the entity with the larger fair value is likely to be the
acquirer.
20
(2) Determining the acquisition date. This is generally the date on which the parent company
(acquirer) transfers consideration and acquires the net assets of the acquiree.

(3) Recognising and measuring the identifiable assets acquired, the liabilities assumed and any
non-controlling interest in the acquiree.
(4) Recognising and measuring goodwill or a gain from a bargain purchase.
Measurement of the non-controlling interest in Step 3 along with the measurement of goodwill in
Step 4 are covered in more detail in the next section.
Measurement of the identifiable assets and liabilities in Step 3 is covered in section 3.6 of this chapter.
3.2 Calculation of goodwill

IFRS 3 (revised) requires goodwill acquired in a business combination (or a gain on a bargain purchase)
to be measured as:
£
Consideration transferred: Fair value of assets given, liabilities assumed and
equity instruments issued, including contingent amounts X
Non-controlling interest at the acquisition date X
X
Less total fair value of net assets of acquiree (X)
Goodwill/(gain from a bargain purchase) X/(X)
This calculation includes the non-controlling interest and is therefore calculated based on the whole net
assets of the acquiree.
Sections 3.3 and 3.4 consider the first two elements of the revised calculation – consideration
transferred and the non-controlling interest – in more detail.
Worked example: Calculation of goodwill 1

On 1 January 20X7, Avon acquired 80% of the equity share capital of Tweed, for a total consideration of
£670,000. The fair value of the net assets of Tweed at this date was £700,000. The non-controlling
interest is measured at £140,000.
What goodwill arises on the acquisition?
Solution
Goodwill is calculated as:
£
Consideration transferred 670,000
Non-controlling interest at the acquisition date 140,000
810,000
Less total fair value of net assets of acquiree (700,000)
Goodwill 110,000
In this example the non-controlling interest has been measured as the relevant percentage of Tweed's
acquisition date net assets ie, 20% × £700,000.
Note that the non-controlling interest is not necessarily calculated as a proportion of acquisition date
net assets.
3.3 Consideration transferred

Contingent consideration – initial measurement
IFRS 3 (revised) requires the consideration to be measured at the fair value at the acquisition date. This
includes any contingent consideration payable even if, at the date of acquisition, it is not deemed
probable that it will be paid.

Contingent consideration – subsequent measurement
IFRS 3 (revised) requires contingent consideration to be classified as follows:
 A liability where contingent consideration is cash or shares to a specific value
 Equity where contingent consideration is a specified number of ordinary shares regardless of their
value
Subsequent changes are then dealt with as follows:
(a) If the change is due to additional information obtained that affects the position at the acquisition
date, goodwill should be remeasured.
(b) If the change is due to events which took place after the acquisition date, for example, meeting
earnings targets:
(i) where consideration is recorded as a liability (including a provision), any remeasurement is
recorded in profit or loss (so an increase in the liability due to strong performance of the
subsidiary will result in an expense and a decrease in the liability due to underperformance
will result in a gain); and
(ii) where consideration is recorded in equity, remeasurement is not required.
The treatment means that group profits are now reduced where good performance of the subsidiary
results in additional payments to the seller.
Acquisition-related costs
These costs do not form part of consideration within the above calculation. Instead, all finders' fees,
legal, accounting, valuation and other professional fees must be expensed through profit or loss.
Costs incurred to issue securities will be dealt with in accordance with IAS 39.
The treatment will therefore reduce goodwill values and profits.
3.4 Non-controlling interest

The standard allows a choice in valuing the non-controlling interest within the goodwill calculation. It
may be measured either:
 as a proportion of the identifiable net assets of the subsidiary at the acquisition date (as in the
example above); or
 at fair value of the equity shares held by the non-controlling interest on the acquisition date.
The choice is available on a transaction by transaction basis.
The proportion of net assets method is used to value the non-controlling interest (NCI) at the
reporting date. It requires identifiable assets to be recognised at the fair values of the individual assets.
Where this method is used to value the non-controlling interest under IFRS 3 (revised), the resulting
goodwill corresponds only to the share of the entity held by the parent company.
The fair value method brings measurement of the non-controlling interest into line with measurement
of consideration and the acquiree's net assets (ie, all at fair value). The fair value of the non-controlling
interest (eg, the active market prices of the equity shares not held by the acquirer) is likely to exceed the
C
proportion of net assets attributable to the non-controlling interest, this being by an amount which H
represents goodwill attributable to the non-controlling interest. Therefore goodwill on acquisition A
calculated using this method will represent 100% of goodwill in the acquiree. Accordingly, this method P
is sometimes known as the 'full goodwill' method. T
E
R
20

Worked example: Calculation of goodwill 2
The consideration transferred by National plc when it acquired 80,000 of the 100,000 equity shares of
Locale Ltd was £25 million. At the acquisition date the fair value of Locale Ltd's net assets was
£21 million and the fair value of the 20,000 equity shares in Locale Ltd not acquired was £5 million.
Calculate the goodwill acquired in the business combination on the basis that the non-controlling
interest in Locale Ltd is measured at:
(a) Its share of identifiable net assets
(b) Fair value of the non-controlling interest's equity shares
Solution
(a) (b)
NCI at share NCI at fair
of net assets value
£'000 £'000
Consideration transferred 25,000 25,000
Non-controlling interest – 20%  £21m/fair value 4,200 5,000
29,200 30,000
Total net assets of acquiree (21,000) (21,000)
Goodwill acquired in business combination 8,200 9,000
As the non-controlling interest is £0.8 million higher when measured at fair value, it follows that
goodwill is also £0.8 million higher.
This amount is the goodwill relating to the non-controlling interest. The calculation of goodwill when
the NCI is valued at fair value could be laid out as:
Group NCI
£'000 £'000
Consideration/fair value 25,000 5,000
Share of net assets 80%/20%  £21m (16,800) (4,200)
Goodwill 8,200 800
Total (or full) goodwill is £9 million; of this, the parent's share is £8.2 million and the non-controlling
interest's share is £0.8 million.
Note that the goodwill is not split in the same proportion as ownership of the shares:
 National owns 80% of the shares but 91% of goodwill.
 The non-controlling interest owns 20% of shares but just 9% of goodwill.
This discrepancy is due to the 'control premium' paid by National.
Interactive question 1: Calculation of goodwill

On 1 January 20X5, ABC acquired 90% of DEF when the fair value of DEF's net assets was £18 million.
The consideration was structured as follows.
 Three million ABC ordinary shares to be issued on the acquisition date.
 An additional one million ABC ordinary shares to be issued on 31 December 20X6 if DEF's revenue
increases by 10% in the interim two years. This condition is likely to be achieved.
The market price of ABC ordinary shares is £7 at the acquisition date and has increased to £9 by
31 December 20X6.
ABC incurs professional acquisition fees amounting to £50,000.
It is ABC group policy to value the non-controlling interest using the proportion of net assets method.
Requirement
Calculate the consideration transferred and the goodwill arising on acquisition.

3.4.1 Non-controlling interest – subsequent valuation
Where the non-controlling interest is measured using the proportion of net assets method, the NCI at
the reporting date is calculated as the non-controlling interest's share of the subsidiary's net assets.
Where the non-controlling interest is measured using the fair value method, a consolidation adjustment
is required to recognise the additional goodwill in the consolidated statement of financial position. This
is best achieved using the following calculation:
Non-controlling interest
£ £
Share of net assets (NCI%  net assets at reporting date (W2)) X
Share of goodwill:
NCI at acquisition date at fair value (W3) X
NCI at acquisition date at share of net assets (NCI%  net
assets at acquisition (W2)) (X)
Difference, being goodwill attributable to NCI X
X
Note: The references are to standard consolidation workings:
W2 Net assets of the subsidiary
W3 Goodwill working
Interactive question 2: Non-controlling interest

Robson acquired 75% of the ordinary shares of Ives on 30 June 20X7. At this date Ives had net assets of
£250,000, and the fair value of the 25% of Ives's equity shares not acquired by Robson was £90,000.
Ives uses the fair value (full goodwill) method to measure non-controlling interests.
The abbreviated statement of financial position of Ives at 31 December 20X9 is as follows:
£
Assets 440,000
Share capital 100,000
Liabilities 95,000
440,000
 At acquisition, the fair value of land owned by Ives was £50,000 greater than its carrying amount;
Ives has subsequently sold the land to a third party.
 During the year ended 31 December 20X9, Ives sold goods to Robson, making a profit of £12,000.
Half of these goods are included in Robson's inventory count at the year end.
Requirement
What is the value of the non-controlling interest in the consolidated statement of financial position at
31 December 20X9?
3.5 Step acquisitions

C
Under IFRS 3 and IFRS 10, acquisition accounting is only applied to business combinations when control H
is achieved. A
P
Where a parent acquires control of a subsidiary in stages (a step acquisition), this means that goodwill is T
only calculated once, upon initially achieving control. It is not then recalculated in response to further E
R
acquisitions of shares in the same subsidiary.
Accounting for step acquisitions is covered in further detail within section 9 of this chapter.
20

3.6 Assets and liabilities acquired
In the previous sections, we discussed the first two elements of the goodwill calculation: consideration
transferred and the non-controlling interest.
This section deals with the third element of goodwill – the net assets acquired.
3.6.1 Recognition
Assets and liabilities existing at the acquisition date, and meeting the Framework definition of an asset or
liability, should be recognised within the goodwill calculation.
(a) Only those liabilities which exist at the date of acquisition are recognised (so not future operating
losses or reorganisation plans which will be put into effect after control is gained).
(b) Some assets not recognised by the acquiree in its individual company financial statements may be
recognised by the acquirer in the consolidated financial statements. These include identifiable
intangible assets, such as brand names. Identifiable means that these assets are separable or arise
from contractual or other legal rights.
3.6.2 Measurement
The basic requirement of IFRS 3 (revised) is that the identifiable assets and liabilities acquired are
measured at their acquisition date fair value.
To understand the importance of fair values in the acquisition of a subsidiary, consider again the
definition of goodwill.
Definition
Goodwill: Any excess of the cost of the acquisition over the acquirer's interest in the fair value of the
identifiable assets and liabilities acquired as at the date of the exchange transaction.
The statement of financial position of a subsidiary company at the date it is acquired may not be a
guide to the fair value of its net assets. For example, the market value of a freehold building may have
risen greatly since it was acquired, but it may appear in the statement of financial position at historical
cost less accumulated depreciation.
3.6.3 What is fair value?

Fair value is defined as follows by IFRS 13 Fair Value Measurement – it is an important definition.
Definition
Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date. (IFRS 13)
We will look at the requirements of IFRS 3 (revised) and IFRS 13 regarding fair value in more detail in
section 4. First, let us look at some practical matters. The following example will remind you how to
make a fair value adjustment, using the standard consolidation workings from your Professional Level
studies.
Worked example: Fair value adjustment

P Co acquired 75% of the ordinary shares of S Co on 1 September 20X5. At that date the fair value of
S Co's non-current assets was £23,000 greater than their carrying amount, and the balance of retained
earnings was £21,000. The fair value of the non-controlling interest was £17,000. The statements of
financial position of both companies at 31 August 20X6 are given below. S Co has not incorporated any
revaluation in its financial statements.
P Co values the non-controlling interest using the fair value (full goodwill) method.

P Co statement of financial position as at 31 August 20X6
£ £
Assets
Non-current assets
Tangible assets 63,000
Investment in S Co at cost 51,000
114,000
Current assets 82,000
Total assets 196,000
Equity
Ordinary shares of £1 each 80,000
176,000
Current liabilities 20,000
Total equity and liabilities 196,000
S Co statement of financial position as at 31 August 20X6

£ £
Assets
Tangible non-current assets 28,000
Total assets 71,000
Equity
Ordinary shares of £1 each 20,000
61,000
If S Co had revalued its non-current assets at 1 September 20X5, an addition of £3,000 would have
been made to the depreciation expense charged for 20X5/X6.
Requirement
Prepare P Co's consolidated statement of financial position as at 31 August 20X6.
Solution
P Co consolidated statement of financial position as at 31 August 20X6
£ £
Assets
Non-current assets
Tangible non-current assets £(63,000 + 28,000 + 23,000 – 3,000) 111,000
Intangibles – goodwill (W3) 4,000
115,000
Current assets £(82,000 + 43,000) 125,000
Total assets 240,000
Equity and liabilities C
Capital and reserves H
Ordinary share capital 80,000 A
Retained earnings (W5) 108,750 P
Equity 188,750 T
E
Non-controlling interest (W4) 21,250 R
210,000
Current liabilities £(20,000 + 10,000) 30,000
20

WORKINGS
(1) Group structure
P Co
75%
S Co
(2) Net assets
Reporting Acquisition Post-
date acquisition
£ £ £
Share capital 20,000 20,000 –
Retained earnings – per question 41,000 21,000 20,000
– additional depreciation (3,000) (3,000)
Fair value adjustment to PPE 23,000 23,000
81,000 64,000 17,000
(3) Goodwill
£
Non-controlling interest 17,000
68,000
Less net assets of acquiree (W2) (64,000)
4,000
(4) Non-controlling interest
£ £
S Co (25% × £81,000 (W2)) 20,250
NCI share of goodwill at acquisition
FV of NCI at acquisition 17,000
NCI share of net assets at acquisition (25% × £64,000) (16,000)
1,000
Non-controlling interest 21,250
(5) Retained earnings
£
P Co 96,000
S Co (£17,000 (W2)  75%) 12,750
108,750
Remember also that when preparing consolidated financial statements all intra-group balances,
transactions, profits and losses need to be eliminated. Where there are provisions for unrealised profit
and the parent is the seller the adjustment is made against the parent's retained earnings (in the
retained earnings working). Where the subsidiary is the seller its retained earnings are adjusted (in the
net assets working) thus ensuring that the non-controlling interest (ie, the minority interest) bear their
share of the provision.
3.7 Impairments and the non-controlling interest

A subsidiary is subject to impairment review as a cash generating unit. The recoverable amount of the
subsidiary is compared with its carrying amount to assess whether an impairment has occurred.
Notional grossing up of goodwill
In order to be comparable with the calculated recoverable amount, the carrying amount of the
subsidiary must include 100% of both its net assets and goodwill. Therefore:
(a) where the proportion of net assets method is used to measure the NCI, goodwill must be
notionally adjusted so that it represents both the parent and NCI share of goodwill (ie, 100% of

goodwill). This involves grossing up the parent's goodwill according to percentage
shareholdings; and
(b) where fair value is used to measure the NCI, goodwill already represents 100% of goodwill and no
such adjustment is required.
Split of goodwill between the parent and NCI
Where goodwill requires grossing up according to ownership percentages, total goodwill is split in
proportion to these ownership percentages.
Where goodwill does not require grossing up, total goodwill is not necessarily split in proportion to
ownership percentages due to the control premium.
Illustration: Notional goodwill

A acquires 80% of B for £120,000. The net assets at the date of acquisition were £130,000 and the fair
value of the 20% non-controlling interest equity shares was £28,000.
Proportion of net Fair value
assets method method
£ £
Consideration transferred 120,000 120,000
Non-controlling interest (20% × £130,000)/fair value 26,000 28,000
146,000 148,000
Net assets of acquiree (130,000) (130,000)
Goodwill 16,000 18,000
Attributable to:
Parent 16,000 16,000
NCI [£28,000 – (20% × £130,000)] n/a 2,000
For the purposes of an impairment review, the goodwill calculated using the proportion of net assets
method is notionally adjusted as follows:
£
Parent goodwill 16,000
Notional NCI goodwill (20%/80% × £16,000) 4,000
20,000
In other words, the notional goodwill attributable to the non-controlling interest calculated here
includes an element of control premium which is not evident when calculating goodwill attributable to
the non-controlling interest using the fair value method.
Allocation of the impairment loss to parent / NCI

IFRS 3 (revised) has amended IAS 36 Impairment of Assets to require that any impairment loss is
allocated 'on the same basis as that on which profit or loss is allocated'. This is likely to correspond
to ownership percentages.
Therefore in the illustration above, any impairment loss to goodwill is allocated 80% to the parent and
20% to the NCI.
C
(a) Where the proportion of net assets method is used and goodwill is notionally calculated for the H
A
NCI, this split corresponds exactly to the split of goodwill. Assuming an impairment of £10,000: P
Parent NCI T
£ £ E
R
Goodwill 16,000 4,000
Impairment (80%/20% × £10,000) (8,000) (2,000)
8,000 2,000
20
Impairment of goodwill 50% 50%
Thus half the total goodwill has been impaired, being half of the parent's goodwill and half of the
NCI's notional goodwill.

(b) Where the fair value method is used, and there is a control premium, such that the parent and NCI
goodwill are not in proportion, then any impairment is not in proportion to the starting goodwill.
This time assuming an impairment of £9,000:
Parent NCI
£ £
Goodwill 16,000 2,000
Impairment (80%/20% × £9,000) (7,200) (1,800)
8,800 200
Impairment of goodwill 45% 90%
3.8 Restructuring and future losses

An acquirer should not recognise liabilities for future losses or other costs expected to be incurred as
a result of the business combination.
IFRS 3 (revised) explains that a plan to restructure a subsidiary following an acquisition is not a present
obligation of the acquiree at the acquisition date. Neither does it meet the definition of a contingent
liability. Therefore, an acquirer should not recognise a liability for such a restructuring plan as part of
allocating the cost of the combination unless the subsidiary was already committed to the plan before
the acquisition.
This prevents creative accounting. An acquirer cannot set up a provision for restructuring or future
losses of a subsidiary and then release this to profit or loss in subsequent periods in order to reduce
losses or smooth profits.
3.9 Intangible assets

The acquiree may have intangible assets, such as development expenditure. These can be recognised
separately from goodwill only if they are identifiable. An intangible asset is identifiable only if it:
(a) is separable ie, capable of being separated or divided from the entity and sold, transferred or
exchanged, either individually or together with a related contract, asset or liability; or
(b) arises from contractual or other legal rights.
3.10 Contingent liabilities

Contingent liabilities of the acquirer are recognised if their fair value can be measured reliably. A
contingent liability must be recognised even if the outflow is not probable, provided there is a present
obligation.
This is a departure from the normal rules in IAS 37 Provisions, Contingent Liabilities and Contingent Assets;
contingent liabilities are not normally recognised, but only disclosed.
After their initial recognition, the acquirer should measure contingent liabilities that are recognised
separately at the higher of:
(a) the amount that would be recognised in accordance with IAS 37; and
(b) the amount initially recognised.
3.11 Other exceptions to the recognition or measurement principles

(a) Deferred tax: Use IAS 12 values
(b) Employee benefits: Use IAS 19 values
(c) Indemnification assets: Measurement should be consistent with the measurement of the
indemnified item, for example an employee benefit or a contingent liability
(d) Reacquired rights: Value on the basis of the remaining contractual term of the related contract
regardless of whether market participants would consider potential contractual renewals in
determining its fair value

(e) Share-based payment: Use IFRS 2 values
(f) Assets held for sale: Use IFRS 5 values
3.12 Goodwill arising on the acquisition

Goodwill should be carried in the statement of financial position at cost less any accumulated
impairment losses. The treatment of goodwill was covered in detail in your earlier studies.
3.13 Adjustments after the initial accounting is complete

Sometimes the fair values of the acquiree's identifiable assets, liabilities or contingent liabilities or the
cost of the combination can only be measured provisionally by the end of the period in which the
combination takes place. In this situation, the acquirer should account for the combination using
those provisional values. The acquirer should recognise any adjustments to those provisional values
as a result of completing the initial accounting:
(a) within twelve months of the acquisition date
(b) from the acquisition date (ie, retrospectively)
This means that:
(a) the carrying amount of an item that is recognised or adjusted as a result of completing the initial
accounting shall be calculated as if its fair value at the acquisition date had been recognised
from that date; and
(b) goodwill should be adjusted from the acquisition date by an amount equal to the adjustment to
the fair value of the item being recognised or adjusted.
Any further adjustments after the initial accounting is complete should be recognised only to correct
an error in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Any
subsequent changes in estimates are dealt with in accordance with IAS 8 (ie, the effect is recognised in
the current and future periods). IAS 8 requires an entity to account for an error correction
retrospectively, and to present financial statements as if the error had never occurred by restating the
comparative information for the prior period(s) in which the error occurred.
3.14 Reverse acquisitions

IFRS 3 also addresses a certain type of acquisition, known as a reverse acquisition or reverse takeover.
This is where Company A acquires ownership of Company B through a share exchange. (For example, a
private entity may arrange to have itself 'acquired' by a smaller public entity as a means of obtaining a
stock exchange listing.) The number of shares issued by Company A as consideration to the
shareholders of Company B is so great that control of the combined entity after the transaction is with
the shareholders of Company B.
In legal terms Company A may be regarded as the parent or continuing entity, but IFRS 3 states that, as it
is the Company B shareholders who control the combined entity, Company B should be treated as the
acquirer. Company B should apply the acquisition method to the assets and liabilities of Company A.
Illustration: Reverse acquisition C

H
On 1 January 20X5, ABC's share capital was 10,000 ordinary shares, quoted on a public exchange, and A
the unquoted share capital of DEF was 24,000 ordinary shares. On that date ABC's shares were quoted P
T
at £20. ABC issued 30,000 new shares, and then exchanged them for the entire share capital of DEF.
E
The fair value of DEF's shares on 1 January 20X5 was agreed by the professional advisers to both ABC R
and DEF as £62.
After the acquisition, the relative interests of the two shareholder groups in ABC were as follows.
20
Shares held % of total
ABC shareholders 10,000 25
DEF shareholders 30,000 75
40,000 100

As the DEF shareholder group controls the combined entities, DEF is treated as the acquirer and ABC as
the acquiree.
If DEF had issued enough of its own shares to give ABC shareholders a 25% interest in DEF, it would
have had to issue 8,000 shares (ie, 25/75 of 24,000 shares). DEF's share capital would then have been
32,000 (24,000 + 8,000) and the ABC shareholders' interest would have been 8,000 so 25%.
The consideration for the acquisition is £496,000, being 8,000 DEF shares at their agreed fair value of
£62.
4 IFRS 13 Fair Value Measurement (business combination

aspects)
Section overview
 The accounting requirements and disclosures of the fair value exercise are covered by IFRS 3
(revised). IFRS 13 Fair Value Measurement gives extensive guidance on how the fair value of assets
and liabilities should be established.
 Business combinations are accounted for using the acquisition method.
4.1 Fair value

The general rule under IFRS 3 (revised) is that the subsidiary's assets and liabilities must be measured at
fair value except in limited, stated cases. The assets and liabilities must:
(a) meet the definitions of assets and liabilities in the IASB Conceptual Framework; and
(b) be part of what the acquiree (or its former owners) exchanged in the business combination rather
than the result of separate transactions.
IFRS 13 Fair Value Measurement (see Chapter 2) provides extensive guidance on how the fair value of
assets and liabilities should be established.
This standard requires that the following are considered in measuring fair value:
(a) The asset or liability being measured
(b) The principal market (ie, that where the most activity takes place) or where there is no principal
market, the most advantageous market (ie, that in which the best price could be achieved) in
which an orderly transaction would take place for the asset or liability
(c) The highest and best use of the asset or liability and whether it is used on a standalone basis or in
conjunction with other assets or liabilities
(d) Assumptions that market participants would use when pricing the asset or liability
Having considered these factors, IFRS 13 provides a hierarchy of inputs for arriving at fair value.
It requires that Level 1 inputs are used where possible:
Level 1 Quoted prices in active markets for identical assets that the entity can access at the
measurement date
Level 2 Inputs other than quoted prices that are directly or indirectly observable for the asset
Level 3 Unobservable inputs for the asset
Illustration: Examples of fair value and business combinations

For non-financial assets, fair value is decided based on the highest and best use of the asset as
determined by a market participant. The following examples, adapted from the illustrative examples to
IFRS 13, demonstrate what is meant by this.

Example: Land
Anscome Co has acquired land in a business combination. The land is currently developed for industrial
use as a site for a factory. The current use of land is presumed to be its highest and best use unless
market or other factors suggest a different use. Nearby sites have recently been developed for residential
use as sites for high-rise apartment buildings. On the basis of that development and recent zoning and
other changes to facilitate that development, Anscome determines that the land currently used as a site
for a factory could be developed as a site for residential use (ie, for high-rise apartment buildings)
because market participants would take into account the potential to develop the site for residential use
when pricing the land.
Requirement
How would the highest and best use of the land be determined?
Solution
The highest and best use of the land would be determined by comparing both of the following:
(a) The value of the land as currently developed for industrial use (ie, the land would be used in
combination with other assets, such as the factory, or with other assets and liabilities)
(b) The value of the land as a vacant site for residential use, taking into account the costs of
demolishing the factory and other costs (including the uncertainty about whether the entity would
be able to convert the asset to the alternative use) necessary to convert the land to a vacant site
(ie, the land is to be used by market participants on a standalone basis)
The highest and best use of the land would be determined on the basis of the higher of those values.
Example: Research and development project

Searcher acquires a research and development (R&D) project following a business combination.
Searcher does not intend to complete the project. If completed, the project would compete with one of
its own projects (to provide the next generation of the entity's commercialised technology). Instead, the
entity intends to hold (ie, lock up) the project to prevent its competitors from obtaining access to the
technology. In doing this the project is expected to provide defensive value, principally by improving
the prospects for the entity's own competing technology.
If it could purchase the R&D project, Developer Co would continue to develop the project and that use
would maximise the value of the group of assets or of assets and liabilities in which the project would be
used (ie, the asset would be used in combination with other assets or with other assets and liabilities).
Developer Co does not have similar technology.
Requirement
How would the fair value of the project be measured?
Solution
The fair value of the project would be measured on the basis of the price that would be received in a
current transaction to sell the project, assuming that the R&D would be used with its complementary
assets and the associated liabilities and that those assets and liabilities would be available to Developer
Co.
Example: Decomissioning liability C

H
Deacon assumes a decommissioning liability in a business combination. It is legally required to A
dismantle a power station at the end of its useful life, which is estimated to be 20 years. P
T
Requirement E
R
How would the decommissioning liability be measured?
Solution
20
Because this is a business combination, Deacon must measure the liability at fair value in accordance
with IFRS 13, rather than using the best estimate measurement required by IAS 37 Provisions, Contingent
Liabilities and Contingent Assets.

Deacon will use the expected present value technique to measure the fair value of the decommissioning
liability. If Deacon were contractually committed to transfer its decommissioning liability to a market
participant, it would conclude that a market participant would use all of the following inputs, probability
weighted as appropriate, when estimating the price it would expect to receive.
(a) Labour costs
(b) Allocated overhead costs
(c) The compensation that a market participant would generally receive for undertaking the activity,
including profit on labour and overhead costs and the risk that the actual cash outflows might
differ from those expected
(d) The effect of inflation
(e) The time value of money (risk-free rate)
(f) Non-performance risk, including Deacon's own credit risk
As an example of how the probability adjustment might work, Deacon values labour costs on the basis
of current marketplace wages adjusted for expected future wage increases. It determines that there is a
20% probability that the wage bill will be £15 million, a 30% probability that it will be £25 million and
a 50% probability that it will be £20 million. Expected cash flows will then be (20% × £15m) + (30% ×
£25m) + (50% × £20m) = £20.5m. The probability assessments will be developed on the basis of
Deacon's knowledge of the market and experience of fulfilling obligations of this type.
Interactive question 3: Goodwill on consolidation

Tyzo plc prepares its financial statements to 31 December. On 1 September 20X7 Tyzo plc acquired
6 million £1 shares in Kono Ltd at £2 per share. The purchase was financed by an additional issue of
loan stock at an interest rate of 10%. At that date Kono Ltd produced the following interim financial
information.
Non-current assets £m
Property, plant and
equipment (Note 1) 16.0
Current assets
Inventories (Note 2) 4.0
Receivables 2.9
Cash and cash equivalents 1.2
8.1
Total assets 24.1

Equity
Share capital (£1 shares) 8.0
Reserves 4.4
12.4
Long-term loan (Note 3) 4.0
Current liabilities
Trade payables 3.2
Provision for taxation 0.6
Bank overdraft 3.9
7.7
Total equity and liabilities 24.1

Notes
1 The following information relates to the property, plant and equipment of Kono Ltd at
1 September 20X7.
£m
Gross replacement cost 28.4
Net replacement cost 16.8
Economic value 18.0
Net realisable value 8.0
2 The inventories of Kono Ltd in hand at 1 September 20X7 consisted of raw materials at cost. They
would have cost £4.2 million to replace at 1 September 20X7.
3 The long-term loan of Kono Ltd carries a rate of interest of 10% per annum, payable on 31 August
annually in arrears. The loan is redeemable at par on 31 August 20Y1. The interest cost is
representative of current market rates. The accrued interest payable by Kono Ltd at
31 December 20X7 is included in the trade payables of Kono Ltd at that date.
4 On 1 September 20X7 Tyzo plc took a decision to rationalise the group so as to integrate Kono
Ltd. The costs of the rationalisation were estimated to total £3 million and the process was due to
start on 1 March 20X8. No provision for these costs has been made in any of the financial
statements given above.
5 Kono Ltd has disclosed a contingent liability of £200,000 in its interim financial statements relating
to litigation.
6 Tyzo Group values the non-controlling interest using the proportion of net assets method.
Requirement
Compute the goodwill on consolidation of Kono Ltd that will be included in the consolidated financial
statements of Tyzo plc for the year ended 31 December 20X7, explaining your treatment of the items
mentioned above. You should refer to the provisions of relevant accounting standards.
5 IAS 28 Investments in Associates and Joint Ventures
Section overview
 IAS 28 deals with accounting for associates and joint ventures using the equity method.
 An associate exists where there is 'significant influence'.
 The criteria for identifying a joint venture are contained in IFRS 11.
 The accounting for associates and joint ventures is identical.
IAS 28 does not apply to investments in associates or joint ventures held by venture capital
organisations, mutual funds, unit trusts and similar entities that are measured at fair value in accordance
with IAS 39.
IAS 28 requires investments in associates to be accounted for using the equity method, unless the
investment is classified as 'held for sale' in accordance with IFRS 5, in which case it should be accounted C
for under IFRS 5. H
A
An investor is exempt from applying the equity method if: P
T
(a) it is a parent exempt from preparing consolidated financial statements under IAS 27 (revised); or E
R
(b) all of the following apply:
(i) The investor is a wholly owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been 20
informed about, and do not object to, the investor not applying the equity method.
(ii) Its securities are not publicly traded.

(iii) It is not in the process of issuing securities in public securities markets.
(iv) The ultimate or intermediate parent publishes consolidated financial statements that
comply with International Financial Reporting Standards.
IAS 28 does not allow an investment in an associate to be excluded from equity accounting when an
investee operates under severe long-term restrictions that significantly impair its ability to transfer funds
to the investor. Significant influence must be lost before the equity method ceases to be applicable.
The use of the equity method should be discontinued from the date that the investor ceases to have
significant influence.
From that date, the investor shall account for the investment in accordance with IAS 39. The fair value
of the retained interest must be regarded as its fair value on initial recognition as a financial asset under
IAS 39.
5.1 Separate financial statements of the investor

In accordance with IAS 27 Separate Financial Statements where an entity prepares separate financial
statements it must account for associates (and joint ventures) in its separate financial statements in one
of the following ways:
 Accounted for at cost
 In accordance with IAS 39
 Using the equity method as described in IAS 28 Investments in Associates and Joint Ventures
5.2 Application of the equity method: consolidated accounts

The equity method should be applied in the consolidated accounts as follows:
(a) Statement of financial position includes investment in associate at cost plus (or minus) the
group's share of the associate's post-acquisition profits (or losses) minus any impairments in the
investment to date.
(b) Profit or loss (statement of profit or loss and other comprehensive income): group share of
associate's profit after tax.
(c) Other comprehensive income (statement of profit or loss and other comprehensive income):
group share of associate's other comprehensive income after tax.
The investment in the associate will also include any other long-term interests in the associate, for
example preference shares or long-term receivables or loans.
IAS 39 sets out a list of indications that a financial asset (including an associate) may have become
impaired.
Many of the procedures required to apply the equity method are the same as are required for full
consolidation. In particular, fair value adjustments are required and the group share of intra-group
unrealised profits must be excluded.
Worked example: Associate

P Co, a company with subsidiaries, acquires 25,000 of the 100,000 £1 ordinary shares in A Co for
£60,000 on 1 January 20X8. In the year to 31 December 20X8, A Co earns profits after tax of £24,000,
from which it declares and pays a dividend of £6,000.
Requirement
How will A Co's results be accounted for in the individual and consolidated accounts of P Co for the year
ended 31 December 20X8?

Solution
In the individual accounts of P Co, the investment will be recorded on 1 January 20X8 at cost. Unless
there is an impairment in the value of the investment (see below), most companies will choose the
policy that this amount (the cost) will remain in the individual statement of financial position of P Co
permanently. The only entry in P Co's individual statement of profit or loss and other comprehensive
income will be to record dividends received. For the year ended 31 December 20X8, P Co will:
DEBIT Cash (£6,000  25%) £1,500
CREDIT Income from shares in associated companies £1,500
In the consolidated accounts of P Co equity accounting will be used. Consolidated profit after tax will
include the group's share of A Co's profit after tax (25%  £24,000 = £6,000).
In the consolidated statement of financial position the non-current asset 'Investment in associates' will
be stated at £64,500, being cost of £60,000 plus the group's share of post-acquisition retained profits of
£4,500 ((24,000 – 6,000) × 25%).
5.3 Transactions between a group and its associate

Unlike for subsidiaries, trading transactions are not cancelled out. However, any unrealised profits on
these transactions should be eliminated, but only to the extent of the group's share.
Where the associate sells to the parent/subsidiary the double entry is as follows, where A% is the
parent's holding in the associate, and PURP is the provision for unrealised profit:
DEBIT Retained earnings of parent/subsidiary PURP  A%
CREDIT Group inventories/PPE PURP  A%
Where the parent/subsidiary sells to the associate:
DEBIT Retained earnings of parent/subsidiary PURP  A%
CREDIT Investment in associate PURP  A%
5.4 Associate's losses

When the equity method is being used and the investor's share of losses of the associate equals or
exceeds its interest in the associate, the investor should discontinue including its share of further losses.
The investment is reported at nil value. After the investor's interest is reduced to nil, additional losses
should only be recognised where the investor has incurred obligations or made payments on behalf of
the associate (for example, if it has guaranteed amounts owed to third parties by the associate).
5.5 Impairment losses

Any impairment loss is recognised in accordance with IAS 36 Impairment of Assets for each associate
individually.
6 IFRS 11 Joint Arrangements
Section overview C
 IFRS 11 classes joint arrangements as either joint operations or joint ventures. H
A
 The classification of a joint arrangement as a joint operation or a joint venture depends on the P
T
rights and obligations of the parties to the arrangement.
E
 Joint arrangements are often found when each party can contribute in different ways to the R
activity. For example, one party may provide finance, another purchases or manufactures goods,
while a third offers its marketing skills.
20

6.1 Definitions
The IFRS begins by listing some important definitions.
Definitions
Joint arrangement: An arrangement of which two or more parties have joint control.
Joint control: The contractually agreed sharing of control of an arrangement, which exists only when
decisions about the relevant activities require the unanimous consent of the parties sharing control.
Joint operation: A joint arrangement whereby the parties that have joint control of the arrangement
have rights to the assets and obligations for the liabilities relating to the arrangement.
Joint venture: A joint arrangement whereby the parties that have joint control of the arrangement have
rights to the net assets of the arrangement. (IFRS 11)
6.2 Forms of joint arrangement

IFRS 11 classes joint arrangements as either joint operations or joint ventures. The classification of a joint
arrangement as a joint operation or a joint venture depends on the rights and obligations of the parties
to the arrangement.
A joint operation is a joint arrangement whereby the parties that have joint control (the joint operators)
have rights to the assets, and obligations for the liabilities, of that joint arrangement. A joint
arrangement that is not structured through a separate entity is always a joint operation.
A joint venture is a joint arrangement whereby the parties that have joint control (the joint venturers)
of the arrangement have rights to the net assets of the arrangement.
A joint arrangement that is structured through a separate entity may be either a joint operation or a
joint venture. In order to ascertain the classification, the parties to the arrangement should assess the
terms of the contractual arrangement together with any other facts or circumstances to assess whether
they have:
 rights to the assets, and obligations for the liabilities, in relation to the arrangement (indicating a
joint operation); and
 rights to the net assets of the arrangement (indicating a joint venture).
Detailed guidance is provided in the appendices to IFRS 11 in order to help this assessment, giving
consideration to, for example, the wording contained within contractual arrangements.
IFRS 11 summarises the basic issues that underlie the classifications in the following diagram.

Structure of the joint arrangement
Not structured through a separate Structured through a separate

vehicle vehicle
An entity shall consider:

(i) The legal form of the separate
vehicle
(ii) The terms of the contractual
arrangement; and
(iii) Where relevant, other facts and
circumstances
Joint operation Joint venture
Figure 20.1: Joint Arrangements

(Source: IFRS 11: AG. B21)
6.2.1 Contractual arrangement

The existence of a contractual agreement distinguishes a joint arrangement from an investment in an
associate. If there is no contractual arrangement, then a joint arrangement does not exist.
Evidence of a contractual arrangement could be in one of several forms.
 Contract between the parties
 Minutes of discussion between the parties
 Incorporation in the articles or by-laws of the joint venture
The contractual arrangement is usually in writing, whatever its form, and it will deal with the following
issues surrounding the joint venture.
 Its activity, duration and reporting obligations
 The appointment of its board of directors (or equivalent) and the voting rights of the parties
 Capital contributions to it by the parties C
H
 How its output, income, expenses or results are shared between the parties A
P
It is the contractual arrangement which establishes joint control over the joint venture, so that no single
T
party can control the activity of the joint venture on its own. E
R
The terms of the contractual arrangement are key to deciding whether the arrangement is a joint
venture or joint operation. IFRS 11 includes a table of issues to consider and explains the influence of a
range of points that could be included in the contract. The table is summarised below.
20

Joint operation Joint venture
The terms of The parties to the joint arrangement have The parties to the joint arrangement
the rights to the assets, and obligations for the have rights to the net assets of the
contractual liabilities, relating to the arrangement. arrangement (ie, it is the separate
arrangement vehicle, not the parties, that has
rights to the assets, and obligations
for the liabilities).
Rights to The parties to the joint arrangement share all The assets brought into the
assets interests (eg, rights, title or ownership) in the arrangement or subsequently
assets relating to the arrangement in a acquired by the joint arrangement
specified proportion (eg, in proportion to the are the arrangement's assets. The
parties' ownership interest in the arrangement parties have no interests (ie, no
or in proportion to the activity carried out rights, title or ownership) in the
through the arrangement that is directly assets of the arrangement.
attributed to them).
Obligations The parties share all liabilities, obligations, The joint arrangement is liable for
for liabilities costs and expenses in a specified proportion the debts and obligations of the
(eg, in proportion to their ownership interest arrangement.
in the arrangement or in proportion to the
The parties are liable to the
activity carried out through the arrangement
arrangement only to the extent of
that is directly attributed to them).
their respective:
 investments in the arrangement;
or
 obligations to contribute any
unpaid or additional capital to
the arrangement; or
 both.
The parties to the joint arrangement are liable Creditors of the joint arrangement
for claims by third parties. do not have rights of recourse
against any party.
Revenues, The contractual arrangement establishes the The contractual arrangement

expenses, allocation of revenues and expenses on the establishes each party's share in the
profit or loss basis of the relative performance of each party profit or loss relating to the activities
to the joint arrangement. For example, the of the arrangement.
contractual arrangement might establish that
revenues and expenses are allocated on the
basis of the capacity that each party uses in a
plant operated jointly.
Guarantees The provision of guarantees to third parties, or the commitment by the parties to
provide them, does not, by itself, determine that the joint arrangement is a joint
operation.
6.2.2 Section summary

 There are two types of joint arrangement: joint ventures and jointly controlled operations.
 A contractual arrangement must exist which establishes joint control.
 Joint control is important: one operator must not be able to govern the financial and operating
policies of the joint venture.

The accounting treatment of joint arrangements depends on whether the arrangement is a joint venture
or joint operation.

6.3.1 Accounting for joint operations
IFRS 11 requires that a joint operator recognises line by line the following in relation to its interest in a
joint operation:
(a) Its assets, including its share of any jointly held assets
(b) Its liabilities, including its share of any jointly incurred liabilities
(c) Its revenue from the sale of its share of the output arising from the joint operation
(d) Its share of the revenue from the sale of the output by the joint operation
(e) Its expenses, including its share of any expenses incurred jointly
operator.
Interactive question 4: Joint arrangement

Can you think of examples of situations where this type of joint arrangement might take place?
6.3.2 Joint ventures
IFRS 11 and IAS 28 require joint ventures to be accounted for using the equity method.
The rules for equity accounting are included in IAS 28. These were covered in your Professional studies
and are revised above.
Application of IAS 28 (revised 2011) to joint ventures
The consolidated statement of financial position is prepared by:
 including the interest in the joint venture at cost plus share of post-acquisition total comprehensive
income; and
 including the group share of the post-acquisition total comprehensive income in group reserves.
The consolidated statement of profit or loss and other comprehensive income will include:
 the group share of the joint venture's profit or loss; and
 the group share of the joint venture's other comprehensive income.
The use of the equity method should be discontinued from the date on which the joint venturer ceases
to have joint control over, or have significant influence on, a joint venture.
Transactions between a joint venturer and a joint venture
Downstream transactions
A joint venturer may sell or contribute assets to a joint venture so making a profit or loss. Any such
gain or loss should, however, only be recognised to the extent that it reflects the substance of the
transaction.
Therefore:
 only the gain attributable to the interest of the other joint venturers should be recognised in the
financial statements; and C
H
 the full amount of any loss should be recognised when the transaction shows evidence that the net A
P
realisable value of current assets is less than cost, or that there is an impairment loss.
T
Upstream transactions E
R
When a joint venturer purchases assets from a joint venture, the joint venturer should not recognise its
share of the profit made by the joint venture on the transaction in question until it resells the assets to
an independent third party ie, until the profit is realised. 20
Losses should be treated in the same way, except losses should be recognised immediately if they
represent a reduction in the net realisable value of current assets, or a permanent decline in the carrying
amount of non-current assets.

6.3.3 Section summary
 Joint operations are accounted for by including the investor's share of assets, liabilities, income
and expenses as per the contractual arrangement.
 Joint ventures are accounted for using the equity method as under IAS 28.
7 Question technique and practice
Section overview
Although you have studied consolidation at Professional Level, it is vitally important that you have
retained this knowledge and can put it into practice. This section summarises the basic question
techniques and provides question practice before you move on to the more advanced topics of
changes in group structure and foreign currency transactions. A number of standard workings should
be used when answering consolidation questions.
7.1 Question technique for consolidated statement of financial position

As questions increase in complexity a formal pattern of workings is needed. Review the standard
workings below.
(1) Establish group structure
P Ltd
80%
S Ltd
(2) Set out net assets of S Ltd
At year end At acquisition Post-acquisition
£ £ £
Share capital X X X
Retained earnings X X X
X X X
(3) Calculate goodwill

£
Consideration transferred X
Plus Non-controlling interest at acquisition X
X
Less net assets at acquisition (see W2) (X)
X
Impairment to date (X)
Balance c/f X
(4) Calculate non-controlling interest (NCI) at year end

£
At acquisition (NCI% × net assets (W2) or fair value) X
Share of post-acquisition profits and other reserves (NCI% × post-acquisition (W2)) X
X
(5) Calculate retained earnings

£
P Ltd (100%) X
S Ltd (share of post-acquisition retained earnings (see W2)) X
Goodwill impairment to date (see W3) (X)
Group retained earnings X
Note: You should use the proportionate basis for measuring the NCI at the acquisition date unless a
question specifies the fair value basis.

7.2 Consolidated statement of profit or loss
As with the statement of financial position, as questions increase in complexity a formal pattern of
workings is needed.
(1) Establish group structure
P Ltd
80%
S Ltd
Figure 20.5
(2) Prepare consolidation schedule
P S Adj Consol
£ £ £ £
Revenue X X (X) X
Cost of sales – Per Q (X) (X) X (X)
– PURP (seller's books) (X) or (X)
Expenses – Per Q (X) (X) (X)
– Goodwill impairment (if any)* (X)(X) (X)
Tax – Per Q (X) (X) (X)
Profit X
May need workings for (eg)
– PURPs
– Goodwill impairment
(3) Calculate non-controlling interest
£
S PAT × NCI% NCI% × X = X
* If the non-controlling interest is measured at fair value, then the NCI% of the impairment loss will be
debited to the NCI. This is based on the NCI shareholding. For instance, if the parent has acquired 75%
of the subsidiary and the NCI is measured at fair value, then 25% of any goodwill impairment will be
debited to NCI.
Interactive question 5: Consolidation technique 1

At 1 July 20X8 Anima plc had investments in two companies: Orient Ltd and Oxendale Ltd. On
1 April 20X9 Anima plc purchased 85% of the ordinary share capital of Carnforth Ltd for £3 million.
Extracts from the draft individual financial statements of the four companies for the year ended
30 June 20X9 are shown below:
Statements of profit or loss
Anima plc Orient Ltd Carnforth Ltd Oxendale Ltd
£ £ £ £ C
H
Revenue 1,410,500 870,300 640,000 760,090
A
Cost of sales (850,000) (470,300) (219,500) (345,000) P
Gross profit 560,500 400,000 420,500 415,090 T
Operating expenses (103,200) (136,000) (95,120) (124,080) E
Profit before taxation 457,300 264,000 325,380 291,010 R
Income tax expense (137,100) (79,200) (97,540) (86,400)
Profit for the year 320,200 184,800 227,840 204,610
20

Statements of financial position (extracts) at year end
Anima plc Orient Ltd Carnforth Ltd Oxendale Ltd
£ £ £ £
Equity
Ordinary share capital 4,000,000 3,500,000 2,000,000 3,000,000
(£1 shares)
Retained earnings 1,560,000 580,000 605,000 340,000
5,560,000 4,080,000 2,605,000 3,340,000
(a) A number of years ago Anima plc acquired 2.1 million of Orient Ltd's ordinary shares and 900,000
of Oxendale Ltd's ordinary shares. Balances on retained earnings at the date of acquisition were
£195,000 for Orient Ltd and £130,000 for Oxendale Ltd. The non-controlling interest and goodwill
arising on the acquisition of Orient Ltd were both calculated using the fair value method; the fair
value of the non-controlling interest at acquisition was £1,520,000.
(b) At the date of acquisition the fair values of Carnforth Ltd's assets and liabilities were the same as
their carrying amounts except for its head office (land and buildings) which had a fair value of
£320,000 in excess of its carrying amount. The split of the value of land to buildings is 50:50 and
the buildings had a remaining life of 40 years at 1 April 20X9. Carnforth Ltd's profits accrued
evenly over the current year. The non-controlling interest and goodwill arising on the acquisition of
Carnforth Ltd were both calculated using the proportionate method.
(c) During the year Anima plc sold goods to Orient Ltd and Oxendale Ltd at a mark-up of 15%. Anima
plc recorded sales of £149,500 and £207,000 to Orient Ltd and Oxendale Ltd respectively during
the year. At the year-end inventory count Orient Ltd was found still to be holding half these goods
and Oxendale Ltd still held one-third.
(d) Anima plc has undertaken annual impairment reviews in respect of all its investments and at
30 June 20X9 an impairment loss of £10,000 had been identified in respect of Oxendale Ltd.
Requirement
Prepare the consolidated statement of profit or loss of Anima plc for the year ended 30 June 20X9 and
an extract from the consolidated statement of financial position as at the same date showing all figures
that would appear as part of equity.
Interactive question 6: Consolidation technique 2

Preston plc has investments in two companies, Longridge Ltd and Chipping Ltd. The draft summarised
statements of financial position of the three companies at 31 March 20X4 are shown below:
Preston plc Longridge Ltd Chipping Ltd

£ £ £
Assets
Non-current assets
Property, plant and equipment 660,700 635,300 261,600
Intangibles 101,300 72,000 –
Investments 350,000 – –
1,112,000 707,300 261,600
Current assets
Inventories 235,400 195,900 65,700
Trade and other receivables 174,900 78,800 56,600
Cash and cash equivalents 23,700 11,900 3,400
434,000 286,600 125,700
Total assets 1,546,000 993,900 387,300

Preston plc Longridge Ltd Chipping Ltd
£ £ £
Equity
Ordinary share capital (£1 shares) 100,000 500,000 200,000
Revaluation surplus 125,000 – –
Retained earnings 1,084,800 312,100 12,000
1,309,800 812,100 212,000
Current liabilities
Trade and other payables 151,200 101,800 137,400
Taxation 85,000 80,000 37,900
236,200 181,800 175,300
Total equity and liabilities 1,546,000 993,900 387,300
(a) Preston plc acquired 75% of Longridge Ltd's ordinary shares on 1 April 20X2 for total cash
consideration of £691,000. £250,000 was payable on the acquisition date and the remaining
£441,000 two years later, on 1 April 20X4. The directors of Preston plc were unsure how to treat
the deferred consideration and have ignored it when preparing the draft financial statements
above.
On the date of acquisition Longridge Ltd's retained earnings were £206,700. The non-controlling
interest and goodwill arising on the acquisition of Longridge Ltd were both calculated using the
proportionate method.
(b) The intangible asset in Longridge Ltd's statement of financial position relates to goodwill which
arose on the acquisition of an unincorporated business, immediately before Preston plc purchasing
its shares in Longridge Ltd. Cumulative impairments of £18,000 in relation to this goodwill had
been recognised by Longridge Ltd as at 31 March 20X4.
The fair values of the remaining assets, liabilities and contingent liabilities of Longridge Ltd at the
date of its acquisition by Preston plc were equal to their carrying amounts, with the exception of a
building purchased on 1 April 20X0, which had a fair value on the date of acquisition of £120,000.
This building is being depreciated by Longridge Ltd on a straight-line basis over 50 years and is
included in the above statement of financial position at a carrying amount of £92,000.
(c) Immediately after its acquisition by Preston plc, Longridge Ltd sold a machine to Preston plc. The
machine had been purchased by Longridge Ltd on 1 April 20X0 for £10,000 and was sold to
Preston plc for £15,000. The machine was originally assessed as having a total useful life of five
years and that estimate has never changed.
(d) Chipping Ltd is a joint venture, set up by Preston plc and a fellow venturer on 30 June 20X2.
Preston plc paid cash of £100,000 for its 40% share of Chipping Ltd.
(e) During the current year Preston plc sold goods to Longridge Ltd for £12,000 and to Chipping Ltd
for £15,000, earning a 20% gross margin on both sales. All these goods were still in the purchasing
companies' inventories at the year end.
(f) At 31 March 20X4 Preston plc's trade receivables included £50,000 due from Longridge Ltd.
However, Longridge Ltd's trade payables included only £40,000 due to Preston plc. The difference
was due to cash in transit.
C
(g) At 31 March 20X4 impairment losses of £25,000 and £10,000 respectively in respect of goodwill H
arising on the acquisition of Longridge Ltd and the carrying amount of Chipping Ltd need to be A
P
recognised in the consolidated financial statements.
T
In the next financial year, Preston plc decided to invest in a third company, Sawley Ltd. On E
R
1 December 20X4 Preston plc acquired 80% of Sawley Ltd's ordinary shares for £385,000. On the date
of acquisition Sawley Ltd's equity comprised share capital of £320,000 and retained earnings of
£112,300. Preston plc chose to measure the non-controlling interest at the acquisition date at the non-
20
controlling interest's share of Sawley Ltd's net assets. Goodwill arising on the acquisition of Sawley Ltd
has been correctly calculated at £39,160 and will be recognised in the consolidated statement of
financial position as at 31 March 20X5.
An appropriate discount rate is 5% p.a.

Requirements
(a) Prepare the consolidated statement of financial position of Preston plc as at 31 March 20X4.
(b) Set out the journal entries that will be required on consolidation to recognise the goodwill arising
on the acquisition of Sawley Ltd in the consolidated statement of financial position of Preston plc as
at 31 March 20X5.
8 IFRS 12 Disclosure of Interests in Other Entities
Section overview
IFRS 12 Disclosure of Interests in Other Entities requires disclosure of a reporting entity's interests in
other entities in order to help identify the profit or loss and cash flows available to the reporting entity
and determine the value of a current or future investment in the reporting entity.
8.1 Objective
IFRS 12 was published in 2011. The objective of the standard is to require entities to disclose
information that enables the user of the financial statements to evaluate the nature of, and risks
associated with, interests in other entities, and the effects of those interests on its financial position,
financial performance and cash flows.
This is particularly relevant in light of the financial crisis and recent accounting scandals. The IASB
believes that better information about interests in other entities is necessary to help users to identify the
profit or loss and cash flows available to the reporting entity and to determine the value of a current or
future investment in the reporting entity.
8.2 Scope
IFRS 12 covers disclosures for entities which have interests in the following:
 Subsidiaries
 Joint arrangements (ie, joint operations and joint ventures, see above)
 Associates
 Unconsolidated structured entities
8.3 Structured entity

IFRS 12 defines a structured entity.
Definition
Structured entity: 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.
(IFRS 12)
8.4 Disclosure
IFRS 12 Disclosure of Interests in Other Entities was issued in 2011. It removes all disclosure requirements
from other standards relating to group accounting and provides guidance applicable to consolidated

The standard requires disclosure of:
(a) the significant judgements and assumptions made in determining the nature of an interest in
another entity or arrangement, and in determining the type of joint arrangement in which an
interest is held; and
(b) information about interests in subsidiaries, associates, joint arrangements and structured entities
that are not controlled by an investor.
8.4.1 Disclosure of subsidiaries

The following disclosures are required in respect of subsidiaries:
(a) The interest that non-controlling interests have in the group's activities and cash flows, including
the name of relevant subsidiaries, their principal place of business, and the interest and voting
rights of the non-controlling interests
(b) Nature and extent of significant restrictions on an investor's ability to use group assets and liabilities
(c) Nature of the risks associated with an entity's interests in consolidated structured entities, such as
the provision of financial support
(d) Consequences of changes in ownership interest in subsidiary (whether control is lost or not)
8.4.2 Disclosure of associates and joint arrangements

The following disclosures are required in respect of associates and joint arrangements:
(a) Nature, extent and financial effects of an entity's interests in associates or joint arrangements,
including name of the investee, principal place of business, the investor's interest in the investee,
method of accounting for the investee and restrictions on the investee's ability to transfer funds to
the investor
(b) Risks associated with an interest in an associate or joint venture
(c) Summarised financial information, with more detail required for joint ventures than for associates
9 Step acquisitions
Section overview
 Subsidiaries and associates are consolidated/equity accounted for from the date control/significant
influence is gained.
 In some cases acquisitions may be achieved in stages. These are known as step acquisitions.
A step acquisition occurs when the parent entity acquires control over the subsidiary in stages, achieved
by buying blocks of shares at different times.
Acquisition accounting is only applied when control is achieved.
The date on which control is achieved is the date on which the acquirer should recognise the acquiree's
C
identifiable net assets and any goodwill acquired (or bargain purchase) in the business combination. H
A
Until control is achieved, any pre-existing interest is accounted for in accordance with:
P
 IAS 39 in the case of investments T
E
 IAS 28 in the case of associates and joint ventures R
20

9.1 Types of business combination achieved in stages
There are three possible types of business combinations achieved in stages:
(1) A previously held investment, say 10% of share capital, with no significant influence (accounted
for under IAS 39), is increased to a controlling holding of 50% or more.
(2) A previously held equity investment, say 35% of share capital, accounted for as an associate
under IAS 28, is increased to a controlling holding of 50% or more.
(3) A controlling holding in a subsidiary is increased, say from 60% to 80%.
The first two transactions are treated in the same way, but the third is not. There is a reason for this.
9.2 General principle: 'crossing an accounting boundary'

Under IFRS 3 a business combination occurs only when one entity obtains control over another, which
is generally when 50% or more has been acquired. The 2008 Deloitte guide: Business Combinations and
Changes in Ownership Interests calls this 'crossing an accounting boundary'.
When this happens, the original investment – whether an investment in equity instruments with no
significant influence, or an associate – is treated as if it were disposed of at fair value and reacquired
at fair value. This previously held interest at fair value, together with any consideration transferred, is
the 'cost' of the combination used in calculating the goodwill.
If the 50% boundary is not crossed, as when a shareholding in an existing subsidiary is increased, the
event is treated as a transaction between owners.
Whenever you cross the 50% boundary, you revalue, and a gain or loss is reported in profit or loss
for the year. If you do not cross the 50% boundary, no gain or loss is reported; instead there is an
adjustment to the parent's equity.
The following diagram, adapted from the Deloitte guide to IFRS 3 (revised), may help you visualise the
boundary:
IAS 39 IAS 28/IFRS 11 IFRS 10
Acquisition of a
controlling interest in a
10% financial asset
Acquisition of a
controlling interest in
40%
an associate or joint
venture
0% 20% 50% 100%

Passive Significant Control
influence/joint
control
Figure 20.2: Transactions that Trigger Remeasurement of an Existing Interest
As you will see from the diagram, the third situation in section 9.1, where an interest in a subsidiary is
increased from, say, 60% to 80%, does not involve crossing that all-important 50% threshold. Likewise,
purchases of stakes up to 50% do not involve crossing the boundary, and therefore do not trigger a
calculation of goodwill.

9.3 Achieving control
When control is achieved:
 any previously held equity shareholding should be treated as if it had been disposed of and then
reacquired at fair value at the acquisition date; and
 any gain or loss on remeasurement to fair value should be recognised in profit or loss in the period.
£
Fair value of consideration paid to acquire control X
Non-controlling interest (valued using either fair value or the proportion of net assets X
method)
Fair value of previously held equity interest at acquisition date X
X
Fair value of net assets of acquiree (X)
Goodwill X
9.3.1 Reclassification adjustments on achieving control

One of the consequences of the previously held equity being treated as disposed of is that any
unrealised gains in respect of it become realised at the acquisition date and are accounted for under the
relevant IFRS:
(a) If the previously held equity was classified as an available-for-sale (AFS) financial asset, any gains in
respect of it which were previously recognised in other comprehensive income should now be
reclassified from other comprehensive income to profit or loss (IAS 39).
(b) If the previously held equity was classified as an investment in an equity-accounted associate and a
share of the associate's revaluation surpluses in respect of property, plant and equipment was
recognised, these surpluses should now be transferred within reserves, from the revaluation surplus
to retained earnings in the statement of changes in equity (IAS 16).
Worked example: Control in stages – previous holding an AFS investment

Bath Ltd has 1 million shares in issue. Bristol plc acquired 50,000 shares in Bath Ltd on 1 January 20X6
for £100,000. These shares were classified as available-for-sale financial assets and on
31 December 20X8 their carrying amount was £230,000 and increases in fair value of £130,000 had
been recognised in other comprehensive income and were held in equity. On 1 June 20X9 when the fair
value of Bath Ltd's net assets was £4 million, Bristol plc acquired another 650,000 shares in Bath Ltd for
£3.9 million. On 1 June 20X9 the fair value of the 50,000 shares already held was £250,000.
Requirement
Show the journal entry required in respect of the 50,000 shareholding on 1 June 20X9 and calculate the
goodwill acquired in the business combination on that date assuming that goodwill is valued using the
proportion of net assets method.
Solution
Journal entry C
£'000 £'000 H
A
DEBIT Investment in Bath Ltd (250,000 – 230,000) 20
P
DEBIT Other comprehensive income and AFS reserve 130 T
CREDIT Profit or loss 150 E
R
To recognise the gain on the deemed disposal of the shareholding in Bath Ltd existing immediately
before control being obtained.
20

Calculation of goodwill in respect of 70% (5% + 65%) holding in Bath Ltd:
£'000
Non-controlling interest (30% × £4m) 1,200
Acquisition-date fair value of previously held equity 250
5,350
Net assets acquired (4,000)
Goodwill 1,350
Interactive question 7: Control in stages – previous holding equity accounted

On 31 December 20X7, when the fair value of Feeder Ltd's net assets was £460,000, Lawn plc acquired
40,000 of Feeder Ltd's 100,000 equity shares. The consideration given was shares in Lawn plc valued at
£200,000.
Lawn plc acquired a further 30,000 shares in Feeder Ltd on 31 December 20X8 when the fair value of
Feeder Ltd's net assets was £510,000, the increase being as follows:
(a) £20,000 in respect of a revaluation surplus on freehold land
(b) £30,000 in respect of retained earnings
The consideration given was shares in Lawn plc valued at £216,000. On 31 December 20X8 the fair
value of the shares in Feeder Ltd previously held by Lawn plc was £236,000.
Requirement
Calculate the gain on the deemed disposal of Lawn plc's previously held equity investment in Feeder Ltd
on 31 December 20X8 and the goodwill acquired in this business combination assuming that the NCI is
valued using the proportion of net assets method.
9.4 Acquisitions that do not result in a change of control

Where an entity increases its investment in an existing subsidiary:
 no gain or loss is recognised;
 goodwill is not remeasured; and
 the difference between the fair value of consideration paid and the change in the non-controlling
interest is recognised directly in equity attributable to owners of the parent.
Worked example: Acquisitions that do not result in a change of control

On 1 June 20X6, Santander acquired 70% of the equity of Madrid in exchange for £760,000 cash and
100,000 Santander shares. At this date the fair value of the identifiable net assets of Madrid was
£850,000 and the market value of Santander shares was £2.50.
On 31 December 20X8, Santander acquired a further 10% of the equity of Madrid at a cost of
£105,000. On this date the identifiable net assets of Madrid were £970,000.
Santander measures the non-controlling interest using the proportion of net assets method.
Requirement
(a) What goodwill is recorded in the consolidated statement of financial position at
31 December 20X8, assuming that there is no impairment?
(b) What journal adjustment is required on the acquisition of the further 10% of shares?

Solution
(a) The goodwill included in the statement of financial position at 31 December 20X8 is that goodwill
calculated on the initial acquisition in June 20X6:
£'000
Consideration (£760,000 + (100,000 × £2.50)) 1,010
Non-controlling interest (30% × £850,000) 255
1,265
Net assets of acquiree (850)
Goodwill 415
(b) The adjustment required is based on the change in the non-controlling interest at the acquisition
date:
£
NCI on 31 December 20X8 based on old interest (30% × £970,000) 291,000
NCI on 31 December 20X8 based on new interest (20% × £970,000) 194,000
Adjustment required 97,000
Therefore:
DEBIT Non-controlling interest 97,000
DEBIT Shareholders' equity (bal fig) 8,000
CREDIT Cash 105,000
10 Disposals
Section overview
 Subsidiaries and associates are consolidated/equity accounted for until the date control/significant
influence is lost therefore profits need to be time apportioned.
 A gain on disposal must also be calculated, by reference to the fair value of any interest retained in
the subsidiary or associate.
An entity may sell all or some of its shareholding in another entity. Full disposals of subsidiaries and
associates were covered in FR and are revised here. Other situations which may arise are as follows:
 The sale of shares in a subsidiary such that control is retained
 The sale of shares in a subsidiary such that the subsidiary becomes an associate
 The sale of shares in a subsidiary such that the subsidiary becomes an investment
 The sale of shares in an associate such that the associate becomes an investment
10.1 Crossing an accounting boundary revisited

Under IFRS 3 a gain on disposal occurs only when one entity loses control over another, which is
generally when its holding is decreased to less than 50%. As noted above, the Deloitte guide: Business
Combinations and Changes in Ownership Interests calls this 'crossing an accounting boundary' but in this C
case the investment is being reduced, rather than increased as in sections 9.1 and 9.2 above. H
A
On disposal of a controlling interest, any retained shareholding (an associate or trade investment) P
is measured at fair value on the date that control is lost. This fair value is used in the calculation of T
the gain or loss on disposal, and also becomes the carrying amount for subsequent accounting for the E
R
retained shareholding.
If the 50% boundary is not crossed, as when the shareholding in a subsidiary is reduced, but control is
still retained, the event is treated as a transaction between owners and no gain or loss is recognised. 20

Whenever you cross the 50% boundary, you revalue, and a gain or loss is reported in profit or loss
for the year. If you do not cross the 50% boundary, no gain or loss is reported; instead there is an
adjustment to the parent's equity.
The following diagram, adapted from the Deloitte guide, may help you visualise the boundary:
IAS 39 IAS 28/IFRS 11 IFRS 10

Loss of control but
retaining financial asset
10% Loss of control but
retaining an associate
40% or joint venture
Loss of significant
10% influence or joint control
but retaining a financial asset
0% 20% 50% 100%
Passive Significant Control
influence/joint
control
Figure 20.3: Transactions that Require Remeasurement of a Retained Interest
The situation where a shareholding in a subsidiary is reduced from, say, 80% to 60% – that is, where
control is retained – does not involve crossing that all-important 50% threshold.
10.2 Disposal of a whole subsidiary or associate – revision

10.2.1 Parent company's accounts
In the parent's individual financial statements the profit or loss on disposal of a subsidiary or
associate holding will be calculated as:
£
Sales proceeds X
Less carrying amount (cost in P's own statement of financial position) (X)
Profit (loss) on disposal X/(X)
10.2.2 Group accounts – disposal of subsidiary

Gain or loss on disposal
In the group financial statements the profit or loss on disposal will be calculated as:
£ £
Proceeds X
Less: amounts recognised before disposal:
net assets of subsidiary X
goodwill X
Non-controlling interest (X)
(X)
Profit/loss X/(X)
Remember:
(a) If the disposal is mid year:
(i) a working will be required to calculate both net assets and the non-controlling interest at the
disposal date; and
(ii) any dividends declared or paid in the year of disposal and before the disposal date must be
deducted from the net assets of the subsidiary if they have not already been accounted for.
(b) Goodwill recognised before disposal is original goodwill arising less any impairments to date.

Worked example: Group gain or loss on disposal
Kingdom acquired 80% of Westville on 1 January 20X5 for £280,000 when Westville had share capital
of £100,000 and retained earnings of £188,000. On this date the fair value of the non-controlling
interest was £67,000. Kingdom's policy is to value the non-controlling interest using the fair value (ie,
full goodwill) method. Goodwill has suffered no impairment since acquisition.
On 30 June 20X8, Kingdom disposed of its investment in Westville, raising proceeds of £350,000.
The following are extracts from the accounts of Westville for the year ended 31 December 20X8:
£'000
Retained earnings b/f 215
A final dividend for 20X7 of £10,000 was paid on 14 March 20X8. This has not yet been accounted for.
Requirement
What profit or loss on disposal of Westville is reported in the Kingdom group accounts for the year
ended 31 December 20X8?
Solution
£ £
Proceeds 350,000
Less amounts recognised before disposal
Net assets of Westville (£100,000 + £215,000 + (1/2 × £24,000) – £10,000) 317,000
Goodwill (£280,000 + £67,000) – (£100,000 + £188,000) 59,000
NCI at disposal
Share of net assets (20%  £317,000) (63,400)
Goodwill on acquisition (£67,000 – (20% × £288,000)) (9,400)
(303,200)
Profit on disposal 46,800
Consolidated statement of financial position

The statement of financial position does not include the subsidiary disposed of, as it is no longer
controlled at the reporting date.
Consolidated statement of profit or loss and other comprehensive income
 The time-apportioned results of the subsidiary should be consolidated up to the date of disposal.
 The non-controlling interest must be time apportioned.
 The gain or loss on disposal forms part of the profit or loss for the year.
IFRS 5 discontinued operations
If the sale represents a discontinued operation per IFRS 5 the consolidated statement of profit or loss
and other comprehensive income will reflect, as one figure, 'Profit for the period from discontinued
operations', being the group profit on disposal plus the subsidiary's profit for the year to disposal.
10.2.3 Group accounts – disposal of associate C

H
In the consolidated financial statements the profit or loss on disposal should be calculated as: A
P
£ £ T
Proceeds X E
Less: cost of investment X R
share of post-acquisition profits retained by associate at disposal X
impairment of investment to date (X)
(X) 20
Profit/(loss) X/(X)

The other effects of disposal are also similar to those of the disposal of a subsidiary:
 There is no holding in the associate at the end of the reporting period, so there is no investment to
recognise in the consolidated statement of financial position.
 The associate's after-tax earnings should be included in consolidated profit or loss up to the date of
disposal.
10.3 Part disposal from a subsidiary holding

10.3.1 Subsidiary to subsidiary
Shares may be disposed of such that a subsidiary holding is still retained eg, a 90% holding is reduced
to a 70% holding.
In this case there is no loss of control and therefore:
 no gain or loss on disposal is calculated;
 no adjustment is made to the carrying value of goodwill; and
 the difference between the proceeds received and the change in the non-controlling interest is
accounted for in shareholders' equity.
 Consolidate as normal with the NCI calculated by reference to the year-end shareholding
 Calculate goodwill as at the original acquisition date
 Record the difference between NCI and proceeds in shareholders' equity as above
 Consolidate the subsidiary's results for the whole year
 Calculate the NCI on a pro rata basis
Worked example: Part disposal (subsidiary to subsidiary)

Express acquired 90% of Billings in 20X2 when Billings had retained earnings of £250,000. Goodwill
was calculated as £45,000 using the proportion of net assets method to value the non-controlling
interest. Goodwill has been impaired by £5,000 since acquisition.
At 31 December 20X8 the abbreviated statements of financial position of the two entities were as
follows:
Express Billings
£'000 £'000
Non-current assets 2,300 430
Investments 360 –
Current assets 1,750 220
4,410 650
Share capital 1,000 100
Retained earnings b/f 1,190 304
Profit for the year 120 36
Liabilities 2,100 210
4,410 650
Express disposed of a 10% holding in Billings on 31 August 20X8 for £70,000; this has not yet been
recorded in Express's individual accounts.
Requirement
Prepare the consolidated statement of financial position as at 31 December 20X8.

Solution
Express Group statement of financial position at 31 December 20X8
£'000
Non-current assets (£2,300,000 + £430,000) 2,730
Goodwill (£45,000 – £5,000) 40
Current assets (£1,750,000 + £220,000 + proceeds £70,000) 2,040
4,810
Share capital 1,000
Retained earnings (W1) 1,412
Non-controlling interest 20% × (£650,000 – £210,000) 88
Liabilities (£2,100,000 + £210,000) 2,310
4,810
WORKINGS
£'000
Retained earnings of Express (£1,190,000 + £120,000) 1,310.0
Retained earnings of Billings
Acquisition – 31 Aug 20X8 90% × (£304,000 + (8/12 × £36,000) – £250,000) 70.2
31 Aug 20X8 – 31 Dec 20X8 (80% × 4/12 × £36,000) 9.6
Impairment of goodwill (5.0)
NCI adjustment on disposal (W2) 27.2
1,412.0
(2) NCI adjustment on disposal

£'000
NCI in Billings at disposal:
NCI at acquisition (10% × (100 + 250)) 35.0
Share of post acqn. reserves (Working 3) 32.8
67.8
Increase 10%/10% 67.8
NCI after disposal: 20% 135.6
At disposal date:
NCI based on old shareholding (10% × £428,000) 42.8
NCI based on new shareholding (20% × £428,000) 85.6
Adjustment required 42.8
DEBIT Proceeds £70,000

CREDIT NCI £42,800
CREDIT Shareholders' equity (to Working 1) £27,200
(3) NCI share of post acqn. retained earnings

£'000
Retained earnings b/f 304.0
Profit to disposal (£36,000 × 8/12) 24.0
328.0
NCI share 10% 32.8
C
H
A
10.3.2 Subsidiary to associate P
T
Shares may be disposed of such that an associate holding is still retained, eg, a 90% holding is reduced E
to a 30% holding. R

In this case there is a loss of control, and so a gain or loss on disposal is calculated as: 20

£ £
Proceeds X
Fair value of interest retained X
X
Less net assets of subsidiary recognised before disposal:
Net assets X
Goodwill X
Non-controlling interest (X)
(X)
Profit/loss X/(X)
Worked example: Part disposal (subsidiary to associate)

Allister Group acquired a 75% holding in Brown in 20X0, which it held until 31 December 20X8 when
two-thirds of the investment were sold for £490,000.
At this date the net assets of Brown were £800,000, goodwill arising on acquisition had been fully
impaired and the fair value of a 25% interest in Brown was £220,000.
The non-controlling interest is valued using the proportion of net assets method.
Requirement
What gain or loss arises on the disposal in the Allister Group accounts in the year ended
31 December 20X8?
Solution
£ £
Proceeds 490,000
Fair value of 25% interest retained 220,000
710,000
Less amounts recognised before disposal:
Net assets of Brown 800,000
Goodwill (fully impaired) –
NCI at disposal (25% × £800,000) (200,000)
(600,000)
Gain on disposal 110,000
Note: The disposal triggers remeasurement of the residual interest to fair value. The gain on disposal
could be analysed as:
Realised gain £ £
Proceeds on disposal 490,000
Interest disposed of (50% × £800,000) (400,000)
90,000
Holding gain
Retained interest at fair value 220,000
Retained interest at carrying value (25% × £800,000) (200,000)
20,000
Total gain 110,000
The retained 25% interest in Brown is included in the consolidated statement of financial position at
31 December 20X8 at the fair value of £220,000.

 Equity account by reference to the year-end holding. The carrying value of the associate is based
on the fair value of the interest as included within the gain calculation.
 Consolidate results up to the date of disposal based on the pre-disposal holding
 Equity account for results after the date of disposal based on the post-disposal holding
 Include gain or loss on disposal as calculated above

Reclassification of other comprehensive income
At the date of disposal, amounts recognised in other comprehensive income in relation to the subsidiary
should be accounted for in the same way as if the parent company had directly disposed of the assets
that they relate to, for example:
(a) If the subsidiary holds available-for-sale assets then, on disposal, the amounts of other
comprehensive income recorded in the consolidated accounts in relation to these are reclassified to
profit or loss (recycled).
(b) If the subsidiary holds revalued assets, the revaluation surplus previously recognised in consolidated
other comprehensive income should be transferred to group retained earnings.
10.3.3 Subsidiary to investment

Shares may be disposed of such that an investment is still retained eg, a 90% holding is reduced to a
10% holding.
The gain or loss on disposal is calculated as described in section 10.2.2. Therefore at the point of
disposal, the retained interest is measured at fair value.
 The interest retained is initially recorded at fair value (as included within the gain calculation).
 Consolidate results up to the date of disposal based on the pre-disposal holding
 Include dividend income after the date of disposal
Reclassification of other comprehensive income
Upon loss of control, other comprehensive income recorded in relation to the subsidiary should again
be accounted for in the same way as if the parent company had directly disposed of the assets that it
relates to.
10.4 Part disposal from an associate holding

10.4.1 Associate to investment
Shares may be disposed of such that an investment is still retained eg, a 40% holding is reduced to a
10% holding.
In this case there is a loss of significant influence, and a gain or loss on disposal is calculated as:
£ £
Proceeds X
Fair value of interest retained X
X
Less: Cost of investment X
Share of post-acquisition profits retained by associate at disposal X
Impairment of investment to date (X) C
H
(X)
A
Profit/(loss) X/(X) P
T
Statement of financial position E
R
 The interest retained is initially recorded at fair value (as included within the gain calculation).
20
 Equity account for results up to the date of disposal based on the pre-disposal holding
 Include dividend income after the date of disposal

Interactive question 8: All types of disposal
Streatham Co bought 80% of the share capital of Balham Co for £324,000 on 1 October 20X5.
At that date Balham Co's retained earnings balance stood at £180,000. The statements of financial
position at 30 September 20X8 and the summarised statements of profit or loss for the year to that date
are given below:
Streatham Co Balham Co
£'000 £'000
Non-current assets 360 270
Investment in Balham Co 324 –
Current assets 370 370
1,054 640
Equity
Ordinary shares 540 180
Reserves 414 360
Current liabilities 100 100
1,054 640
Profit before tax 153 126
Tax (45) (36)
No entries have been made in the accounts for any of the following transactions.
Assume that profits accrue evenly throughout the year.
It is the group's policy to value the non-controlling interests at its proportionate share of the fair value of
the subsidiary's identifiable net assets.
Ignore tax on the disposal.
Requirements
Prepare the consolidated statement of financial position and statement of profit or loss at
30 September 20X8 in each of the following circumstances. (Assume no impairment of goodwill.)
(a) Streatham Co sells its entire holding in Balham Co for £650,000 on 30 September 20X8.
(b) Streatham Co sells one-quarter of its holding in Balham Co for £160,000 on 30 September 20X8.
In the following circumstances you are required to calculate the gain on disposal, group retained
earnings and carrying value of the retained investment at 30 September 20X8.
(c) Streatham Co sells one-half of its holding in Balham Co for £340,000 on 30 June 20X8, and the
remaining holding (fair value £250,000) is to be dealt with as an associate.
(d) Streatham Co sells one-half of its holding in Balham Co for £340,000 on 30 June 20X8, and the
remaining holding (fair value £250,000) is to be dealt with as a financial asset at fair value through
11 Consolidated statements of cash flows
Section overview
 The consolidated statement of cash flows shows the impact of the acquisition and disposal of
subsidiaries and associates.
 Exchange differences arising on the translation of the foreign currency accounts of group
companies will also impact the consolidated statement of cash flows. This is covered in more
detail in Chapter 21.
 Both single company and consolidated statements of cash flow were covered at Professional Level.
Single company statements were revised in Chapter 14 of this Study Manual. In this chapter we
summarise the main points and provide two interactive questions and two comprehensive self-test
questions. Please look back to your earlier study material if you have any major problems with
these.

11.1 Consolidated statements of cash flows – revision
You should remember from your Professional Level studies that the consolidated statement of cash flows
is put together from the consolidated financial statements themselves. Additional figures over and above
a single company statement of cash flows will be as follows:
 Dividends paid to the non-controlling interest
 Dividend received from associates and joint ventures
 Acquisitions/disposals of subsidiaries
 Acquisitions/disposals of associates and joint ventures
11.1.1 Cash flows to the non-controlling interest

The non-controlling interest represents a third party so dividends paid to the non-controlling interest
are reflected as a cash outflow. This payment should be presented separately and classified as 'Cash
flows from financing activities'.
Dividends paid to the non-controlling interest may be calculated using a T account as follows:
NON-CONTROLLING INTEREST
£ £
b/f NCI (CSFP) X
NCI (CIS) X
NCI dividend paid (balancing figure) X
c/f NCI (CSFP) X
X X
11.1.2 Associates and joint ventures

There are two issues to consider with regard to the associate/joint venture. (Note that joint ventures are
treated like associates in that they are equity accounted, so the points below apply to both.)
(1) The aim of the statement of cash flows is to show the cash flows of the parent and any subsidiaries
with third parties, therefore any cash flows between the associate and third parties are
irrelevant. As a result, the group share of profit of the associate must be deducted as an
adjustment in the reconciliation of profit before tax to cash generated from operations. This
is because group profit before tax includes the results of the associate.
(2) Dividends received from the associate must be disclosed as a separate cash flow classified as
'Cash flows from investing activities'. The cash receipt can be calculated as follows:
INVESTMENTS IN ASSOCIATES
£ £
b/f Investment in Associate (CSFP) X
Share of profit of Associate (CIS) X Dividend received (balancing figure) X
c/f Investment in Associate (CSFP) X
X X
11.1.3 Acquisitions and disposals of subsidiaries

If a subsidiary is acquired or disposed of during the accounting period the net cash effect of the
purchase or sale transaction should be shown separately under 'Cash flows from investing C
activities'. The net cash effect will be the cash purchase price/cash disposal proceeds net of any cash or H
A
cash equivalents acquired or disposed of.
P
As the cash effect of the acquisition/disposal of the subsidiary is dealt with in a single line item as we saw T
E
above, care must be taken not to double count the effects of the acquisition/disposal when R
looking at the movements in individual asset balances.
20

Each of the individual assets and liabilities of a subsidiary acquired/disposed of during the period must
be excluded when comparing group statements of financial position for cash flow calculations as
follows:
Subsidiary acquired in the period Subtract PPE, inventories, payables, receivables etc, at the
date of acquisition from the movement on these items.
Subsidiary disposed of in the period Add PPE, inventories, payables, receivables etc, at the
date of disposal to the movements on these items.
This would also affect the calculation of the dividend paid to the non-controlling interest. The
T account working is modified as follows:
NON-CONTROLLING INTEREST
£ £
NCI in Subsidiary at disposal X b/f NCI (CSFP) X
NCI dividend paid (balancing X NCI in Subsidiary at acquisition X
figure)
c/f NCI (CSFP) X NCI (CIS) X
X X
11.1.4 Acquisitions and disposals of associates

If an associate is acquired or disposed of during the accounting period the payment or receipt of cash
is classified as investing activities.
Interactive question 9: Acquisition of a subsidiary

On 1 October 20X8 Pippa plc acquired 90% of S Ltd by issuing 100,000 shares at an agreed value of £2
per share and paying £100,000 in cash.
At that time the net assets of S Ltd were as follows:
£'000
Property, plant and equipment 190
Inventories 70
Trade receivables 30
Cash and cash equivalents 10
Trade payables (40)
260
The consolidated statements of financial position of Pippa plc as at 31 December were as follows:
20X8 20X7
£'000 £'000
Non-current assets
Property, plant and equipment 2,500 2,300
Goodwill 66 –
2,566 2,300
Current assets
Inventories 1,450 1,200
Trade receivables 1,370 1,100
Cash and cash equivalents 76 50
2,896 2,350
5,462 4,650

20X8 20X7
£'000 £'000
Equity attributable to owners of the parent
Ordinary share capital (£1 shares) 1,150 1,000
Share premium account 650 500
Retained earnings 1,791 1,530
3,591 3,030
Non-controlling interest 31 –
Total equity 3,622 3,030
Current liabilities
Trade payables 1,690 1,520
Income tax payable 150 100
1,840 1,620
5,462 4,650
The consolidated statement of profit or loss for the year ended 31 December 20X8 was as follows:
£'000
Revenue 10,000
Cost of sales (7,500)
Gross profit 2,500
Administrative expenses (2,080)
Profit before tax 420
Income tax expense (150)
Profit attributable to:
Owners of Pippa plc 261
Non-controlling interest 9
270
The statement of changes in equity for the year ended 31 December 20X8 (extract) was as follows:
Retained
earnings
£'000
Balance at 31 December 20X7 1,530
Total comprehensive income for the year 261
Balance at 31 December 20X8 1,791
You are also given the following information:
(1) All other subsidiaries are wholly owned.
(2) Depreciation charged to the consolidated statement of profit or loss amounted to £210,000.
(3) There were no disposals of property, plant and equipment during the year.
(4) Goodwill is not impaired.
(5) Non-controlling interest is valued on the proportionate basis.
Requirement
Prepare a consolidated statement of cash flows for Pippa plc for the year ended 31 December 20X8
under the indirect method in accordance with IAS 7 Statement of Cash Flows. The only notes required
are those reconciling profit before tax to cash generated from operations and a note showing the effect
of the subsidiary acquired in the period. C
H
A
P
T
E
R
20

Interactive question 10: Disposal
Below is the consolidated statement of financial position of the Caitlin Group as at 30 June 20X8 and
the consolidated statement of profit or loss for the year ended on that date:
Consolidated statement of financial position as at 30 June
20X8 20X7
£'000 £'000
Non-current assets
Current assets
Inventories 736 535
Receivables 605 417
1,635 1,190
5,702 5,140
Share capital 1,000 1,000
4,637 4,118
Non-controlling interest 482 512
Total equity 5,119 4,630
Current liabilities
Trade payables 380 408
Income tax payable 203 102
583 510
5,702 5,140
Consolidated statement of profit or loss for the year ended 30 June 20X8 (summarised)
£'000
Continuing operations
Income tax expense (((290)
Profit for the year from continuing operations 572
Discontinued operations
Profit for the year from discontinued operations 50
Owners of Caitlin plc 519
622
You are given the following information:

(1) Caitlin plc sold its entire interest in Desdemona Ltd on 31 March 20X8 for cash of £400,000.
Caitlin plc had acquired an 80% interest in Desdemona Ltd on incorporation several years ago. The
net assets at the date of disposal were:
£'000
Inventories 50
Receivables 39
Trade payables (42)
457
(2) The profit for the period from discontinued operations figure is made up as follows:
£'000
Income tax expense (4)
Profit on disposal 34
50

(3) The depreciation charge for the year was £800,000.
There were no disposals of non-current assets other than on the disposal of the subsidiary.
Requirements
With regard to the consolidated statement of cash flows for the year ended 30 June 20X8:
(a) Show how the disposal will be reflected in the statement of cash flows.
(b) Calculate additions to property, plant and equipment as they will be reflected in the statement of
cash flows.
(c) Calculate dividends paid to the non-controlling interest.
(d) Prepare the note to the statement of cash flows required for the disposal of the subsidiary.
(e) Prepare the reconciliation of profit before tax to cash generated from operations.
Work to the nearest £'000.
12 Audit focus: group audits
Section overview
 The group auditor has sole responsibility for the audit opinion on the group financial statements.
 The component auditors should co-operate with the group auditors. In some cases this will be a
legal duty.
 The group auditor will need to assess the extent to which the work of the component auditors can
be relied on.
 Specific audit procedures will be performed on the consolidation process.
 Where a group includes a foreign subsidiary, compliance with relevant accounting standards will
need to be considered.
12.1 Introduction
Many of the basic principles applied in the audit of a group are much the same as the audit of a single
company. However, there are a number of significant additional considerations.
The first area to consider is the use of another auditor. Often, one or more subsidiaries in the group will
be audited by a different audit firm. Evaluating whether the component auditor's work can be relied on,
and communicating effectively with the component auditor, therefore become important.
Another of the key issues will be the impact of the group structure on the risk assessment, including
the process by which the existing structure has been achieved eg, acquisition and MBO, and/or changes
to that structure. In many cases, the risk issues will be related to the accounting treatments adopted.
12.2 Acceptance as group auditors

C
ISA (UK) 600 (Revised June 2016) Special Considerations – Audits of Group Financial Statements (Including
H
the Work of Component Auditors) was revised in June 2016. The main changes result from the A
implementation in the UK of the Audit Directive. P
T
ISA 600.12 states that the auditor must consider whether 'sufficient appropriate audit evidence can E
reasonably be expected to be obtained in relation to the consolidation process and the financial R
information of the components on which to base the group audit opinion'. For this purpose, the group
engagement partner must obtain an understanding of the group. This may be obtained from the
following sources. 20

In the case of a new engagement:
 Information provided by group management
 Communication with group management
 Where applicable, communication with the previous group engagement team, component
manager or component auditors
Other matters to consider will include the following:
 The group structure
 Components' business activities including the industry and regulatory, economic and political
environments in which those activities take place
 The use of service organisations
 A description of group-wide controls
 The complexity of the consolidation process
 Whether component auditors that are not from the group engagement partner's firm will perform
work on the financial information of any of the components
 Whether the group engagement team will have unrestricted access to those charged with
governance of the group, those charged with governance of the component, component
management, component information and the component auditors (including relevant audit
documentation sought by the group engagement team)
 Whether the group engagement team will be able to perform necessary work on the financial
information of the components (ISA 600.A10–.A11)
In the case of continuing engagements, the group engagement team's ability to obtain sufficient
appropriate audit evidence may be affected by significant changes, for example changes in group
structure, changes in business activities and concerns regarding the integrity and competence of group
or component management. (ISA 600.A12)
Where components within the group are likely to be significant components the group engagement
partner evaluates the extent to which the group engagement team will be able to be involved in the
work of those component auditors.
The group engagement partner must either refuse to accept, or resign from, the engagement if he
concludes that it will not be possible to obtain sufficient appropriate audit evidence. (ISA 600.13)
Point to note:
In addition to these points, the prospective group auditor should consider the general points relating to
acceptance of appointment which you have covered in your earlier studies.
12.3 Using the work of another auditor

We have identified the fact that entities within the group may be audited by different auditors as a risk
factor. Guidance on this aspect of the group audit is provided in ISA 600. Subsidiaries may be audited
by firms other than the parent company auditor, meaning that the parent company auditor will have to
express an opinion on financial information, some of which has been audited by another party.
ISA 600 addresses this issue in particular and is summarised below.
12.3.1 Responsibility of group auditors
Definitions
Group audit: The audit of the group financial statements.
Group engagement partner: The partner or other person in the firm who is responsible for the group
audit engagement and its performance and for the auditor's report on the group financial statements
that is issued on behalf of the firm.

Group engagement team: Partners and staff who establish the overall group audit strategy,
communicate with component auditors, perform work on the consolidation process, and evaluate the
conclusions drawn from the audit evidence as the basis for forming an opinion on the group financial
statements.
Component auditor: An auditor who, at the request of the group engagement team, performs work on
financial information related to a component for the group audit.
Component: An entity or business activity for which the group or component management prepares
financial information that should be included in the group financial statements.
Component materiality: The materiality level for a component determined by the group engagement
team.
Significant component: A component identified by the group engagement team: (a) that is of
individual significance to the group, or (b) that, due to its specific nature or circumstances, is likely to
include significant risks of material misstatement of the group financial statements.
(ISA 600.9)
The duty of the group auditors is to report on the group accounts, which includes balances and
transactions of all the components of the group.
In the UK (and in most jurisdictions), the group auditors have sole responsibility for this opinion even
where the group financial statements include amounts derived from accounts which have not been
audited by them. ISA 600 explains that even where an auditor is required by law or regulation to refer
to the component auditors in the auditor's report on the group financial statements, the report must
indicate that the reference does not diminish the group engagement partner's or the firm's responsibility
for the group audit opinion. As a result, they cannot discharge their responsibility to report on the
group financial statements by an unquestioning acceptance of component companies' financial
statements, whether audited or not. (ISA 600.11)
Point to note:
In the UK for audits of group financial statements of PIEs the group engagement partner is also
responsible for the additional report to the audit committee as required by ISA 260. (ISA 600.49D1)
12.3.2 Rights of group auditors

The group auditors of a parent company incorporated in the UK have the following rights:
 The right to require the information and explanations they require from auditors of subsidiaries also
incorporated in the UK
 The right to require the parent company to take all reasonable steps to obtain reasonable
information and explanations from foreign subsidiaries
In the UK, these rights are contained in the Companies Act 2006, although the principle of co-operation
is also addressed in ISA 600. ISA 600.19D1 states that 'The group engagement team shall request the
agreement of the component auditor to the transfer of relevant documentation during the conduct of
the group audit, a condition of the use by the group engagement team of the work of the component
auditor'. We will consider the wider issue of co-operation in the remainder of this section.
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Note: The group auditors also have all the statutory rights and powers in respect of their audit of the H
parent company that you should be familiar with from your earlier studies (for example, right of access A
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at all times to the parent company's books, accounts and vouchers).
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12.4 Planning and risk assessment as group auditor
The planning and risk assessment process will need to take into account the fact that all elements of the 20
group financial statements are not audited by the group auditor directly. The group auditor will not be
able to simply rely on the conclusions of the component auditor. ISA 600 requires the group auditor to
evaluate the reliability of the component auditor and the work performed. This will then determine the
extent of further procedures.

Understanding the component auditor
This involves an assessment of the following:
(a) Whether the component auditor is independent and understands and will comply with the ethical
requirements that are relevant to the group audit
(b) The component auditor's professional competence
(c) Whether the group engagement team will be involved in the work of the component auditor to
the extent that it is necessary to obtain sufficient appropriate audit evidence
(d) Whether the component auditor operates in a regulatory environment that actively oversees
auditors (ISA 600.19)
The group engagement team's understanding of the component auditor's professional competence may
include considering whether the component auditor:
 possesses an understanding of auditing and other standards applicable to the group audit;
 in the UK, has sufficient resources to perform the work;
 possesses the special skills necessary to perform the work; and
 where relevant, possesses an understanding of the applicable financial reporting framework.
(ISA 600.A38)
The group engagement team may obtain this understanding in a number of ways. In the first year, for
example, the component auditor may be visited to discuss these issues. Alternatively, the component
auditor may be asked to confirm these matters in writing or to complete a questionnaire. Confirmations
from professional bodies may also be sought and the reputation of the firm will be taken into account.
Materiality
The group auditor is responsible for setting the materiality level for the group financial statements as a
whole. Materiality levels should also be set for components which are individually significant. These
should be set at a lower level than the materiality level of the group as a whole. (ISA 600.21)
Extent of work required on components
The ISA distinguishes between significant components and other components which are not
individually significant to the group financial statements.
The group auditor should be involved in the assessment of risk in relation to significant components.
If a component is financially significant to the group financial statements then the group engagement
team or a component auditor will perform a full audit based on the component materiality level.
If the component is likely to include significant risks of material misstatement of the group financial
statements due to its nature or circumstances, the group auditors will require one of the following:
 A full audit using component materiality
 An audit of specified account balances related to identified significant risks
 Specified audit procedures relating to identified significant risks (ISA 600.27)
Components that are not significant components will be subject to analytical review at a group level.
(ISA 600.28)
If the group engagement team does not consider that sufficient appropriate audit evidence on which to
base the group audit opinion will be obtained from the work performed on significant components, on
group-wide controls and the consolidation process and the analytical procedures performed at group
level, then some components that are not significant components will be selected and one or more of
the following will be performed (either by the group auditor or the component auditor):
 An audit using component materiality
 An audit of one or more account balances, classes of transactions or disclosures
 A review using component materiality
 Specified procedures (ISA 600.29)

Involvement in the work of a component auditor
The extent of involvement by the group auditor at the planning stage will depend on the:
 significance of the component;
 identified significant risks of material misstatement of the group financial statements; and
 group auditor's understanding of the component auditor.
Based on these factors the group auditors may perform the following procedures:
(a) Meeting with the component management or the component auditors to obtain an understanding
of the component and its environment
(b) Reviewing the component auditor's overall audit strategy and audit plan
(c) Performing risk assessment procedures to identify and assess risks of material misstatement at the
component level. These may be performed with the component auditor or by the group auditor
Where the component is a significant component the nature, timing and extent of the group auditor's
involvement is affected by their understanding of the component auditor but at a minimum should
include the following procedures:
(a) Discussion with the component auditor or component management regarding the component's
business activities that are significant to the group
(b) Discussing with the component auditor the susceptibility of the component to material
misstatement of the financial information due to fraud or error
(c) Reviewing the component auditor's documentation of identified significant risks of material
misstatements. This may be in the form of a memorandum including the conclusions drawn by the
component auditors (ISA 600.30)
12.4.1 Evaluating the work of the component auditor

For all companies in the group, the group auditor is required to perform a review of the work done by
the component auditor (ISA 600.42D1). This is normally achieved by reviewing a report or
questionnaire completed by the component auditor which highlights the key issues which have been
identified during the course of the audit. The effect of any uncorrected misstatements and any instances
where there has been an inability to obtain sufficient appropriate audit evidence should also be
evaluated. On the basis of this review the group auditor then needs to determine whether any
additional procedures are necessary. These may include the following:
 Designing and performing further audit procedures. These may be designed and performed with
the component auditors, or by the group auditor
 Participating in the closing and other key meetings between the component auditors and
component management
 Reviewing other relevant parts of the component auditors' documentation
12.4.2 Communication
The group engagement team shall communicate its requirements to the component auditor on a timely
basis. (ISA 600.40)
ISA 600 prescribes the types of information that must be sent by the group auditor to the component C
auditor and vice versa. H
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The group auditor must set out for the component auditor the work to be performed, the use to be P
made of that work and the form and content of the component auditor's communication with the T
group engagement team. This includes the following: E
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 A request that the component auditor confirms their co-operation with the group engagement
team
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 The ethical requirements that are relevant to the group audit and in particular independence
requirements

 In the case of an audit or review of the financial information of the component, component
materiality and the threshold above which misstatements cannot be regarded as clearly trivial to
the group financial statements
 Identified significant risks of material misstatement of the group financial statements, due to fraud
or error that are relevant to the work of the component auditor. The group engagement team
requests the component auditor to communicate any other identified significant risks of material
misstatement and the component auditor's responses to such risks
 A list of related parties prepared by group management and any other related parties of which
the group engagement team is aware. Component auditors are requested to communicate any
other related parties not previously identified
In addition to the above, the group auditor must ask the component auditor to communicate matters
relevant to the group engagement team's conclusion with regard to the group audit. These include the
following:
(a) Whether the component auditor has complied with ethical requirements that are relevant to the
group audit, including independence and professional competence
(b) Whether the component auditor has complied with the group engagement team's requirements
(c) Identification of the financial information of the component on which the component auditor is
reporting
(d) Information on instances of non-compliance with laws and regulations that could give rise to
material misstatement of the group financial statements
(e) A list of uncorrected misstatements of the financial information of the component (the list need
not include items that are below the threshold for clearly trivial misstatements)
(f) Indicators of possible management bias
(g) Description of any identified significant deficiencies in internal control at the component level
(h) Other significant matters that the component auditor communicated or expects to communicate
to those charged with governance of the component, including fraud or suspected fraud involving
component management, employees who have significant roles in internal control at the
component level or others where the fraud resulted in a material misstatement of the financial
information of the component
(i) Any other matters that may be relevant to the group audit or that the component auditor wishes
to draw to the attention of the group engagement team, including exceptions noted in the written
representations that the component auditor requested from component management
(j) The component auditor's overall finding, conclusions or opinion
This communication often takes the form of a memorandum or report of work performed.
12.4.3 Communicating with group management and those charged with governance
ISA 600 states that the group engagement team will determine which of the identified deficiencies in
internal control should be communicated to those charged with governance and group management.
In making this assessment the following matters should be considered.
 Significant deficiencies in the design or operating effectiveness of group-wide controls
 Deficiencies that the group engagement team has identified in internal controls at components
that are judged to be significant to the group
 Deficiencies that component auditors have identified in internal controls at components that are
judged to be significant to the group
 Fraud identified by the group engagement team or component auditors or information indicating
that a fraud may exist (ISA 600.46-.47)
Where a component auditor is required to express an audit opinion on the financial statements of a
component, the group engagement team will request group management to inform component
management of any matters that they, the group engagement team, have become aware of that may

be significant to the financial statements of the component. If group management refuses to pass on
the communication, the group engagement team will discuss the matter with those charged with
governance of the group. If the matter is still unresolved the group engagement team shall consider
whether to advise the component auditor not to issue the audit report on the component financial
statements until the matter is resolved. (ISA 600.48)
12.4.4 Communication with those charged with governance of the group

The following matters should be communicated to those charged with governance of the group:
(a) An overview of the type of work to be performed on the financial statements of the component
(b) An overview of the nature of the group engagement team's planned involvement in the work to be
performed by the component auditors on significant components
(c) Instances where the group engagement team's evaluation of the work of a component auditor
gave rise to a concern about the quality of that auditor's work
(d) Any limitations on the group audit, for example, where the group engagement team's access to
information may have been restricted
(e) Fraud or suspected fraud involving group management, component management, employees who
have significant roles in group-wide controls or others where fraud resulted in a material
misstatement of the group financial statements (ISA 600.49)
12.4.5 Documentation
The group engagement team must include in the audit documentation the following matters:
(a) An analysis of components, indicating those that are significant
(b) The nature, timing and extent of the group engagement team's involvement in the work
performed by the component auditors on significant components including, where applicable, the
group engagement team's review of the component auditor's audit documentation
(c) Written communications between the group engagement team and the component auditors about
the group engagement team's requirements
In the UK, the Companies Act 2006 requires group auditors to review the audit work conducted by
other persons and to record that review. This requirement is now also specifically addressed in the
revised ISA (ISA 600.50D1).
Interactive question 11: Component auditors

You are the main auditor of Mouldings Holdings, a listed company, which has subsidiaries in the UK and
overseas, many of which are audited by other firms. All subsidiaries are involved in the manufacture or
distribution of plastic goods and have accounting periods coterminous with that of the parent company.
Requirements
(a) State why you would wish to review the work of the auditors of the subsidiaries not audited by
you.
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(b) Describe the key audit procedures you would carry out in performing such a review. H
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See Answer at the end of this chapter. P
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12.5 Risk assessment procedures
12.5.1 General accounting issues 20
Consolidated financial statements give rise to additional audit risks:

 Are consolidated group accounts correctly prepared?

 Where there have been any disposals of material business segments, have the requirements of
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations been satisfied?
 Have adequate disclosures of significant investments and financing been made?
 Where there have been acquisitions during the year, have new assets and liabilities been correctly
brought into the financial statements?
 Where there have been acquisitions during the year, has purchase consideration been correctly
accounted for and disclosed?
 Have foreign taxes (including corporate tax, income taxes for employees and capital gains tax)
been accounted for correctly?
 Have transfer pricing issues around intercompany transactions, and their VAT impact, been
considered?
12.5.2 Acquisition
Acquisitions can take many forms. The type of acquisition (eg, hostile, friendly) and future management
of the subsidiary (fully integrated, autonomous) will also impact on risk.
Risk areas Key issues
Valuation of assets and liabilities These should be valued at fair value at the date of
acquisition in accordance with IFRS 13.
Valuation of consideration This should be at fair value and will include any
contingent consideration. Any deferred
consideration should be discounted.
Goodwill This must be calculated and accounted for in
accordance with IFRS 3.
Date of control The results of any subsidiary should only be
accounted for from the date of acquisition.
Level of control or influence This will determine the nature of the investment and
its subsequent treatment in the group financial
statements eg, subsidiary, associate and should be
determined in accordance with IFRS 10/IAS 28
(IFRS 10 retains control as the key concept
underlying the parent/subsidiary relationship but
has broadened the definition and clarified the
application).
Accounting policies/reporting periods Accounting policies and reporting periods must be
consistent across the group.
Consolidation adjustments The group must have systems which enable the
identification of intra-group balances and accounts.
Adequacy of provisions in the target company While the acquirer is likely to know its plans, other
provisions may be necessary within the acquired
entity.
If such provisions are currently unrecognised and
have never been recorded (eg, in board minutes),
there is a clear risk that the acquiring entity will
overpay.
Use of provisions to manipulate post- Provisions may be recognised at the point of
acquisition profits acquisition and then released at some point in the
future in order to make post-change results appear
impressive. This may imply that change was a
correct business decision. The use of such provisions
has been reduced by IAS 37.

12.5.3 Divestment and withdrawal
The withdrawal from a market will give rise to several audit issues:
Obsolete inventory
Inventory which is no longer required will need to be written down. When carrying out the inventory
count, the auditor will need to ensure that all inventory relating to the discontinued activity is identified.
The following procedures should take place.
 Discussions with management concerning net realisable value of inventory
 Investigation of future costs relating to any modifications needed for the inventory
 Review of after-date sales to assess likelihood of sale and sale proceeds
Obsolete non-current assets
If an operation has been withdrawn from, rather than sold as, a business segment, it is likely that some
non-current assets such as plant and machinery and property will remain with the company. The
following will need to be considered.
(a) Net realisable value of non-current assets (review of post year end sales invoices/review of trade
magazines)
(b) Write-down of non-current assets to recoverable amount, surplus property to the market value
(c) Impairment reviews will need to be performed. This is likely to consider the remaining assets as
one cash generating unit; lack of future revenue from this unit is likely to result in the assets being
valued at their net realisable value (ie, fair value less costs of disposal) rather than their value in use
Disposal of investments
Disposal of a subsidiary, or other investment, will need to be accounted for in the group and parent
company financial statements.
The auditor will need to ascertain the date of disposal, through inspection of sale agreements, to
identify the correct period of allocation to the accounts.
(a) Parent company – The auditor will need to compare the sale proceeds (inspection of sale
agreements/bank receipts) with the carrying amount of the investment in the statement of
financial position to ensure that the correct profit or loss on disposal is accounted for.
(b) Group accounts – The auditor would need to ensure that the investment is not included in the
year-end statement of financial position (unless some shareholding remains). Amounts in the
statement of profit or loss and other comprehensive income should be pro-rated for the number of
months held.
Chargeable gains and corporation tax
The disposal of a subsidiary or other investment is likely to have chargeable gains tax and corporation
tax implications. These include:
(a) Chargeable gains on disposal – Chargeable gains or losses will arise on the disposal of subsidiaries
or other investments. The auditor will need to discuss with management and inspect the sale
agreement, in order to understand which party will bear the tax liability arising from chargeable
gains. Where the tax liability falls on the seller, the chargeable gains tax calculations must be
reviewed, and the utilisation of losses or tax relief verified. This should be done by a tax specialist if C
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the matter is material. A
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(b) Degrouping charges – Degrouping charges will arise if any assets have previously been transferred
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to the subsidiary being sold at no gain/no loss. If the amount is material, the workings should be E
reviewed and recalculated. R
(c) Intra-group balances – Existing loans and other outstanding balances with group companies may
be written off when subsidiaries are disposed of or liquidated. The availability of corporation tax
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deductions on intercompany loan write-offs can be a complex issue and often constitutes a
material matter. The corporation tax calculations should therefore be reviewed by a tax accounting
specialist.

12.5.4 Joint arrangements
The example below illustrates some of the risk factors the auditor needs to consider in relation to joint
arrangements.
Worked example: Joint arrangements

The Royal Bank of Edinburgh (RBE) has entered into several joint arrangements:
(1) 'Ecost Personal Finance has made excellent progress since it was launched 18 months ago. To date,
it has acquired over 700,000 customers.
In a relatively short time, in partnership with Ecost, we have established a significant and innovative
new force in UK banking. We remain very optimistic about the prospects for Ecost Personal Finance
and our expectations remain that this business will move into profit in the near future.
(2) We have also received an encouraging response to the Branson One Account through our
collaboration with Branson Direct Personal Financial Services.'
Requirement
Examine the risk factors associated with the Royal Bank of Edinburgh joint arrangements.
Solution
Costs
The set-up costs of the two ventures will need financing. Will this be done from the existing funds
within the companies, or will external finance be needed?
As RBE is a financial institution, is it providing the bulk of the finance with loan amount outstanding to
the other parties?
How will the infrastructure be established? Who will pay for the website to be constructed and
maintained? What is the split of these costs?
What is the profit forecast for the first periods? Initial expenses are likely to exceed revenues, therefore
losses may be expected in the initial periods.
Accounting
RBE is already established in this market and is therefore likely to be providing the asset base to support
its activities. How are the assets valued in the joint venture accounts?
Is there any payment to be made to RBE for the knowledge and experience that it brings to the joint
arrangements?
What type of joint arrangement is it?
What is the agreement on profit sharing? The underlying elements will need to be audited and the
profit share recalculated. The tax liability arising from RBE's share of the profits also needs to be audited.
How long is the joint arrangement agreement for? This will help ascertain the correct write-off period of
assets.
If either of the joint arrangements is loss making, has consortium relief been assumed in RBE's accounts?
Has this been correctly calculated?
Markets
The products are likely to be launched through the internet; this may expand the customer base of the
companies. E-business has its own specific set of risks; these are covered in the Business Strategy section
of Business Environment.
People
It is likely that there will be a combination of staff involved from each of the parties, plus some
additional staff new to both organisations. The cultural and operational impacts (as explained in the
main text) need to be considered.

Systems
If the arrangements described are joint ventures, a completely new set of systems will need to be
established. Risk will be increased due to the unfamiliarity of the staff with these systems.
Responsibility for control
If the entity is a limited company then the directors will be responsible for ensuring proper controls.
12.5.5 Management buy-outs

Whether it is a management buy-out (MBO), a management buy-in (MBI) or a combination of the two
(BIMBO), the most pressing risk is that one party is likely to have a comparative advantage on detailed
financial information. In this respect, the current management team of a business have a major
advantage over existing shareholders, interested investors/buyers and providers of finance.
For example, in an MBI where the outgoing management team own stakes in the entity, there is an
inherent danger of overstating the value of the organisation. In an MBO, it may work both ways, with
the MBO team looking for as low a price as possible, but also needing to convince outside providers of
finance to invest.
In a BIMBO, the situation becomes even more complicated, with the existing management team
looking to convince the additional management team that prospects are good in order to conclude the
deal, while knowing that once the deal is finalised the two groups will have to work in tandem.
In addition to the above issues, an existing management team may find its role changing from manager
to owner/manager, introducing new risks (conflict of interest, bias in preparing financial information
etc).
In any buy-out scenario, both historical and future financial information will play a key role.
Consistency must exist between accounting treatments in both past and future data to ensure
comparability.
Historical data is likely to suffer from the problem that the audit was not designed with a business
valuation in mind. Future data presents a more obvious problem for auditors and accountants, in that
there is full knowledge of the reasons for preparation and, as such, liability for error and omission is
clearer. The level of assurance, and therefore the level of detail of the assurance work, will necessarily be
greater than for a statutory audit.
As a result of these issues, the external parties in a buy-out situation are likely to take independent
assurance advice, rather than reliance being placed on the work of the company's usual auditors or
accountants. While any deal remains incomplete, privacy is likely to ensure that external parties have to
rely on complete and accurate information being presented. The due diligence exercise (see
Chapter 25) provides a detailed verification, normally after the deal is complete, that the information
relied upon was correct.
The greater the level of assurance that can be achieved, the easier it is likely to be to raise finance,
whatever the source. The cost of finance may also be reduced if the assurance achieved is considered
reliable. For this reason, many organisations will pay relatively high professional fees to the largest and
most renowned firms of accountants and advisers.
While the initial investment in fees is high, the returns (greater probability of finance and at a lower
cost) can easily make the decision valid. C
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12.6 Audit procedures P
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The diagram below summarises the key points in the context of the group audit. E
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Risk assessment
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Accounting Subsidiaries'
treatment in group financial statements
accounts

Potential misstatement in group accounts due Factors affecting risk of material misstatement
to in subsidiary financial statements
 Misclassification of investments (subsidiary vs  Scope of component auditors' work (may not
associate vs financial asset) provide sufficient appropriate evidence that
 Inappropriate inclusion, or exclusion from, financial statements are free from material
consolidation or incorrect treatment of misstatement)
excluded subsidiaries  Past audit problems
 Inappropriate consolidation method
 Anticipated changes
 Inappropriate translation method for overseas
subsidiaries  Materiality
 Incorrect consolidation adjustments eg, failure  Sufficiency of evidence to confirm amounts

to eliminate intra-group items properly eg,  Overseas subsidiaries (see section 12.8)
leading to potential overstatements of assets
and profits  Non-coterminous year ends
 Inconsistent accounting policies for amounts  Existence of letter of comfort (see section 12.9)
included in consolidation
 Incorrect calculation (fair values) or treatment
of goodwill
 Incorrect calculation of profit/loss on disposal
or classification of results of subsidiaries
disposed of (continuing vs discontinued)
 Incorrect determination of date of acquisition
 Deferred or contingent consideration; step
acquisition
12.6.1 Acquisition
If the group audit includes a newly acquired subsidiary or a subsidiary which is disposed of, compliance
with IFRS 3 and IFRS 10 will be relevant. The auditor will need to consider the following issues in particular:
Issue Audit consequence
Level of control The auditor will need to consider whether the

appropriate accounting treatment has been
adopted depending on the level of control (per
IFRS 10 an investor controls an investee if it has
power over the investee, exposure or rights to
variable returns and the ability to use power to
affect returns). Procedures will be as follows:
 Identify total number of shares held to
calculate % holding.
 Review contract or agreements between
companies to identify key terms which may
indicate control and any restriction on control
eg, right of veto of third parties.
Date of control/change in stake The auditor should:
 Review purchase agreement to identify date
of control.
 Ensure consolidation has occurred from date
control achieved.
 Review consolidation schedules to ensure
amounts have been time apportioned if
appropriate.

Valuation of assets and liabilities at fair value A review will need to be carried out of the fair
value of assets and liabilities at the date of
acquisition, adjusted to the year end (in
accordance with IFRS 13). Review of trade journals
or specialist valuations may be required. Where
specialist valuers have been used (eg, to value
brands) an assessment will need to be made on the
reliability of these valuations. Where intangibles
have been recognised on consolidation which
were not previously recognised in the individual
financial statements of the company acquired the
auditor will need to give careful consideration as to
the justification of this and whether the treatment
is in accordance with IFRS 3/IFRS 13.
Estimates for provisions existing at the date of
acquisition will need to be assessed for reliability.
Valuation of consideration Contingent consideration should be included as
part of the consideration transferred. It must be
measured at fair value at the acquisition date. The
discount rate used to discount deferred
consideration should be validated.
Goodwill The auditor will need to consider whether the
initial calculation is correct in accordance with
IFRS 3. Performance of the subsidiary company will
need to be reviewed to identify whether any
impairment is necessary.
Tax liabilities and assets The amount of corporation tax liabilities provided
for will need to be reviewed.
Deferred tax assets and liabilities must also be
reviewed. The impairment of assets or goodwill
should be taken into account.
Prior year audit of subsidiary As first year of inclusion of subsidiary, review last
year's audit report for any modification and
consider implications for this year's audit if
necessary.
Planning issues Adjust audit plan to ensure visit to subsidiary is
included. If audited by another auditor contact
secondary auditor to discuss the following:
 Audit deadline
 Type and quality of audit papers
 Review of audit
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 Identification of consolidation adjustments
H
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12.6.2 Disposal P
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Where the group includes a subsidiary which has been disposed of during the year, the following issues
E
will be relevant: R
 Identification of the date of the change in stake
 Assessment of the remaining stake to determine the appropriate accounting treatment post-disposal
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 Assessment of the fair value of the remaining stake
 Whether the profit or loss on disposal has been calculated in accordance with IFRSs
 Whether amounts have been appropriately time apportioned eg, income and expense items

12.6.3 Auditing an ongoing group of companies
Certain issues will be relevant to the auditor each year irrespective of whether there is any change in
the structure of the group. In particular, the auditor will need to ensure that IFRS 10 has been
complied with. The following will be relevant.
Accounting policies/reporting period Identify subsidiary's accounting policies from

review of financial statements, compare to parent
company's and adjust for consistency where
necessary.
Further adjustments may be required if some group
companies prepare financial statements in
accordance with IFRSs and others in accordance
with UK GAAP.
Ensure that subsidiary's reporting period is
consistent with the parent company's or that
interim accounts have been prepared where
necessary. (If not possible subsidiary's accounts
may still be used for consolidation provided that
the gap between the reporting dates is three
months or less.)
Consolidation adjustments Review consolidation schedules, purchase, sales
ledger and intra-group accounts to identify any
intra-group transactions or outstanding balances,
ensure these have been cancelled out in the group
accounts.
Transactions involving group companies
Transactions involving group companies should be
audited in the same way as other transactions with
third parties. However, systems should exist to
ensure all intra-group transactions are separately
identified to ensure they are all appropriately
eliminated on consolidation.
Intra-group balances
These should be audited in the same way as
balances with third parties. In particular:
 share certificates should be examined;
 dividends should be verified;
 intra-group balances should be verified
including any security attaching thereto;
 carrying amounts should be assessed in the
same way as third-party investments; and
 the need for transfer pricing adjustments
assessed.
Intercompany guarantees
Any intercompany guarantees (eg, as surety for
external loans) should be ascertained and
consideration given to whether disclosure as a
contingent liability is required.

12.6.4 Materiality
Where a subsidiary is immaterial, limited work will be performed. However, care should be taken with
respect to the following:
 Apparently immaterial subsidiaries may be materially understated.
 Several small subsidiaries may cumulatively be material.
 Subsidiaries with a small asset base may engage in transactions of significant value and which may
be relevant to understanding the group.
The ICAEW Audit and Assurance faculty document Auditing Groups: A Practical Guide (2014) identifies
the following as factors which may influence component materiality levels:
 The fact that component materiality must always be lower than group materiality
 The size of the component
 Whether the component has a statutory audit
 The characteristics or circumstances that make the component significant
 The strength of the component's control environment
 The likely incidence of misstatements, taking account past experience
12.6.5 Understanding the group structure

The ICAEW Audit and Assurance faculty booklet Auditing in a Group Context: Practical Considerations for
Auditors (2008) emphasises the need to analyse the group structure. It states that an understanding of
the group structure allows the group auditor to:
 plan work to deal with different accounting frameworks or policies applied throughout the group;
 deal with differences in auditing standards; and
 integrate the group audit process effectively with local statutory audit requirements.
12.7 The consolidation: audit procedures

After receiving and reviewing all the subsidiaries' (and associates') financial statements, the group
auditors will be in a position to audit the consolidated financial statements. The ICAEW Audit and
Assurance faculty booklet Auditing in a Group Context: Practical Considerations for Auditors warns against
treating the consolidation as simply an arithmetical exercise. It indicates that there are risks inherent in
the consolidation process itself, for example:
 Consolidation adjustments are a major source of journal entries therefore procedures relating to the
detection of fraud may be relevant.
 Risks may arise from incomplete information to support adjustments between accounting
frameworks.
An important part of the work on the consolidation will be checking the consolidation adjustments.
Consolidation adjustments generally fall into two categories:
 Permanent consolidation adjustments
 Consolidation adjustments for the current year
The audit steps involved in the consolidation process may be summarised as follows. C
H
Step 1 A
Compare the audited accounts of each subsidiary/associate to the consolidation schedules to ensure P
figures have been transposed correctly. T
E
Step 2 R
Review the adjustments made on consolidation to ensure they are appropriate and comparable with the
previous year. This will involve the following:
20
 Recording the dates and costs of acquisitions of subsidiaries and the assets acquired
 Calculating goodwill and pre-acquisition reserves arising on consolidation
 Preparing an overall reconciliation of movements on reserves and NCIs

 Adjusting the individual subsidiary financial statements for differences in accounting policies
compared to the parent. This may include compliance with the accounting regulations of a different
jurisdiction (eg, where the individual subsidiary is UK GAAP compliant and the group reports under
IFRSs)
Step 3
For business combinations, determine the following:
 Whether combination has been appropriately treated as an acquisition
 The appropriateness of the date used as the date of combination
 The treatment of the results of investments acquired during the year
 If acquisition accounting has been used, that the fair value of acquired assets and liabilities is in
accordance with IFRS 13
 Goodwill has been calculated correctly and impairment adjustment made if necessary
Step 4
For disposals:
 agree the date used as the date for disposal to sales documentation; and
 review management accounts to ascertain whether the results of the investment have been
included up to the date of disposal, and whether figures used are reasonable.
Step 5
Consider whether previous treatment of existing subsidiaries or associates is still correct (consider
level of influence, degree of support)
Step 6
Verify the arithmetical accuracy of the consolidation workings by recalculating them
Step 7
Review the consolidated accounts for compliance with the legislation, accounting standards and other
relevant regulations. Care will need to be taken in the following circumstances:
 Where group companies do not have coterminous accounting periods
 Where subsidiaries are not consolidated
 Where accounting policies of group members differ because foreign subsidiaries operate under
different rules, especially those located in developing countries
 Where elimination of intra-group balances, transactions and profits is required
Other important areas include the following:
 Treatment of associates
 Treatment of goodwill and intangible assets
 Foreign currency translation
 Taxation and deferred tax
 Treatment of loss-making subsidiaries
 Treatment of restrictions on distribution of profits of a subsidiary
 Share options
Step 8
Review the consolidated accounts to confirm that they give a true and fair view in the circumstances
(including subsequent event reviews from all subsidiaries updated to date of audit report on
consolidated accounts).
The Audit and Assurance faculty document Auditing Groups: A Practical Guide also highlights the
importance of considering the process used to perform the consolidation process. Where spreadsheets
are used it is not enough to check the data that has been entered. Auditors also need to check that the
consolidation spreadsheets are actually working properly.

Interactive question 12: Intra-group balances/profits
Your firm is the auditor of Beeston Industries, a limited company, which has a number of subsidiaries in
your country (and no overseas subsidiaries), some of which are audited by other firms of professional
accountants. You have been asked to consider the work which should be carried out to ensure that
intra-group transactions and balances are correctly treated in the group accounts.
Requirements
(a) Describe the audit procedures you would perform to check that intra-group balances agree, and
state why intra-group balances should agree and the consequences of them not agreeing.
(b) Describe the audit procedures you would perform to verify that intra-group profit in inventory has
been correctly accounted for in the group accounts.
12.8 Overseas subsidiaries

The inclusion of one or more foreign subsidiaries within a group introduces additional risks, including
the following:
 Non-compliance with the accounting requirements of IAS 21
 Potential misstatement due to the effects of high inflation
 Possible difficulty in the parent being able to exercise control, for example due to political
instability
 Currency restrictions limiting payment of profits to the parent
 There may be threats to going concern due to economic and/or political instability
 Non-compliance with local taxes or misstatement of local tax liabilities
Audit procedures should include the following:
 Check that the balances of the subsidiary have been appropriately translated to the group
reporting currency:
– Assets and liabilities at the closing rate at the end of the reporting period
– Income and expenditure at the rate ruling at the transaction date. An average would be a
suitable alternative provided there have been no significant fluctuations
 Confirm consistency of treatment of the translation of equity (closing rate or historical rate)
 Check that the consolidation process has been performed correctly eg, elimination of intra-group
balances
 Check the basis of the calculation of the non-controlling interest
 Confirm that goodwill has been translated at the closing rate
 Check the disclosure of exchange differences as a separate component of equity
 Assess whether disclosure requirements of IAS 21 have been satisfied C
H
 If the foreign operation is operating in a hyperinflationary economy confirm that the financial A
statements have been adjusted under IAS 29 Financial Reporting in Hyperinflationary Economies P
T
before they are translated and consolidated E
R
 Involve a specialist tax audit team to review the calculation of tax balances against submitted and
draft tax returns
20

12.9 Other considerations in the group context
Other considerations include the following:
12.9.1 Related parties

Remember that when auditing a consolidation, the relevant related parties are those related to the
consolidated group. Transactions with consolidated subsidiaries need not be disclosed, as they are
incorporated in the financial statements. However, related party relationships where there is control
(eg, a parent) need to be disclosed even where there are no transactions with this party.
The group auditors are often requested to carry out the consolidation work even where the accounts of
the subsidiaries have been prepared by the client. In these circumstances the auditors are, of course,
acting as accountants and auditors and care must be taken to ensure that the audit function is carried
out and evidenced.
Transfer pricing issues around transactions with related parties must also be considered. Transfer pricing
adjustments, when they are required, are often material to the financial statements.
12.9.2 Support (comfort) letters

It is sometimes the case that a subsidiary, when considered in isolation, does not appear to be a going
concern. In the context of group accounts, the parent and the subsidiary are seen to be a complete
entity, so if the group as a whole is a going concern, that is sufficient.
When auditing the incorporation of the single company into the group accounts, however, the auditor
will need assurance that the subsidiary is a going concern.
In such a case, the auditor may request a 'support letter' from the directors of the parent company. This
letter states that the intention of the parent is to continue to support the subsidiary, which makes it a
going concern. A support letter may be sufficient appropriate audit evidence on this issue, but further
evidence would be bank guarantees.
12.10 Promoting best practice in group audits

The ICAEW Audit and Assurance faculty booklet Auditing in a Group Context: Practical Considerations for
Auditors provides practical guidance regarding the audit of groups. It sets out guidance for each stage of
the audit as follows.
Understand group Understand the group structure and the nature of the components of the
management's process group
and timetable to
Consider whether to accept an engagement where the group auditor is
produce consolidated
only directly responsible for a minority of the total group
accounts
Understand the accounting framework applicable to each component and
any local statutory reporting requirements
Understand the component auditors – consider their qualifications,
independence and competence
For unrelated auditors or related auditors where the group auditor is
unable to rely on common policies and procedures, consider the following:
 Visiting the component auditor
 Requesting that the component auditor completes a questionnaire or
representation
 Obtaining confirmation from a relevant regulatory body
 Discussing the component auditor with colleagues from their own firm
For component auditors based overseas consider whether they have
enough knowledge and experience of ISAs

Design group audit Get involved early. Talk to group management while they are planning the
process to match consolidation
management's process
Draft instructions to component auditors allocating work and be clear as to
and timetable
deadlines required
Focus the group audit on high risk areas
Consider risks arising from the consolidation process itself:
 Consolidation adjustments
 Incomplete information to support adjustments between accounting
frameworks eg, where a subsidiary prepares its local accounts under US
GAAP and the parent is preparing IFRS financial statements
Discuss fraud with component auditors and consider the following:
 Business risks
 How and where the group financial statements may be susceptible to
material misstatement due to fraud or error
 How group management and component management could
perpetrate and conceal fraudulent financial reporting and how assets of
the components could be misappropriated
 Known factors affecting the group that may provide the incentive or
pressure for group or component management or others to commit
fraud or indicate a culture or environment that enables those people to
rationalise committing fraud
 The risk that group or component management may override controls
Understand internal control across the group:
 Request details of material weaknesses in internal controls identified by
component auditors
 Communicate material weaknesses in group-wide controls and
significant weaknesses in internal controls of components to group
management
Clearly communicate Explain the extent of the group auditors' involvement in the work of the
expectations and component auditors:
information required
 Make it clear what the component auditors are being asked to perform
including timetable
eg, a full audit, a review or work on specific balances or transactions
 Clarify the timetable and format of reporting back
Review completed questionnaires and other deliverables from component
auditors carefully
Decide whether and when to visit component auditors and when to
request access to their working papers C
Get group management to obtain the consent of subsidiary management H
A
to communicate with the group auditor to deal with concerns about client P
confidentiality and sensitivity T
E
Consider whether holding discussions with or visiting component auditors R
could deal with secrecy and data-protection issues
20

Obtain information early There is often only a short time for group auditors to resolve any issues
where practicable arising from the report they receive from component auditors
Request some information early, such as copies of management letter
points from component auditors carrying out planning and control testing
before the year end
Keep track of whether Where component auditors indicate up front that they will not be able to
reports have been provide the information requested, consider alternatives rather than
received and respond to waiting until the sign-off deadline
any issues in a timely
Put in place a system to monitor responses to instructions and follow up on
fashion
non-submission
Conclude on the audit The group auditors should be in a position to form their opinion on the
and consider possible group financial statements
improvements for the
The group auditors will consider the need for a group management letter
next year's process
and reporting to those charged with governance of the group
including management
letter issues Debrief the team and consider whether the process worked as well as it
could have done, along with any changes to future accounting and
auditing requirements, and whether there are any issues that should be
communicated to management and those charged with governance, or
any changes to next year's audit strategy
13 Auditing global enterprises
Section overview
 Global enterprises are particularly affected by the following risks:
– Financial risks
– Political risks
– Regulatory risks
 Internal control will have to have regard to a variety of local requirements.
 Compliance will be a key feature of international business strategy.
 In response to the trend towards globalisation the Forum of Firms has been founded.
13.1 Introduction
Large businesses are increasingly becoming global organisations. This has implications for the business
itself and the way in which the audit is conducted. In the remainder of this section we will look at a
number of key issues affecting global organisations.
13.2 Inherent risk

13.2.1 Financial risks
By its very nature a global organisation will have businesses in countries all over the world. At any point
in time these countries may be experiencing diverse economic circumstances. This may impact on key
aspects of financial management, including the effects of the following:
 Inflation
 Interest rates
 Exchange rates
 Currency restrictions
In some instances the impact of these can be significant. For example, Zimbabwe experienced inflation
in excess of 200 million per cent in 2008.

Overseas financial risk
The financial strategy of the company may be one of overseas financing. This could be in two
situations.
(1) The raising of finance overseas but remittance of funds back to the UK – probably to take
advantage of more reasonable terms
(2) The raising of finance overseas for the purpose of providing capital for an overseas subsidiary,
branch or significant equity investment
Identifying overseas financial risks
The business choice between the above transactions can be summarised as follows.
 The legal requirements for raising loan capital in the country of origin may be more complex than
the UK equivalent.
 The tax implications may be diverse and difficult to manage.
 The country of origin may have strict rules on remittance of proceeds back to the UK.
 The company may have a cultural image or mission statement with which overseas financing
conflicts.
 The decision to finance overseas may have been made on factors that can easily be distorted in the
short term. The factors likely to have been considered would have been:
– the prevailing rate of exchange
– the cost of financing interest or dividend payments
Foreign exchange and interest rates are outside the control of the individual entity. Therefore, if there is
an unfavourable movement in the foreign exchange or interest rates, it could result in a significant
change in cash flow in both the short and long term.
Mitigating overseas financial risks
The business may choose to mitigate risk by adopting the following or similar procedures.
 The company should obtain legal, taxation and accounting advice before the overseas financing
commencing.
 The company should hedge any overseas transactions to reduce the risk of currency and interest
rate movements significantly affecting its assets and liabilities.
 The company at board level should consider the cultural and political implications of an
investment overseas.
Assessing overseas financial risks
The assurance adviser can approach the assignment initially by focusing on business risk and, where
necessary, with a more substantive approach.
The assurance adviser will therefore be addressing the issue of changing exchange and interest rates,
where material, in the relevant accounting period. He would discuss with management any difficulties
that had arisen over the legal requirements and whether remittance from overseas had proved
straightforward.
C
The advisor would also have gained assurance that the company had identified the UK reporting H
requirements. A
P
Having addressed business risk, the following steps may need to be taken: T
E
 Examination of the loan capital terms and contractual liabilities of the company R
 Checking the remittance of proceeds between the country of origin and the company by reference
to bank and cash records 20
 Reviewing the movement of exchange and interest rates, and discussing their possible impact with
the directors

 Obtaining details of any hedging transaction and ensuring that exchange rate movements on the
finance had been offset
 Examining the financial statements to determine accurate disclosure of accounting policy and
accounting treatment conforming to UK requirements
 Evaluating whether the directors had satisfied themselves as to the company's conforming status as
a going concern
13.2.2 Political risks

Political issues, particularly political unrest, may have implications for both the business and the way in
which its results are reported. For example, restrictions imposed by foreign governments may call into
question the ability of a parent to control its subsidiary. This may raise questions about possible
impairment of the value of the parent's investment in the subsidiary and may affect the way in which
the investment is recorded in the group financial statements.
13.2.3 Regulatory risks

A global organisation will need to be equipped to deal with a range of local legislation. Key areas
 Health and safety
 Environmental legislation
 Trade descriptions
 Consumer protection
 Data protection
 Employment issues
Failure to comply with these may result in financial or other penalties, having to spend money and
resources in fighting litigation and loss of reputation.
In this area, governance codes will be particularly important examples of best practice which should be
adopted worldwide, and organisations must consider the risks of breaching provisions relating to
integrity and objectivity, and also control over the organisation as a whole.
Audit impact
The variation in local regulation may have an impact on the audit itself. For example, some subsidiaries
may be in countries which do not have accounting and auditing standards developed to the same
extent as those in the UK. As a result, the financial statements and the audit work carried out on them
by local practitioners may not conform to UK standards.
In this situation, the group auditor may need to:
 request adjustments to be made to the financial statements of the subsidiary; and
 request additional audit procedures to be performed.
The increasing acceptance of international accounting and auditing standards and ongoing
convergence between these and local regulation means that this problem should become less significant
over time.
13.3 Internal control

Many of the internal control issues stem from the inherent risks identified above. For example,
geographical, cultural and regulatory differences may result in a variety of internal control mechanisms
being adopted by the organisation. The entity will need to ensure that these mechanisms satisfy not
only local requirements but also the internal control objectives of the entity as a whole. The following
specific points should be noted.

Risk management
The management of a global enterprise will need to have regard to the corporate governance
requirements (see Chapter 4) as follows:
Control environment This sets the tone from the top of the organisation and will
need to be applicable at both a local and global level. Factors
to consider include the following:
 Organisational structure of the group
 Level of involvement of the parent company in
components
 Degree of autonomy of management of components
 Supervision of components' management by parent
company
 Information systems, and information received centrally on
a regular basis
Risk assessment The nature of a global organisation increases risk.
Management need to ensure that a process is in place to
identify the risks at the global level and assess their impact
Information systems Information systems will need to be designed so that accurate
and timely information is available both at the local level and
on an entity basis. Compatibility of systems and processes will
be important
Control procedures While there may be local variations, minimum entity-wide
standards must be established to ensure that there are
adequate controls throughout the organisation
Monitoring In organisations of this size audit committees and the internal
audit function will have a crucial role to play
13.3.1 Transfer pricing

Transfer pricing addresses the need to value the use of goods and services of one division by another. A
well thought-out system may allow accurate divisional performance measurement while ensuring that
divisions are not motivated to make decisions adverse for the company as a whole.
Transfer pricing systems have four primary aims:
(1) To enable the realistic measurement of divisional profit
(2) To provide producer and receiver with realistic income and cost
(3) To avoid taking too much autonomy from managers
(4) To ensure goal congruence and profit maximisation for the company as a whole
Transfer pricing is notoriously difficult to get right. One particular problem associated with transfer
prices is in valuing a company or division as an independent unit. For example, a division of a major
company is likely to find major costs (eg, rent) to be much higher without the economic support of a
parent. C
H
Where the product or service has a readily available outside market, internal transfers are unlikely to A
occur unless the transfer price is similar to the market price. The transfer price may be slightly below the P
T
market price to recognise the reduction in risk (eg, no cash changes hands so risk of bad debts may be
E
reduced) and likely savings in packing and delivery. R
Another method used to set transfer prices is 'cost plus'. The transferring division should be able to
recover its variable costs and any contribution lost because it diverted resources in order to fulfil the
internal transfer. The costs involved should be standard rather than actual, otherwise inefficiencies in the 20
selling division will be passed on to the buying division.
The choice of the most appropriate transfer pricing method depends on the nature of the business and
the level of risks borne by the selling division.

Transfer pricing can be used to manipulate profits for tax purposes, rather than to measure
performance. Consequently, transfer pricing issues have come to the top of the agenda for tax
authorities worldwide, and become the focus of an increasing number of HM Revenue & Customs tax
inquiries (particularly where they involve transactions between divisions which are resident in different
countries).
Worked example: Divisional performance

Company C is organised into two divisions, Division A and Division B. Division A can sell its product
outside the company at £20 per unit or transfer internally to Division B at £20 per unit.
Division B buys the product from Division A and develops it into a higher-margin finished product. The
division's usual selling price for its finished product is £70.
Division A's variable costs are £10 per unit and its fixed costs are £5 per unit. Division B's variable costs
are £15 per unit and its fixed costs are £10 per unit.
If Division B received an offer from a customer of £30 per unit for its final product, it would not accept
the offer. This is because, taking the transfer price of £20 into account, its accounts would show a
negative contribution per unit of (30 – 20 – 15) £5.
However, assuming that Division A has surplus capacity, Company C would accept the offer. From the
point of view of the company as a whole, the contribution would be positive: (30 – 10 – 15) £5 per unit.
If Division A is already operating at full capacity then there would be a lost external sales contribution in
A of (20 – 10) £10. Therefore, in this situation, the company as a whole should also reject the offer
because the deal would represent a loss in potential contribution of £5 per unit.
If challenged by the tax authorities, transfer pricing adjustments can have a material impact on the
selling and buying divisions' corporation tax expense and tax liabilities. It may also change the
recognition of intercompany revenue in the individual companies' financial statements.
Auditing the transfer pricing status of large multinational groups often requires the involvement of tax
specialists. Issues that the auditor should consider when reviewing the company's transfer pricing
policies include the following:
(a) Are there any unresolved tax enquiries/tax audits relating to transfer pricing?
(b) Has an Advanced Transfer Pricing Agreement been signed between the group and the tax
authorities? If so, does the transfer pricing policy applied in the period conform to the Agreement?
(c) Is the transfer pricing method adopted appropriate for the type of transaction, and the nature of
the selling division's business?
(d) Do the transfer prices appear reasonable, compared to existing benchmarks (for example, is the
percentage of mark-up in a cost-plus policy in line with the mark-ups applied by comparable
companies in the industry)?
(e) Have there been any changes in the divisions' business, which may require the transfer pricing
policy to be revised?
13.4 Compliance
A key feature of any international business strategy is that it is likely to involve compliance with overseas
accounting and auditing regulations of the host countries in which an entity does business. The most
important piece of recent legislation in this respect has been the Sarbanes-Oxley Act. This is covered in
detail in Chapter 4 of this Study Manual.

13.5 Transnational audits
13.5.1 The Forum of Firms
In response to the trend towards globalisation an international grouping, the Forum of Firms (FoF), was
founded by the following networks: BDO, Deloitte Touche Tohmatsu, Ernst & Young, Grant Thornton,
KPMG and PricewaterhouseCoopers.
Membership is open to firms and networks that have transnational audit appointments or are interested
in accepting such appointments.
These firms have a voluntary agreement to meet certain requirements that are set out in their
constitution. These relate mainly to the following:
 Promoting the use of high-quality audit practices worldwide, including the use of ISAs
 Maintaining quality control standards in accordance with International Standards on Quality
Control issued by the IAASB, and conducting globally co-ordinated internal quality assurance
reviews
The Transnational Auditors Committee (TAC) provides guidance to the members of the FoF and
provides the official linkage between the FoF and the International Federation of Accountants (IFAC).
The TAC has issued the following definition of transnational audit.
Definition
Transnational audit: An audit of financial statements which are or may be relied upon outside the
audited entity's home jurisdiction for purposes of significant lending, investment or regulatory decisions;
this will include audits of all financial statements of companies with listed equity or debt and other
public interest entities which attract particular public attention because of their size, products or services
provided.
Audits of entities with listed equity or debt are always transnational audits, as their financial statements
are or may be relied upon outside their home jurisdiction. Other audits that are transnational audits
include audits of those entities in either the public or the private sectors where there is a reasonable
expectation that the financial statements of the entity may be relied upon by a user outside the entity's
home jurisdiction for purposes of significant lending, investment or regulatory decisions, whether or not
the entity has listed equity or debt or where entities attract particular attention because of their size,
products or services provided. (These would include, for example, large charitable organisations or
trusts, major monopolies or duopolies, providers of financial or other borrowing facilities to commercial
or private customers, deposit-taking organisations and those holding funds belonging to third parties in
connection with investment or savings activities.)
In principle, the definition of transnational audit should be applied to the whole group audit, including
the individual components comprising the consolidated entity.
C
H
A
P
T
E
R
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Examples to illustrate the definition.
Example Explanation
Audit of a private company in the US This would qualify as a transnational audit, as it is reasonable
raising debt finance in Canada to expect that the financial statements of the company would
be used across national borders in obtaining the debt
financing.
Audit of a private savings and loans Although it could be considered a public interest entity, this
business operating entirely in the US would not qualify as a transnational audit assuming it can
(ie, only US depositors and US be demonstrated that there are no transnational users.
investments)
In applying the definition of transnational audit, there
should be a rebuttable presumption that all banks and
financial institutions are included, unless it can be clearly
demonstrated that there is no transnational element from
the perspective of a financial statement user and that there
are no operations across national borders. Potential
transnational users would include investors, lenders,
governments, customers and regulators.
Audit of an international charity taking This entity can clearly be considered a public interest entity
donations through various national and operating across borders. Further, the international
branches and making grants around structure would create a reasonable expectation that the
the world financial statements could be used across national borders
by donors in other countries if not by others for purposes of
significant lending, investment or regulatory decisions. The
audit is likely to qualify as transnational.
13.5.2 Features of transnational audits

In the globalised business and financial environment, many audits are clearly transnational, and this
produces a number of specific problems which can limit the reliability of the audited financial
statements:
 Regulation and oversight of auditors differs from country to country
 Differences in auditing standards from country to country
 Variability in audit quality in different countries
13.5.3 Role of the international audit firm networks

The 'Big 4' and other international networks of firms can be seen as being ahead of governments and
institutions in terms of their global influence. They are in a position to establish consistent practices
worldwide in areas such as:
 training and education
 audit procedures
 quality control procedures
These firms may as a result be in a better position than national regulators to ensure consistent
implementation of high-quality auditing standards.
Membership of the Forum of Firms imposes commitments and responsibilities, namely to:
 perform transnational audits in accordance with ISAs;
 comply with the IESBA Code of Ethics; and
 be subject to a programme of quality assurance.

Summary
Group accounts:
and statement of comprehensive income
Subsidiary Associate
Control Significant
influence
Direct Indirect Potential Loss of

shareholding shareholding voting rights control
Goodwill
Consideration Non-controlling Fair value

interest of identifiable
assets and
liabilities
Deferred Contingent Fair Proportion

value of net
assets
C
H
A
P
T
E
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Acquisitions and disposals
Acquisitions Disposals
Step acquisitions to
achieve control Disposal of whole
Part disposal
investment
Acquisition not
resulting in change
of control
Loss of No loss of
control control
IAS 7 Statement of cash flows
Classify cash flows as Consolidated cash flows include

• Operating Direct • Dividends to NCI
• Investing Indirect • Dividends from associates
• Financing • Acquisition/disposal of subsidiaries and associates
Joint arrangements
Joint ventures Joint operations
Equity account in Line by line recognition

consolidated financial of assets, liabilities, revenues
statements and expenses

Self-test
IFRS 3 Business Combinations
1 Burdett
The Burdett Company acquired an 80% interest in The Swain Company for £1,340,000 when the
fair value of Swain's identifiable assets and liabilities was £1,200,000.
Burdett acquired a 60% interest in The Thamin Company for £340,000 when the fair value of
Thamin's identifiable assets and liabilities was £680,000.
Neither Swain nor Thamin had any contingent liabilities at the acquisition date and the above fair
values were the same as the carrying amounts in their financial statements. Annual impairment
reviews have not resulted in any impairment losses being recognised. The Burdett Company values
the non-controlling interest as the proportionate interest in the identifiable net assets at acquisition.
Requirement
Under IFRS 3 Business Combinations, what figures in respect of goodwill and of the excess of assets
and liabilities acquired over the cost of combination should be included in Burdett's consolidated
statement of financial position?
2 Sheliak
The Sheliak Company acquired equipment on 1 January 20X3 at a cost of £1,000,000,
depreciating it over eight years with a nil residual value.
On 1 January 20X6 The Parotia Company acquired 100% of Sheliak and estimated the fair value of
the equipment at £575,000, with a remaining life of five years. This fair value was not incorporated
into Sheliak's books and subsequent depreciation charges continued to be made by reference to
original cost.
Requirement
Under IFRS 3 Business Combinations and IFRS 10 Consolidated Financial Statements, what
adjustments should be made to the depreciation charge for the year and the SFP carrying amount
in preparing the consolidated financial statements for the year ended 31 December 20X7?
3 Finch
On 1 January 20X6 The Finch Company acquired 85% of the ordinary share capital and 40% of the
irredeemable preference share capital of The Sequoia Company for consideration totalling
£5.1 million. At the acquisition date Sequoia had the following statement of financial position.
£'000
Non-current assets 5,500
8,100
Ordinary shares of £1 1,000
Preference shares of £1 2,500
8,100 C
H
Included in non-current assets of Sequoia at the acquisition date was a property with a carrying A
amount of £600,000 that had a fair value of £900,000. P
T
Sequoia had been making losses, so Finch created a provision for restructuring of £800,000 under E
plans announced on 2 January 20X6. R
Sequoia has disclosed in its accounts a contingent liability with a reliably estimated value of
£20,000. Sequoia has not recorded this as a provision, as payment is not considered probable.
20
Finch values the non-controlling interest using the proportion of net assets method.
Requirement
Under IFRS 3 Business Combinations, what goodwill arises at the time of the acquisition of Sequoia?

4 Maackia
On 31 December 20X7 The Maackia Company acquires 65% of the ordinary share capital of The
Sorbus Company for £4.8 million. Sorbus is incorporated in Flatland, which has not adopted IFRS
for its financial statements. At the acquisition date the fair value of a 35% interest in Sorbus is
£1.8 million and net assets of Sorbus have a carrying amount of £4.6 million before taking into
account the following.
Included in the net assets of Sorbus is a business that Maackia has put on the market for immediate
sale. This business has a carrying amount of £500,000, a fair value of £760,000 and a value in use
of £810,000. Costs to sell are estimated at £40,000.
Sorbus also has a defined benefit pension plan which has a plan asset of £1.6 million, and an
obligation with present value of £1,280,000. Sorbus has recognised the net plan asset of £320,000
in its statement of financial position. Maackia does not anticipate any reduction in contributions as
a result of acquiring Sorbus.
Requirement
Under IFRS 3 Business Combinations, what (to the nearest £1,000) is the goodwill arising on the
acquisition of Sorbus, assuming that Maackia measures the non-controlling interest using the fair
value method?
5 Gibbston
On 1 May 20X7 The Gibbston Company acquired 70% of the ordinary share capital of The Crum
Company for consideration of £15 million cash payable immediately and £5.5 million payable on
1 May 20X8. Further consideration of £13.3 million cash is payable on 1 May 20Y0 dependent on
a range of contingent future events. The management of Gibbston believe there is a 45%
probability of paying the amount in full.
The equity of Crum had a carrying amount of £20 million at 1 January 20X7. Crum incurred losses
of £3 million evenly over the year ended 31 December 20X7. The carrying amount and fair values
of the assets of Crum are the same except that at the acquisition date the fair value relating to
plant is £9 million higher than carrying amount. The weighted average remaining useful life of the
plant is three years from the acquisition date.
A rate of 10% is to be used in any discount calculations. The non-controlling interest is measured
using the proportion of net assets method.
Requirement
Calculate the following amounts (to the nearest £0.1m) in accordance with IFRS 3 Business
Combinations and IFRS 10 Consolidated Financial Statements that would be included in the
consolidated financial statements of Gibbston for the year ended 31 December 20X7.
(a) Goodwill
(b) Non-controlling interest in profit/loss
(c) Non-controlling interest included in equity
IFRS 11 Joint Arrangements
6 Supermall
This question is based on Illustrative example 2 from IFRS 11.
Two real estate companies (the parties) set up a separate vehicle (Supermall) for the purpose of
acquiring and operating a shopping centre. The contractual arrangement between the parties
establishes joint control of the activities that are conducted in Supermall. The main feature of
Supermall's legal form is that the entity, not the parties, has rights to the assets, and obligations for
the liabilities, relating to the arrangement. These activities include the rental of the retail units,
managing the car park, maintaining the centre and its equipment, such as lifts, and building the
reputation and customer base for the centre as a whole.
The terms of the contractual arrangement are such that:
(a) Supermall owns the shopping centre. The contractual arrangement does not specify that the
parties have rights to the shopping centre.

(b) The parties are not liable in respect of the debts, liabilities or obligations of Supermall. If
Supermall is unable to pay any of its debts or other liabilities or to discharge its obligations to
third parties, the liability of each party to any third party will be limited to the unpaid amount
of that party's capital contribution.
(c) The parties have the right to sell or pledge their interests in Supermall.
(d) Each party receives a share of the income from operating the shopping centre (which is the
rental income net of the operating costs) in accordance with its interest in Supermall.
Requirement
Explain how Supermall should be classified in accordance with IFRS 11 Joint Arrangements.
7 Green and Yellow
Green entered into an agreement with Yellow, a public limited company, on 1 December 20X8.
Each of the companies holds one-half of the equity in an entity, Orange, a public limited company,
which operates offshore oil rigs. The contractual arrangement between Green and Yellow
establishes joint control of the activities that are conducted in Orange. The main feature of
Orange's legal form is that Orange, not Green or Yellow, has rights to the assets, and obligations
for the liabilities, relating to the arrangement.
The terms of the contractual arrangement are such that:
(a) Orange owns the oil rigs. The contractual arrangement does not specify that Green and
Yellow have rights to the oil rigs.
(b) Green and Yellow are not liable in respect of the debts, liabilities or obligations of Orange. If
Orange is unable to pay any of its debts or other liabilities or to discharge its obligations to
third parties, the liability of each party to any third party will be limited to the unpaid amount
of that party's capital contribution.
(c) Green and Yellow have the right to sell or pledge their interests in Orange.
(d) Each party receives a share of the income from operating the oil rig in accordance with its
interest in Orange.
Green wants to account for the interest in Orange by using the equity method, and wishes for
advice on the matter.
Green also owns a 10% interest in a pipeline, which is used to transport the oil from the offshore
oil rig to a refinery on the land. Green has joint control over the pipeline and has to pay its share of
the maintenance costs. Green has the right to use 10% of the capacity of the pipeline. Green
wishes to show the pipeline as an investment in its financial statements to 30 November 20X9.
Requirement
Discuss how the above arrangements would be accounted for in Green's financial statements.
Step acquisitions
8 Stuhr
On 1 January 20X6 The Stuhr Company acquired 30% of the ordinary share capital of the Bismuth
Company by the issue of one million shares with a fair value of £4.00 each. From that date Stuhr
did not exercise significant influence over Bismuth, and accounted for the investment at fair value C
with changes in value included in profit or loss. At 1 January 20X6 the net assets of Bismuth had a H
A
carrying amount of £6.4 million and a fair value of £7.2 million.
P
On 1 March 20X7, Stuhr bought a further 50% of the ordinary share capital of Bismuth by issuing T
E
a further 2 million shares with a fair value of £5.00 each. At that date the net assets of Bismuth had
R
a carrying amount of £7.8 million and a fair value of £8.4 million. The non-controlling interest had
a fair value of £2 million, and the 30% interest already held by Stuhr had a fair value of £3 million.
Stuhr values the non-controlling interest using the full goodwill method. 20
Requirement
What is the goodwill figure in the consolidated statement of financial position at
31 December 20X7, in accordance with IFRS 3 Business Combinations?

Disposals
9 Fleurie
Fleurie bought 85% of Merlot on 30 June 20X3, providing consideration in the form of £2 million
cash immediately and a further £1.5 million cash conditional upon earnings targets being met.
At acquisition, the net assets of Merlot were £2.2 million and the fair value of the 15% not
purchased was £350,000. Fleurie measures the non-controlling interest using the full goodwill
method.
On 31 December 20X7, as part of a long-term strategy, Fleurie sold a 15% stake from its 85%
holding in Merlot, realising proceeds of £560,000. At this date the net assets of Merlot were
£3.5 million.
Requirement
What impact does the disposal have on the financial statements of the Fleurie Group?
10 Chianti
Chianti purchased 95% of the 100,000 £1 ordinary share capital of Barolo on 1 January 20X2,
giving rise to goodwill of £70,000. At this date Barolo's retained earnings were £130,000. There
were no other reserves.
On 30 September 20X2, when the net assets of Barolo were £320,000, Chianti disposed of the
majority of its holding in Barolo, retaining just 5% of share capital, with a fair value of £20,000.
Chianti received £340,000 consideration for the sale.
The following information is relevant:
 Goodwill in Barolo has been impaired by £20,000.
 In April 20X2, Barolo revalued a plot of land from £50,000 to £75,000. This land was held
with the intention of building a new head office on it.
 Since acquisition, Barolo has recognised a net amount of £16,000 gains on AFS investments in
 The non-controlling interest is valued using the proportion of net assets method.
Requirement
What is the impact of the disposal on the Chianti Group statement of profit or loss and other
comprehensive income?

IAS 7 Statement of Cash Flows
11 Porter
The following consolidated financial statements relate to Porter, a public limited company:
Porter group: statement of financial position as at 31 May 20X6
20X6 20X5
£m £m
Non-current assets
Property, plant and equipment 958 812
Goodwill 15 10
Investment in associate 48 39
1,021 861
Current assets
Inventories 154 168
Trade receivables 132 112
Financial assets at fair value through profit or loss 16 0
460 328
1,481 1,189
Share capital (£1 ordinary shares) 332 300
Share premium account 212 172
Retained earnings 188 165
Revaluation surplus 101 54
833 691
Non-controlling interests 84 28
917 719
Long-term borrowings 380 320
Deferred tax liability 38 26
418 346
Current liabilities
Trade and other payables 110 98
Interest payable 8 4
Current tax payable 28 22
146 124
1,481 1,189
Porter group: statement of profit or loss and other comprehensive income

for the year ended 31 May 20X6
£m
Revenue 956
Cost of sales (634)
Gross profit 322
Other income 6
Distribution costs (97)
Administrative expenses (115) C
Finance costs (16) H
Share of profit of associate 12 A
P
T
Income tax expense (34) E
Profit for the year 78 R
Other comprehensive income (items that will not be reclassified to profit
or loss):
Gains on property revaluation 58 20
Share of other comprehensive income of associate 8
Income tax relating to items of other comprehensive income (17)
Other comprehensive income for the year, net of tax 49

Profit attributable to: £m
Owners of the parent 68
Non-controlling interests 10
78
Total comprehensive income attributable to:
Non-controlling interests 12
127
The following information relates to the consolidated financial statements of Porter:

(1) During the period, Porter acquired 60% of a subsidiary. The purchase was effected by issuing
shares of Porter on a 1 for 2 basis, at their market value on that date of £2.25 per share, plus
£26 million in cash.
A statement of financial position of the subsidiary, prepared at the acquisition date for
consolidation purposes, showed the following position:
£m
Inventories 20
136
Share capital (£1 shares) 80

Reserves 40
120
Trade payables 12
Income taxes payable 4
136
An impairment test conducted at the year end resulted in a write down of goodwill relating to
another wholly owned subsidiary. This was charged to cost of sales.
Group policy is to value non-controlling interests at the date of acquisition at the
proportionate share of the fair value of the acquiree's identifiable assets acquired and liabilities
assumed.
(2) Depreciation charged to the consolidated profit or loss amounted to £44 million. There were
no disposals of property, plant and equipment during the year.
(3) Other income represents gains on financial assets at fair value through profit or loss. The
financial assets are investments in quoted shares. They were purchased shortly before the year
end with surplus cash, and were designated at fair value through profit or loss as they are
expected to be sold shortly after the year end. No dividends have yet been received.
(4) Included in 'trade and other payables' is the £ equivalent of an invoice for 102 million shillings
for some equipment purchased from a foreign supplier. The asset was invoiced on
5 March 20X6, but had not been paid for at the year end, 31 May 20X6.
Exchange gains or losses on the transaction have been included in administrative expenses.
Relevant exchange rates were as follows:
Shillings to £1
5 March 20X6 6.8
31 May 20X6 6.0
(5) Movement on retained earnings was as follows:
£m
At 31 May 20X5 165
Total comprehensive income 68
Dividends paid (45)
At 31 May 20X6 188

Requirement
Prepare a consolidated statement of cash flows for Porter for the year ended 31 May 20X6 in
accordance with IAS 7 Statement of Cash Flows, using the indirect method.
Notes to the statement of cash flows are not required.
12 Tastydesserts
The following are extracts from the financial statements of Tastydesserts and one of its wholly
owned subsidiaries, Custardpowders, the shares in which were acquired on 31 October 20X2.
Statements of financial position
Tastydesserts
and subsidiaries Custardpowders
31 December 31 December 31 October
20X2 20X1 20X2
£'000 £'000 £'000
Non-current assets
Property, plant and equipment 4,764 3,685 694
Goodwill 42 – –
Investment in associates 2,195 2,175 –
7,001 5,860 694
Current assets
Inventories 1,735 1,388 306
Receivables 2,658 2,436 185
Bank balances and cash 43 77 7
4,436 3,901 498
11,437 9,761 1,192
Equity
Share capital 4,896 4,776 400
Share premium 216 – –
Retained earnings 2,540 2,063 644
7,652 6,839 1,044
Loans 1,348 653 –
Deferred tax 111 180 –
1,459 833 –
Current liabilities
Payables 1,915 1,546 148
Bank overdrafts 176 343 –
Current tax payable 235 200 – –
2,326 2,089 148
11,437 9,761 1,192

for the year ended 31 December 20X2
£'000
Profit before interest and tax 546
Finance costs – – C
Share of profit of associates 120 H
Profit before tax 666 A
P
Income tax expense 126
T
Profit/total comprehensive income for the year 540 E
Attributable to: R
Non-controlling interests –
540 20

The following information is also given:
(a) The consolidated figures at 31 December 20X2 include Custardpowders.
(b) The amount of depreciation on property, plant and equipment during the year was £78,000.
There were no disposals.
(c) The cost on 31 October 20X2 of the shares in Custardpowders was £1,086,000 comprising
the issue of £695,000 unsecured loan stock at par, 120,000 ordinary shares of £1 at a value of
280p each and £55,000 in cash.
(d) No write-down of goodwill was required during the period.
(e) Total dividends paid by Tastydesserts (parent) during the period amounted to £63,000.
Requirement
Prepare a consolidated statement of cash flows for Tastydesserts and subsidiaries for the year ended
31 December 20X2 using the indirect method.
Notes to the statement of cash flows are not required.

Technical reference
Basics
 Definitions: control, parent, subsidiary, acquisition date, goodwill IFRS 3 (App A)
 Acquisition method: acquirer, acquisition date, recognising and measuring IFRS 3.5
assets, liabilities, non-controlling interest and goodwill
Measurement of identifiable assets acquired

 At fair value IFRS 3.18
 Non-controlling interest measured at fair value or as a proportionate share of IFRS 3.19

the acquiree's net assets
 Exceptions to measurement principles
– Contingent liabilities recognised if fair value measured reliably regardless IFRS 3.23
of probable outcome
– Income taxes in accordance with IAS 12 IFRS 3.24
– Employee benefits in accordance with IAS 19 IFRS 3.26
– Assets held for sale in accordance with IFRS 5 IFRS 3.31
Consideration transferred
 Fair value of assets transferred, liabilities incurred and equity instruments IFRS 3.37
issued
 Contingent consideration accounted for at fair value IFRS 3.39
 Subsequent accounting for contingent consideration IFRS 3.58
 Acquisition related costs IFRS 3.53
Goodwill
 Calculation IFRS 3.32
Bargain purchases
 Reassess identification and measurement of the net assets acquired, the non- IFRS 3.36
controlling interest, if any, and consideration transferred
 Any remaining amount recognised in profit or loss in period the acquisition is IFRS 3.34
made
Business combination achieved in stages (step acquisition) C

H
 Remeasure previously held interest to fair value at acquisition date IFRS 3.42 A
P
Measurement period T
E
 Adjustment to amounts only within 12 months of acquisition date IFRS 3.45 R
 Subsequently: errors accounted for retrospectively, everything else IFRS 3.50

prospectively 20

Disclosures
 Business combinations occurring in the accounting period or after its finish IFRS 3.59
but before financial statements authorised for issue (in the latter case, by way
of note)
IFRS 10 Consolidated Financial Statements
Basic rule
 Parent must prepare CFS to include all subsidiaries IFRS 10.2
Exception
 No need for CFS if wholly owned or all non-controlling shareholders have IFRS 10.4
been informed of and none have objected to the plan that CFS need not be
prepared
IFRS 10.7
Control
 Power over the investee
 Exposure or rights to variable returns
 Ability to use its power
 Power is existing rights that give the current ability to direct the relevant
activities of the investee
Procedures
 Non-controlling interest shown as a separate figure:
– In the statement of financial position, within total equity but separately IFRS 10.22
from the parent shareholders' equity
– In the statement of profit or loss and other comprehensive income, the
share of the profit after tax and share of the total comprehensive income
 Accounting dates of group companies to be no more than three months IFRS 10.B93
apart
 Uniform accounting policies across group or adjustments to underlying IFRS 10.19
values
 Bring in share of new subsidiary's income and expenses: IFRS 10.20
– From date of acquisition, on acquisition

– To date of disposal, on disposal
 Changes that do not result in a loss of control accounted for as equity IFRS 10.B96
transactions
IFRS 10.B97–99
Loss of control
 Calculation of gain
 Account for amounts in other comprehensive income as if underlying assets
disposed of
 Retained interest accounted for in accordance with relevant standard based
on fair value
Parent's separate financial statements

 Account for subsidiary on basis of cost and distributions declared IAS 27.12

IAS 28 Investments in Associates and Joint Ventures
Definitions
 The investor has significant influence, but not control IAS 28.2
 Significant influence is the power to participate in financial and operating

policy decisions of the investee, but is not control over those policies (if the
investor had control, then under IFRS 10 the investee would be its subsidiary)
 Presumptions re less than 20% and 20% or more IAS 28.6
 Can be an associate, even if the subsidiary of another investor

 No significant influence if 'associate' in legal reorganisation etc IAS 28.10
Equity method
IAS 28.38,
 In statement of financial position: non-current asset = cost plus share of post-
IAS 28.11 and
acquisition change in A's net assets
IAS 28.39
IAS 28.11 and

 In income statement: share of A's post-tax profits less any impairment loss
IAS 28.38
 In statement of changes in equity: share of A's changes IAS 28.39
 Use cost method of accounting in investor's separate financial statements IAS 28.35
 Also applies to joint ventures IAS 28.35
Disclosures
 Fair value of associate where there are published price quotations IAS 28.37
 Summarised financial statements of the associate

 Reasons why 20% presumptions overcome, if that be the case
 The investment to be shown as a non-current asset in the statement of IAS 28.38
financial position, at cost plus/minus share of post-acquisition change in
associate's net assets plus long-term financing less impairment losses
 The investor's share of the associate's:

– After-tax profits
– Discontinued operations
– Changes recognised in other comprehensive income as recognised IAS 28.39
directly in other comprehensive income of investor
– Contingent liabilities IAS 28.40
Key areas of consolidations

 Control still possible if less than 50% of the voting rights owned IAS 27.13
C
 Potential voting rights IAS 27.14–15 H
A
 Loss of control IAS 27.32–34 P
T
 Contingent consideration IFRS 3.39–40,58 E
R
 Definitions Appendix A 20
 Two forms of joint arrangement IFRS 11.6
 Contractual arrangement IFRS 11.5

 Joint ventures IFRS 11.24
– Equity method
 Joint operations IFRS 11.20
– What a joint operation is

– Line by line recognition
Consolidated statements of cash flows

 Only cash flows between the group and an associate are reported in the IAS 7.37
group statement of cash flows with respect to associates
 Aggregate cash flows from acquisitions and disposals of subsidiaries IAS 7.39
presented as investing activities
Audit of groups
 Definitions:
– Group audit partner and group engagement team ISA 600.9
– Component auditor ISA 600.9
 Responsibility ISA 600.11
 Acceptance considerations ISA 600.12–.13
 Procedures to assess the extent to which the component auditor can be ISA 600.19–.20
relied upon
 Significant components ISA 600.26–.27
 Communication with component auditors ISA 600.40–.41
 Communication with group management and those charged with ISA 600.46–.49
governance


Goodwill on acquisition of DEF
£'000
Consideration 3m shares issued at £7 21,000
1m additional shares at £7 7,000
Non-controlling interest 10% × £18m 1,800
29,800
Net assets acquired (18,000)

Goodwill 11,800

£99,750
Net assets of Ives
At
At reporting
acquisition date
£ £
FV adjustment 50,000 –
PURP in inventory – (6,000)
300,000 339,000
£ £
Share of net assets (25% × 339,000) 84,750
Share of goodwill:
NCI at acquisition date at fair value 90,000
NCI share of net assets at acquisition date (25% × £300,000) (75,000)
15,000
99,750

Goodwill on consolidation of Kono Ltd
£m £m
Consideration (£2.00  6m) 12.0
Share capital 8.0
Pre-acquisition retained earnings 4.4
Fair value adjustments C
Property, plant and equipment (16.8 – 16.0) 0.8 H
Inventories (4.2 – 4.0) 0.2 A
Contingent liability (0.2) P
T
13.2
E
Non-controlling interest (25%) 3.3 R
15.3
Net assets acquired (13.2)
Goodwill 2.1
20

Notes on treatment
(a) It is assumed that the market value (ie, fair value) of the loan stock issued to fund the purchase of
the shares in Kono Ltd is equal to the price of £12 million. IFRS 3 requires goodwill to be calculated
by comparing the consideration transferred plus the non-controlling interest, valued either at fair
value or, in this case, as a percentage of net assets, with the fair value of the identifiable net assets
of the acquired business or company.
(b) Share capital and pre-acquisition profits represent the book value of the net assets of Kono Ltd at
the date of acquisition. Adjustments are then required to this book value in order to give the fair
value of the net assets at the date of acquisition. For short-term monetary items, fair value is their
carrying value on acquisition.
(c) The fair value of property, plant and equipment should be determined by market value or, if
information on a market price is not available (as is the case here), then by reference to depreciated
replacement cost, reflecting normal business practice. The net replacement cost (ie, £16.8m)
represents the gross replacement cost less depreciation based on that amount, and so further
adjustment for extra depreciation is unnecessary.
(d) Raw materials are valued at their replacement cost of £4.2 million.
(e) The rationalisation costs cannot be reported in pre-acquisition results under IFRS 3, as they are not
a liability of Kono Ltd at the acquisition date.
(f) The fair value of the loan is the present value of the total amount payable (principal and interest).
The present value of the loan is the same as its par value.
(g) The contingent liability should be included as part of the acquisition net assets of Kono even
though it is not deemed probable and therefore has not been recognised in Kono's individual
accounts. However, the disclosed amount is not necessarily the fair value at which a third party
would assume the liability. If the probability is low, then the fair value is likely to be lower than
£200,000.

IFRS 11 gives examples in the oil, gas and mineral extraction industries. In such industries companies may,
say, jointly control and operate an oil or gas pipeline. Each company transports its own products down the
pipeline and pays an agreed proportion of the expenses of operating the pipeline (perhaps based on
volume). In this case the parties have rights to assets (such as exploration permits and the oil or gas produced
by the activities).
A further example is a property which is jointly controlled, each venturer taking a share of the rental
income and bearing a portion of the expense.

Consolidated statement of profit or loss for the year ended 30 June 20X9
£
Revenue (W2) 2,291,300
Cost of sales (W2) (1,238,125)
Gross profit 1,053,175
Operating expenses (W2) (263,980)
Profit from operations 789,195
Share of profits of associate (W6) 51,383
Profit before tax 840,578
Income tax expense (W2) (240,685)
Profit for the year 599,893
Owners of Anima plc (Bal) 517,579
Non-controlling interest (W5) 82,314
599,893

Consolidated statement of financial position (extract)
Equity attributable to owners of Anima plc £

Ordinary share capital 4,000,000
Retained earnings (W7) 1,879,116
5,879,116
Non-controlling interest (W8) 2,112,600
Total equity 7,991,716
WORKINGS
(1) Group structure
Anima
900 / 3,000 = 30%
2.1 / 3.5 Oxendale
= 60%
85%
1 Apr X9
Orient
(3/12 months)
Carnforth
Figure 20.11
(2) Consolidation schedule

Anima Orient Carnforth Adjustments Total
3/12
Revenue 1,410,500 870,300 160,000 (149,500) 2,291,300
Cost of sales
Per question (850,000) (470,300) (54,875) 149,500 (1,238,125)
PURP (W4) (9,750)
PURP (W4) (2,700)
Operating expenses
Per question (103,200) (136,000) (23,780) (263,980)
Fair value adj (dep) (W3) (1,000)
Tax (137,100) (79,200) (24,385) (240,685)
PAT 184,800 55,960
(3) Fair value adjustment

Additional fair value £320,000
Buildings £320,000 × 50% = £160,000
Additional depreciation charge in year £160,000 / 40 years × 3/12 months = £1,000
(4) Unrealised profit
Oxendale Orient %
207,000 149,500 115 C
(180,000) (130,000) (100) H
27,000 19,500 15 A
P
T
Orient – £19,500 × ½ = £9,750 E
R
Oxendale – £27,000 × 1/3 = £9,000
Anima share of Oxendale PURP – £9,000 × 30% = £2,700
20

(5) Non-controlling interest
Orient Ltd (40% × £184,800 (W2)) = £73,920
Carnforth Ltd (15% × £55,960 (W2)) = £8,394
Non-controlling interest = £73,920 + £8,394 = £82,314
(6) Share of profits of associate
£
Anima share × 30% 61,383
Less impairment for year (10,000)
51,383
(7) Consolidated retained earnings
£
Anima plc – c/fwd 1,560,000
Less PURP with Orient (W4) (9,750)
Less PURP with Oxendale (W4) (2,700)
Orient Ltd (60% × (580 – 195)) 231,000
Carnforth Ltd (85% × 55,960) (W2) 47,566
Oxendale Ltd ((30% × (340 – 130)) – 10 (impairment)) 53,000
1,879,116
(8) Non-controlling interest – SFP

£ £
Orient Ltd
FV of NCI at acquisition date 1,520,000
Share of post-acquisition reserves ((580 – 195) × 40%) 154,000
1,674,000
Carnforth Ltd
Net assets per question 2,605,000
Fair value adjustment (increase) 320,000
Less extra depreciation on FV adj (1,000)
2,924,000
NCI – 2,924,000 × 15% 438,600
2,112,600

(a) Consolidated statement of financial position as at 31 March 20X4
Assets £ £
Non-current assets
Property, plant and equipment
(660,700 + 635,300 + 24,000 – 1,000 (W1) – 3,000 (W7)) 1,316,000
Intangibles (101,300 + 144,475 (W2)) 245,775
Investment in joint venture (W6) 93,600
1,655,375
Current assets
Inventories (235,400 + 195,900 – 2,400 (W5)) 428,900
Trade and other receivables (174,900 + 78,800 – 50,000) 203,700
Cash and cash equivalents (23,700 + 11,900 + 10,000) 45,600
678,200
Total assets 2,333,575
Equity attributable to owners of Preston plc
Ordinary share capital 100,000
Revaluation surplus 125,000
Retained earnings (W4) 1,099,550
1,324,550
Total equity 1,514,575
Current liabilities
Trade and other payables (151,200 + 101,800 – 40,000) 213,000
Taxation (85,000 + 80,000) 165,000
Deferred consideration 441,000
819,000
Total equity and liabilities 2,333,575
WORKINGS
(1) Net assets – Longridge Ltd
Year end Acquisition Post acq
£ £ £
Retained earnings
Per Q 312,100 206,700
Less intangible (72,000 + 18,000) (72,000) (90,000)
Fair value adj re PPE (120,000 – (92,000 × 48/46)) 24,000 24,000
Dep thereon (24,000 × 2/48) (1,000) –
PPE PURP (W7) (3,000) –
760,100 640,700 119,400
(2) Goodwill – Longridge Ltd

£
Consideration transferred (250,000 + (441,000 – 41,000 (W4))) 650,000
Non-controlling interest at acquisition (640,700 (W1) × 25%) 160,175
C
810,175
H
Net assets at acquisition (W1) (640,700) A
169,475 P
Impairment to date (25,000) T
144,475 E
R
(3) Non-controlling interest – Longridge Ltd
Non-controlling interest at acquisition (W2) 160,175
Share of post-acquisition reserves (119,400 (W1) × 25%) 29,850 20
190,025

£
Preston plc 1,084,800
Unwinding of discount on deferred consideration:
2
Two years (441,000 – (441,000 / 1.05 )) (41,000)
Less PURP (Longridge Ltd) (W5) (2,400)
Longridge Ltd (119,400 (W1) × 75%) 89,550
Chipping Ltd (W6) 3,600
Less impairments to date (25,000 + 10,000) (35,000)
1,099,550
(5) Inventory PURPs

Chipping Ltd Longridge Ltd
% £ £
SP 100 15,000 12,000
Cost (80) (12,000) (9,600)
GP 20 3,000 2,400
(6) Investment in joint venture – Chipping Ltd

£ £
Cost 100,000
Add post-acquisition profits 12,000
Less PURP (W5) (3,000)
9,000
× 40% 3,600
103,600
Less impairment to date (10,000)
93,600
(7) PPE PURP – Longridge Ltd

£
Asset now in Preston plc's books at 15,000 × 1/3 5,000
Asset would have been in Longridge Ltd's books at 10,000 × 1/5 (2,000)
3,000
(b) Goodwill journal entries
£ £
DEBIT Intangibles – goodwill 39,160
DEBIT Share capital 320,000
CREDIT Investments 385,000
CREDIT Non-controlling interest (320,000 + 112,300) × 20% 86,460

The holding of 40,000 out of Feeder Ltd's 100,000 shares gave Lawn plc significant influence over
Feeder Ltd, so Lawn plc should have used equity accounting. The deemed disposal gain is calculated as:
£'000
Cost of 40,000 shares 200
Share of revaluation surplus over period of ownership (40% × 20) 8
Share of retained earnings over period of ownership (40% × 30) 12
Carrying amount at 31 December 20X8 220
Acquisition date fair value of previously held equity 236
Gain to be recognised in profit or loss 16
Note: The revaluation gain should not be reclassified to profit or loss, because it would not be so
reclassified if there had been a real disposal of the interest in Feeder Ltd. It should, however, be
transferred to retained earnings in the statement of changes in equity.

Goodwill acquired in the business combination
£'000
Consideration transferred at acquisition date 216
Non-controlling interest – 30% × 510,000 153
Fair value of previously held equity 236
605
Net assets acquired (510)
Goodwill 95

(a) Complete disposal at year end (80% to 0%)
Consolidated statement of financial position as at 30 September 20X8
Streatham Balham Adjustment 1 Adjustment 2 Disposal Consolidated
£'000 £'000 £'000 £'000 £'000 £'000
Non-current 360 270 (270) 360
assets
Investment 324 (324)
Goodwill 36 (36)
Current 370 370 (370) 1,020
assets 650
1,380
Share capital 540 180 (180) 540
Reserves 414 360 (180) (36) 182 740
NCI 72 36 (108) –
Current 100 100 (100) 100
liabilities
1,380
Consolidated statement of profit or loss for the year ended 30 September 20X8
Streatham Balham Adjustment 1 Adjustment 2 Disposal Consolidated
£'000 £'000 £'000 £'000 £'000 £'000
Profit before 153 126 279
tax
Profit on 182 182
disposal
Tax (45) (36) (81)
108 90 380
Owners of 108 90 (18) 182 362
parent
NCI 18 18
380
WORKINGS
(1) Goodwill
£'000
Consideration transferred 324
NCI: 20%  (180 + 180) 72 C
H
396 A
Net assets (180 + 180) (360) P
36 T
E
£'000 £'000 R
Consolidation adjustment journal
DEBIT Goodwill 36
DEBIT Share capital 180
DEBIT Reserves 180 20
CREDIT Investment 324
CREDIT Non-controlling interest 72
To recognise the acquisition and related goodwill and non-controlling interest.

(2) Allocate profits between acquisition date and disposal date to NCI
£
Post-acquisition profits (360 – 180) 180,000
NCI share (20%) 36,000
Of these, £18,000 (90,000  20%) relate to the current year.
Consolidation adjustment journal (SOFP) £'000 £'000
DEBIT Reserves 36
CREDIT Non-controlling interest 36
To allocate the NCI share of post-acquisition profits.
In addition, 20% of the profits of Balham Co arising in the year are allocated to the NCI:
Consolidation adjustment journal (SPL) £'000 £'000
DEBIT Profits attributable to owners of parent 18
CREDIT Non-controlling interest in profit 18
To allocate the NCI share of post-acquisition profits in the current year.
(3) Profit on disposal of Balham Co

£'000 £'000
Fair value of consideration received 650
Less: net assets at disposal 540
goodwill 36
NCI (540  20%) (108)
(468)
182
Consolidation adjustment journal (SPL) £'000 £'000

DEBIT Cash 650
DEBIT NCI 108
DEBIT Disposal date liabilities of Balham 100
CREDIT Goodwill 36
CREDIT Disposal date current assets of Balham 370
CREDIT Disposal date non-current assets of Balham 270
CREDIT Reserves 182
To recognise the group gain on disposal of Balham Co.
(b) Partial disposal: subsidiary to subsidiary (80% to 60%)

Consolidated statement of financial position as at 30 September 20X8
Adjustment Adjustment
Streatham Balham 1 (part (a)) 2 (part (a)) Disposal Consolidated
£'000 £'000 £'000 £'000 £'000 £'000
Non-current 360 270 630
assets
Investment 324 (324)
Goodwill 36 36
Current assets 370 370 160 900
1,566
Share capital 540 180 (180) 540
Reserves 414 360 (180) (36) 52 610
NCI 72 36 108 216
Current 100 100 200
liabilities
1,566

Consolidated statement of profit or loss for the year ended 30 September 20X8
Adjustment Adjustment
Streatham Balham 1 2 Disposal Consolidated
£'000 £'000 £'000 £'000 £'000 £'000
Profit before 153 126 279
tax
Profit on
disposal –
Tax (45) (36) (81)
108 90 198
Owners of 108 90 (18) 180
parent
NCI 18 18
198
WORKING: Disposal
Adjustment is made to equity as control is not lost. £'000
NCI before disposal 80% (360 + 180) 432
NCI after disposal 60% (360 + 180) (324)
Required adjustment 108
Consolidation adjustment journal (SOFP) £'000 £'000

DEBIT Current assets (cash) 160
CREDIT NCI 108
CREDIT Reserves 52
(c) Partial disposal: subsidiary to associate (80% to 40%)
(1) Profit on disposal
£'000 £'000
Fair value of consideration received 340
Fair value of 40% investment retained 250
Less: Net assets when control lost
(540 – (90  /12))
3
517.5
Goodwill (part (a)) 36
NCI (517.5  20%) (103.5)
(450)
140
(2) Group reserves

Streatham Balham 40%
reserves Balham reserve
£'000 £'000 £'000
At date of disposal 414
Group profit on disposal (W1) 140
Balham: share of post-acquisition
earnings (157.5  80%) 126
Balham: share of post-acquisition
earnings (22.5  40%) 9
689
C
At date of disposal
H
(360 – (90  /12))/per question
3
414 337.5 360.0 A
Retained earnings at acquisition/ P
on disposal 414 (180.0) (337.5) T
157.5 22.5 E
R
(3) Investment in associate
£'000
Fair value at date control lost (new 'cost') 4250 20
Share of post-acquisition reserves (90  /12  40%)
3
9
259

(d) Partial disposal: subsidiary to financial asset (80% to 40%)
(1) Profit on disposal – as in part (c)
(2) Group reserves
£'000
Streatham Co's reserves 414
Group profit on disposal (W1) 140
Balham: share of post-acquisition reserves (157.5 (see below)  80%) 126
680
Balham
£'000
At date of disposal (360 – (90  /12))
3
337.5
Reserves at acquisition (180.0)
157.5
(3) Retained investment – at £250,000 fair value

Consolidated statement of cash flows for the year ended 31 December 20X8
£'000 £'000
Cash flows from operating activities
Cash generated from operations (Note 1) 340
Income taxes paid (W4) (100)
Net cash from operating activities 240
Cash flows from investing activities

Acquisition of subsidiary S Ltd, net of cash acquired (Note 2) (90)
Purchase of property, plant and equipment (W1) (220)
Net cash used in investing activities (310)
Cash flows from financing activities
Proceeds from issue of share capital (1,150 + 650 – 1,000 – 500 – (100  £2)) 100
Dividend paid to non-controlling interest (W3) (4)
Net cash from financing activities 96
Net increase in cash and cash equivalents 26
Cash and cash equivalents at the beginning of period 50
Cash and cash equivalents at the end of period 76
Notes to the statement of cash flows
(1) Reconciliation of profit before tax to cash generated from operations

£'000
Profit before taxation 420
Adjustments for:
Depreciation 210
630
Increase in trade receivables (1,370 – 1,100 – 30) (240)
Increase in inventories (1,450 – 1,200 – 70) (180)
Increase in trade payables (1,690 – 1,520 – 40) 130
Cash generated from operations 340

(2) Acquisition of subsidiary
During the period the group acquired subsidiary S Ltd. The fair values of assets acquired and
liabilities assumed were as follows:
£'000
Inventories 70
Receivables 30
Trade payables (40)
Non-controlling interest (26)
234
Goodwill 66
Total purchase price 300
Less cash of S Ltd (10)
Less non-cash consideration (200)
Cash flow on acquisition net of cash acquired 90
WORKINGS
(1) PROPERTY, PLANT AND EQUIPMENT
£'000 £'000
b/f 2,300 Depreciation 210
On acquisition 190 c/f 2,500
Additions (balancing figure) 220
2,710 2,710
(2) GOODWILL
£'000 £'000
b/f –
Additions (300 – (90%  260)) 66 Impairment losses (balancing figure) 0
c/f 66
66 66
(3) NON-CONTROLLING INTEREST
£'000 £'000
Dividend (balancing figure) 4 b/f –
c/f 31 On acquisition 26
CSPL 9
35 35
(4) INCOME TAX PAYABLE
£'000 £'000
b/f 100
Cash paid (balancing figure) 100 CSPL 150
c/f 150
250 250
Answer to Interactive question 10 C

(a) Cash flows from investing activities H
A
£'000 P
Disposal of subsidiary Desdemona Ltd, net of cash disposed of (400 – 20) 380 T
E
(b) Cash flows from investing activities
R
£'000
Purchase of property, plant and equipment (W1) (1,307)
(c) Cash flows from financing activities 20
£'000
Dividends paid to non-controlling interest (W2) (42)

(d) Note to the statement of cash flows
During the period the group disposed of subsidiary Desdemona Ltd. The book values of assets and
liabilities disposed of were as follows:
£'000
Inventories 50
Receivables 39
Payables (42)
Non-controlling interest (W2) (91)
366
Profit on disposal 34
Total sale proceeds 400
Less cash of Desdemona Ltd disposed of (20)
Cash flow on disposal net of cash disposed of 380
(e) Reconciliation of profit before tax to cash generated from operations

£'000
Profit before tax (862 + 20) 882
Adjustments for:
Depreciation 800
1,682
Increase in receivables (605 – 417 + 39) (227)
Increase in inventories (736 – 535 + 50) (251)
Increase in payables (380 – 408 + 42) 14
Cash generated from operations 1,218
WORKINGS
(1) PROPERTY, PLANT AND EQUIPMENT – CARRYING AMOUNT
£'000 £'000
b/f 3,950 c/f 4,067
Additions (balancing figure) 1,307 Disposal of sub 390
Depreciation charge 800
5,257 5,257
(2) NON-CONTROLLING INTEREST
£'000 £'000
c/f 482 b/f 512
Disposal of sub (457 × 20%) 91 CSPL 103
Dividends to NCI
(balancing figure) 42
615 615

(a) Reasons for reviewing the work of component auditors
The main consideration which concerns the audit of all group accounts is that the holding
company's auditors (the 'group' auditors) are responsible to the members of that company for the
audit opinion on the whole of the group accounts.
It may be stated (in the notes to the financial statements) that the financial statements of certain
subsidiaries have been audited by other firms, but this does not absolve the group auditors from
any of their responsibilities.
The auditors of a holding company have to report to its members on the truth and fairness of the
view given by the financial statements of the company and its subsidiaries dealt with in the group
accounts. The group auditors should have powers to obtain such information and explanations as
they reasonably require from the subsidiary companies and their auditors, or from the parent
company in the case of overseas subsidiaries, in order that they can discharge their responsibilities
as holding company auditors.

The auditing standard ISA (UK) 600 (Revised June 2016) Special Considerations – Audits of Group
Financial Statements (Including the Work of Component Auditors) clarifies how the group auditors can
carry out a review of the audits of subsidiaries in order to satisfy themselves that, with the inclusion
of figures not audited by themselves, the group accounts give a true and fair view.
The scope, standard and independence of the work carried out by the auditors of subsidiary
companies (the 'component' auditors) are the most important matters which need to be examined
by the group auditors before relying on financial statements not audited by them. The group
auditors need to be satisfied that all material areas of the financial statements of subsidiaries have
been audited satisfactorily and in a manner compatible with that of the group auditors themselves.
(b) Procedures to be carried out by group auditors in reviewing the component auditors' work
(i) Send a questionnaire to all other auditors requesting detailed information on their work,
including:
(1) An explanation of their general approach (in order to make an assessment of the
standards of their work)
(2) Details of the accounting policies of major subsidiaries (to ensure that these are
compatible within the group)
(3) The component auditors' opinion of the subsidiaries' overall level of internal control, and
the reliability of their accounting records
(4) Any limitations placed on the scope of the auditors' work
(5) Any qualifications, and the reasons for them, made or likely to be made to their audit
reports
(ii) Carry out a detailed review of the component auditors' working papers on each subsidiary
whose results materially affect the view given by the group financial statements. This review
will enable the group auditors to ascertain whether (inter alia):
(1) An up to date permanent file exists with details of the nature of the subsidiary's business,
its staff organisation, its accounting records, previous year's financial statements and
copies of important legal documents.
(2) The systems examination has been properly completed, documented and reported on to
management after discussion.
(3) Tests of controls and substantive procedures have been properly and appropriately
carried out, and audit programmes properly completed and signed.
(4) All other working papers are comprehensive and explicit.
(5) The overall review of the financial statements has been adequately carried out, and
adequate use of analytical procedures has been undertaken throughout the audit.
(6) The financial statements agree in all respects with the accounting records and comply
with all relevant legal requirements and accounting standards.
(7) Minutes of board and general meetings have been scrutinised and important matters
noted.
(8) The audit work has been carried out in accordance with approved auditing standards.
C
(9) The financial statements agree in all respects with the accounting records and comply H
A
with all relevant legal and professional requirements.
P
(10) The audit work has been properly reviewed within the firm of auditors and any T
E
laid-down quality control procedures adhered to.
R
(11) Any points requiring discussion with the holding company's management have been
noted and brought to the group auditors' attention (including any matters which might
warrant a qualification in the audit report on the subsidiary company's financial 20
statements).
(12) Adequate audit evidence has been obtained to form a basis for the audit opinion on both
the subsidiaries' financial statements and those of the group.

If the group auditors are not satisfied as a result of the above review, they should arrange for
further audit work to be carried out either by the component auditors on their behalf, or jointly
with them. The component auditors are fully responsible for their own work; any additional tests
are those required for the purpose of the audit of the group financial statements.

(a) Intra-group balances should agree because, in the preparation of consolidated accounts, it is
necessary to cancel them out. If they do not cancel out then the group accounts will be displaying
an item which has no value outside of the group and profits may be correspondingly under- or
overstated. The audit procedures required to check that intra-group balances agree would be as
follows.
(i) Obtain and review a copy of the parent company's instructions to all group members relating
to the procedures for reconciliation and agreement of year-end intra-group balances.
Particular attention should be paid to the treatment of 'in transit' items to ensure that there is
a proper cut-off.
(ii) Obtain a schedule of intra-group balances from all group companies and check the details
therein to the summary prepared by the parent company. The details on these schedules
should also be independently confirmed in writing by the other auditors involved.
(iii) Nil balances should also be confirmed by both the group companies concerned and their
respective auditors.
(iv) The details on the schedules in (ii) above should also be agreed to the details in the financial
statements of the individual group companies which are submitted to the parent company for
consolidation purposes.
(b) Where one company in a group supplies goods to another company at cost plus a percentage, and
such goods remain in inventory at the year end, then the group inventory will contain an element
of unrealised profit. In the preparation of the group accounts, best accounting practice requires
that an allowance should be made for this unrealised profit.
In order to verify that intra-group profit in inventory has been correctly accounted for in the group
accounts, the audit procedures required would be as follows.
(i) Confirm the group's procedures for identification of such inventory and their notification to
the parent company who will be responsible for making the required provision.
(ii) Obtain and review schedules of intra-group inventory from group companies and confirm
that the same categories of inventory have been included as in previous years.
(iii) Select a sample of invoices for goods purchased from group companies and check to see that
these have been included in year-end intra-group inventory as necessary and obtain
confirmation from component auditors that they have satisfactorily completed a similar
exercise.
(iv) Check the calculation of the allowance for unrealised profit and confirm that this has been
arrived at on a consistent basis with that used in earlier years, after making due allowance for
any known changes in the profit margins operated by various group companies.
(v) Check the schedules of intra-group inventory against the various inventory sheets and
consider whether the level of intra-group inventory appears to be reasonable in comparison
with previous years, ensuring that satisfactory explanations are obtained for any material
differences.


1 Burdett
Goodwill: £380,000
Excess of assets/liabilities over cost of combination: Nil
Swain Thamin
£'000 £'000
Consideration transferred 1,340 340
NCI (20% × £1.2m) / (40% × £680,000) 240 272
1,580 612
Net assets of acquiree (1,200) (680)
Goodwill / Gain on bargain purchase 380 (68)
See IFRS 3.32 and 34. The second acquisition resulted in an excess over the cost of combination
which should be recognised immediately in profit.
2 Sheliak
Depreciation charge: decrease by £10,000
Carrying amount: decrease by £30,000
Depreciation charge: Sheliak (£1m / 8 years) £125,000
Parotia (£575,000 / 5 years) £115,000
Decrease £10,000
Carrying amount: Sheliak (£1m × 3/8 years) £375,000
Parotia (£575,000 × 3/5 years) £345,000
Decrease £30,000
Fair value adjustments not reflected in the books must be adjusted for on consolidation. In this
example the depreciation is decreased by the difference between Sheliak's depreciation charge and
Parotia's fair value depreciation calculation. The carrying amount is decreased by the difference
between Sheliak's carrying value at 31 December 20X7 and Parotia's carrying value at
31 December 20X7.
3 Finch
£207,000
£'000
Net assets per SFP (£8.1m – £1.3m) 6,800
Fair value adjustment to property 300
Contingent liability (20)
Adjusted net assets 7,080
Net assets is increased by the fair value adjustment of £300,000 and decreased by the contingent
liability, which is recognised in accordance with IFRS 3.23.
C
Goodwill is therefore calculated as: H
£'000 A
Consideration transferred 5,100 P
Non-controlling interest T
687 E
Ordinary shares 15% × (£7.08m – £2.5m) R
Preference shares 60% × £2.5m 1,500
7,287
Net assets of acquiree (7,080)
20
Goodwill 207

4 Maackia
£1,780,000
£'000 £'000
Non-controlling interest (fair value) 1,800
6,600
Net assets of acquiree
Draft 4,600
Business held for sale ((£760,000 – £40,000) – £500,000) 220
(4,820)
Goodwill 1,780
In allocating the cost of the business combination to the assets and liabilities acquired, the business
that is on the market for immediate sale should be valued in accordance with IFRS 5 at fair value
less costs to sell (IFRS 3.31).
The defined benefit plan net asset should be recognised in accordance with IAS 19 (IFRS 3.26).
5 Gibbston
(a) £4.9m
(b) £1.2m share of loss
(c) £7.2m
(a)
£'000 £'000
Consideration transferred: Cash 15,000
Deferred cash (£5.5m/1.1) 5,000
Contingent cash (£13.3m/1.13) × 45% 4,500
24,500
Non-controlling interest: Net assets at 1 Jan 20X7 20,000
Loss to acquisition (£3m × 4/12) (1,000)
Fair value adjustment 9,000
30% × 28,000 8,400
32,900
Net assets of acquiree (28,000)
Goodwill 4,900
IFRS 3.39 requires contingent consideration capable of reliable measurement to be included at fair
value regardless of whether payment is probable.
The net assets at the acquisition date are those at the start of the year adjusted for the fair value
increase of plant (£9m) less the losses between the start of the year and the acquisition date.
(b) Non-controlling interest share of loss: £m
Loss: Acquisition to 31 December (8/12 × £3m) 2
Extra depreciation (£9m/3 years × 8/12) 2
4 × 30% = £1.2m
(c) Non-controlling interest in SFP
Share of the net assets at the date of acquisition (£28m  8.4
30%)
Share of loss since acquisition (part (b)) (1.2)
7.2

6 Supermall
Supermall has been set up as a separate vehicle. As such, it could be either a joint operation or
joint venture, so other facts must be considered.
There are no facts that suggest that the two real estate companies have rights to substantially all
the benefits of the assets of Supermall or an obligation for its liabilities.
Each party's liability is limited to any unpaid capital contribution.

As a result, each party has an interest in the net assets of Supermall and should account for it as a
joint venture using the equity method in accordance with IFRS 11 Joint Arrangements.
7 Green and Yellow

Orange
Green wishes to account for its arrangement with Yellow using the equity method. It can only do
so if the arrangement meets the criteria in IFRS 11 Joint Arrangements for a joint venture.
A joint arrangement is an arrangement, as here, of which two or more parties have joint control.
A joint venture is a joint arrangement whereby the parties that have control of the arrangement
have rights to the net assets of the arrangement.
Orange is a separate vehicle. As such, it could be either a joint operation or joint venture, so other
facts must be considered.
There are no facts that suggest that Green and Yellow have rights to substantially all the benefits of
the assets of Orange or an obligation for its liabilities.
Each party's liability is limited to any unpaid capital contribution.
As a result, each party has an interest in the net assets of Orange and should account for it as a
joint venture using the equity method.
Pipeline
Since Green has joint control over the pipeline, even though its interest is only 10%, it would not
be appropriate to show the pipeline as an investment. This is a joint arrangement under IFRS 11.
The pipeline is a jointly controlled asset, and it is not structured through a separate vehicle.
Accordingly, the arrangement is a joint operation.
IFRS 11 Joint Arrangements requires that a joint operator recognises line by line the following in
relation to its interest in a joint operation:
(i) Its assets, including its share of any jointly held assets
(ii) Its liabilities, including its share of any jointly incurred liabilities
(iii) Its revenue from the sale of its share of the output arising from the joint operation
(iv) Its share of the revenue from the sale of the output by the joint operation, and
(v) Its expenses, including its share of any expenses incurred jointly
operator.
Step acquisitions
8 Stuhr
£6,600,000
£'000
Non-controlling interest (fair value) 2,000
Fair value of retained interest 3,000 C
15,000 H
A
Fair value of net assets of Bismuth (8,400)
P
Goodwill 6,600 T
E
R
20

Disposals
9 Fleurie
There is no loss of control and therefore:
– no gain or loss arises on disposal of the 15% holding in Merlot; and
– there is no change to the carrying value of goodwill.
Instead, the transaction is accounted for in shareholders' equity, with any difference between
proceeds and the change in the non-controlling interest being recognised in retained earnings.
The non-controlling interest before disposal is the fair value at acquisition plus the fair value of
post-acquisition reserves to the date of disposal, as represented by change in net assets:
£
Fair value at acquisition 350,000
Share of post-acquisition reserves [(£3.5m – £2.2m) × 15%)] 195,000
545,000
Increase in NCI: 15%/15% 545,000
NCI after change: 30% 1,090,000
The non-controlling interest has therefore increased by £545,000, recorded by:

DEBIT Cash proceeds £560,000
CREDIT NCI £545,000
CREDIT Retained earnings £15,000
10 Chianti
On disposal of Barolo, the consolidated statement of profit or loss and other comprehensive
income will include:
– a gain on disposal of £6,000 (as calculated below); and
– £15,200 (being Chianti's share of the gain on AFS investments) which is reclassified into profit
or loss.
The group share of the revaluation surplus recognised by Barolo is not reclassified into profit or loss
but is transferred from the group revaluation reserve to group retained earnings.
£ £
Proceeds 340,000
Fair value of interest retained 20,000
360,000
Net assets 320,000
Goodwill (£70,000 – £20,000) 50,000
NCI (5% × 320,000) (16,000)
(354,000)
Gain on disposal 6,000

IAS 7 Statement of Cash Flows
11 Porter
Porter Group statement of cash flows for the year ended 31 May 20X6
£m £m
Adjustments for:
Depreciation 44
Impairment losses on goodwill (W2) 3
Foreign exchange loss (W8) 2
Investment income – share of profit of associate (12)
Investment income – gains on financial assets at fair value
through profit or loss (6)
Interest expense 16
159
Increase in trade receivables (132 – 112 – 16) (4)
Decrease in inventories (154 – 168 – 20) 34
Decrease in trade payables (110 – 98 – 12 – (W8) 17 PPE payable) (17)
Interest paid (W7) (12)
Acquisition of subsidiary, net of cash acquired (26 – 8) (18)
Purchase of financial assets (W4) (10)
Dividend received from associate (W3) 11
Proceeds from issuance of share capital 18
(332 + 212 – 300 – 172 – (80  60%/2  £2.25))
Proceeds from long-term borrowings (380 – 320) 60
Dividend paid (45)
Dividends paid to non-controlling interests (W5) (4)
Net cash from financing activities 29
Net increase in cash and cash equivalents 110
Cash and cash equivalents at the beginning of the year 48
Cash and cash equivalents at the end of the year 158
WORKINGS
(1) Additions to property, plant and equipment
PROPERTY, PLANT AND EQUIPMENT
C
£m £m H
b/d 812 A
Revaluation 58 Depreciation 44 P
Acquisition of subsidiary 92 T
E
Additions on credit (W8) 15
R
 Additions for cash 25 c/d 958
1,002 1,002
20

(2) Impairment losses on goodwill
GOODWILL
£m £m
b/d 10
Acq'n of subsidiary  Impairment losses 3
[(80  60%/2 × 2.25) + 26 + (120 × 40%)
– 120 net assets] 8 c/d 15
18 18
(3) Dividends received from associate

INVESTMENT IN ASSOCIATE
£m £m
b/d 39
P/L 12  Dividends received 11
OCI 8
c/d 48
59 59
(4) Purchase of financial assets

FINANCIAL ASSETS AT FAIR VALUE THROUGH PROFIT OR LOSS
£m £m
b/d 0
P/L 6
 Additions 10
c/d 16
16 16
(5) Dividends paid to non-controlling interests

NON-CONTROLLING INTERESTS
£m £m
b/d 28
 Dividends paid 4 TCI 12
c/d 84 Acquisition of subsidiary (120  40%) 48
88 88
(6) Income taxes paid

INCOME TAX PAYABLE
£m £m
b/d (deferred tax) 26
b/d (current tax) 22
P/L 34
 Income taxes paid 37 OCI 17
c/d (deferred tax) 38 Acquisition of subsidiary 4
c/d (current tax) 28
103 103

(7) Interest paid
INTEREST PAYABLE
£m £m
b/d 4
P/L 16
 Interest paid 12
c/d 8
20 20
(8) Foreign currency transaction
Transactions recorded on: £m £m

(1) 5 March DEBIT Property, plant and equipment (102m/6.8) 15
CREDIT Payables 15
(2) 31 May Payable = 102m/6.0 = £17m
DEBIT P/L (Admin expenses) 2
CREDIT Payables (17 – 15) 2
12 Tastydesserts
Consolidated statement of cash flows for the year ended 31 December 20X2
£'000 £'000

Adjustments for:
Depreciation 78
Share of profit of associates (120)
Interest expense –
624
Increase in receivables (2,658 – 2,436 – 185) (37)
Increase in inventories (1,735 – 1,388 – 306) (41)
Increase in payables (1,915 – 1,546 – 148) 221
Interest paid –
Acquisition of subsidiary Custardpowders net of cash acquired (55 – 7) (48)
Dividends received from associates (W3) 100
Dividends paid (63)
C
Net cash used in financing activities (63) H
Net increase in cash and cash equivalents 133 A
Cash and cash equivalents at beginning of year (266) P
Cash and cash equivalents at end of year (133) T
E
R
20

WORKINGS
(1) Purchase of property, plant and equipment
PROPERTY, PLANT AND EQUIPMENT
£'000 £'000
b/d 3,685
Acquisition of 694 Depreciation 78
Custardpowders
Cash additions 463 c/d 4,764
4,842 4,842
(2) Goodwill
GOODWILL
£'000 £'000
b/d –
Acquisition of 42 Impairment losses 0
Custardpowders
(1,086 – (1,044  100%)) c/d 42
42 42
(3) Dividends received from associates

INVESTMENT IN ASSOCIATE
£'000 £'000
b/d 2,175
Share of profit 120 Dividends received 100
c/d 2,195
2,295 2,295
(4) Reconciliation of share capital

£'000
Share capital plus premium b/d 4,776
Issued to acquire sub (120,000  £2.80) 336
Share capital plus premium c/d (4,896 + 216) 5,112
 no shares have been issued for cash during the year.

(5) Income taxes paid
INCOME TAX PAYABLE
£'000 £'000
b/d – current tax 200
– deferred tax 180
Cash paid 160 P/L 126
c/d – current tax 235
– deferred tax 111
506 506

CHAPTER 21
Foreign currency translation

and hyperinflation
Introduction
Topic List
1 Objective and scope of IAS 21
2 The functional currency
3 Reporting foreign currency transactions
4 Foreign currency translation of financial statements
5 Foreign currency and consolidation
6 Disclosure
7 Other matters
8 Reporting foreign currency cash flows
9 Reporting in hyperinflationary economies
10 Audit focus
Technical reference
1113
Introduction
 Determine and calculate how exchange rate variations are recognised and measured and
how they can impact on reported performance, position and cash flows of single entities
and groups
 Demonstrate, explain and appraise how foreign exchange transactions are measured and
how the financial statements of overseas entities are translated
of details
Specific syllabus references for this chapter are: 7(a), 7(b), 14(c), 14(d), 14(f)

1 Objective and scope of IAS 21 C
H
A
Section overview P
T
This section provides an overview of the objective, scope and main definitions of IAS 21 The Effects of E
Changes in Foreign Exchange Rates. R
IAS 21 deals with two situations where foreign currency impacts financial statements: 21
(1) An entity which buys or sells goods overseas, priced in a foreign currency
A UK company might buy materials from Canada, pay for them in Canadian dollars, then sell its
finished goods in Germany, receiving payment in euros or some other currency. If the company
owes money in a foreign currency at the end of the accounting year or holds assets bought in a
foreign currency, the assets and related liabilities must be translated into the local currency (in this
case pounds sterling), in order to be shown in the books of account.
(2) The translation of foreign currency subsidiary financial statements before consolidation
A UK company might have a subsidiary abroad (ie, a foreign entity that it owns), and the subsidiary
will trade in its own local currency. The subsidiary will keep books of account and prepare its
annual financial statements in its own currency. However, at the year end, the parent company
must 'consolidate' the results of the overseas subsidiary into its group accounts. Therefore the
assets and liabilities and the annual profits of the subsidiary must be translated from the foreign
currency into pounds sterling.
If foreign currency exchange rates remained constant, there would be no accounting problem in either
of these situations. However, foreign exchange rates are continually changing, sometimes significantly,
between the start and the end of the accounting year. For example, in 2010 the British pound was
strong against the euro, as a result of the problems in the Eurozone. It weakened in 2011, strengthened
again by late 2012, then weakened in early 2013. By 2015 it had strengthened again.
1.1 Objective of IAS 21

An entity may carry on foreign activities in either of the two ways outlined above.
In either case, currency fluctuations will affect the financial position of the entity, when foreign currency
transactions or items are translated into the entity's reporting currency.
The objective of IAS 21 is to produce rules that entities should follow in the translation of foreign
currency activities.
1.2 Scope of IAS 21

IAS 21 applies in the following cases.
 In accounting for transactions and balances in foreign currencies except for those derivative
transactions and balances that are within the scope of IAS 39 Financial Instruments: Recognition and
Measurement
 In translating the results and financial position of foreign operations that are included in the
financial statements of the entity by consolidation or the equity method
 In translating an entity's results and financial position into a presentation currency
Definitions
Foreign currency: A currency other than the functional currency of the entity.
Functional currency: The currency of the primary economic environment in which the entity operates.
Presentation currency: The currency in which the financial statements are presented.
Exchange rate: The ratio of exchange for two currencies.
Foreign currency translation and hyperinflation 1115

Closing rate: The spot exchange rate at the reporting date.
Spot exchange rate: The exchange rate for immediate delivery.
Exchange difference: The difference resulting from translating a given number of units of one currency
into another currency at different exchange rates.
Monetary items: Units of currency held and assets and liabilities to be received or paid in a fixed or
determinable number of units of currency.
A group: A parent and all its subsidiaries.
Foreign operations: Defined as any subsidiary, associate, joint venture or branch of a reporting entity,
the activities of which are based or conducted in a country or currency other than those of the reporting
entity.
Net investment in a foreign operation: The amount of the reporting entity's interest in the net assets
of that operation.
1.3 Summary of approach required by the standard

For the preparation of financial statements, an entity needs to determine its functional currency. This is
discussed in section 2 below. For group financial statements, there is no requirement for a group
functional currency; each entity within a group can have its own functional currency.
When an entity enters into a transaction denominated in a currency other than its own functional
currency, then it must translate the foreign currency items into its own functional currency according to
IAS 21. This is covered in section 3.
When transactions create assets and liabilities that remain outstanding at the reporting date, then these
items need to be translated into the entity's functional currency following the provisions of IAS 21. This
is discussed in section 3.
Where a reporting entity comprises a number of individual entities, some of them with their own
functional currencies, it is necessary for the constituent entities to translate their results into the
presentation currency of the parent, in order to be included in the reporting entity's financial
statements. This is covered in sections 4 and 5.
Section 6 deals with disclosures for foreign currency transactions.
2 The functional currency

Section overview
This section defines the functional currency of an entity and discusses the criteria that need to be met
for a currency to be adopted by an entity as its functional currency.
2.1 Determining functional currency

Each entity, whether an individual company, a parent of a group, or an operation within a group (such
as a subsidiary, associate or branch), should determine its functional currency and measure its results
and financial position in that currency.
The functional currency is the currency of the primary economic environment in which the entity
operates and it is normally the currency in which the entity primarily generates and expends cash.
Where an entity is registered in a particular national jurisdiction and the majority of its transactions take
place there, that jurisdiction's currency will be the entity's functional currency. In practice, many entities
operate internationally, with group entities or business divisions located worldwide. In such
circumstances, management will be required to make a reasoned judgement in respect of each
entity/division, based on the available facts.

Where the functional currency of an entity is not obvious, an explanation of why a particular currency
was identified as being its functional currency would aid users' understanding of the business operations C
of the entity. H
A
P
T
2.2 Indicators of functional currency E
R
Under IAS 21, the management of a company needs to determine the functional currency of the
company by assessing various indicators of the economic environment in which the company operates.
IAS 21 provides primary and secondary indicators for use in the determination of an entity's functional
currency, as summarised below. 21
Primary indicators
 The currency that mainly influences sales prices for goods and services (often the currency in
which prices are denominated and settled)
 The currency of the country whose competitive forces and regulations mainly determine the
sales prices of its goods and services
 The currency that mainly influences labour, material and other costs of providing goods or
services (often the currency in which prices are denominated and settled)
Secondary indicators
 The currency in which funds from financing activities (raising loans and issuing equity) are
generated
 The currency in which receipts from operating activities are usually retained
2.3 Functional currency of foreign operations

In addition to the five indicators mentioned above, four additional factors are considered in determining
the functional currency of a foreign operation and whether its functional currency is the same as that of
the reporting entity.
 Whether the foreign operation carries out its business as though it were an extension of the
reporting entity rather than with a significant degree of autonomy
 Whether transactions with the parent are a high or low proportion of the foreign operation's
activities
 Whether cash flows from the activities of the foreign operation directly affect the cash flows of
the parent and are readily available for remittance to it
 Whether cash flows from the activities of the foreign operation are sufficient to service existing and
normally expected debt obligations without funds being made available by the reporting entity

Worked example: Functional currency determination 1
Bogdankur, a small food processing company located in Denmark, is trading almost exclusively with
Germany where the currency is the euro. The management of the company needs to decide on the
functional currency of the company, ie, whether to use the Danish krone or the euro, and is using the
following information (amounts are denominated in krone except as indicated).
Denominated Settled
in € in €
€m % %
Revenue
Export sales 750 100 100
Domestic sales 250 0 0
Total revenues 1,000 75 75
Materials 450 15
Energy and gas 80
Staff costs 80
Other production expenses 30
Depreciation 40
Selling, general and administrative expenses 60 16
Capital expenditure 70
Dividends 180
The main monetary assets and liabilities at 31 December 20X6 were as follows:
Held Expressed
in € in €
€m % %
Cash 120 90
Total accounts receivable 140 80
Trade payables 170 – 0
Borrowings 400 10
Requirement
How might the management of the company determine the functional currency?
Solution
The management of the company has decided using the guidance provided by the IFRS to adopt the
Danish krone as its functional currency, based on the fact that while the currency that influences sales
prices is the euro, the domestic currency influences costs and financing.
Worked example: Functional currency determination 2

Entity A operates an oil refinery in Nigeria. All of the entity's income is denominated in US dollars, as oil
trades in US dollars globally. About 20% of its operational expenses are dollar-denominated salaries and
another 25% is imports of equipment denominated in US dollars. The remaining 55% of the operational
expenses are incurred in Nigeria and are denominated in Naira. Depreciation costs are denominated in
US dollars since the initial investment was in US dollars.
Requirement
What is the appropriate functional currency for Entity A?
Solution
The currency that mainly influences sales prices is the dollar. The currency that mainly influences costs is
not clear, as 55% of the operational costs are in Naira and 45% are in US dollars. Depreciation should
not be taken into account, because it is a non-cash cost, and the economic environment is where an
entity generates and expenses cash.
Since the revenue side is influenced primarily by the US dollar and the cost side is influenced by both
the dollar and the Naira, management will be justified on the basis of IAS 21 guidance to determine the
US dollar as its functional currency.

2.4 Change of functional currency
C
An entity's functional currency may change when its business operations change, leading to a different H
primary economic environment being identified. This is not a change in accounting policy, but instead A
results from a change in circumstances, and therefore the new functional currency should be adopted P
T
prospectively from the date of that change. The new functional currency is applied by retranslating all E
items and comparative amounts into the new currency at the date of the change in circumstances. The R
carrying amounts of non-monetary items translated into the new currency at the date of change should
be deemed to be their historical translated amounts.
21
Worked example: Change in functional currency
An entity commenced trading many years ago in Belgium, using the euro as its functional currency.
After a number of years the entity started exporting its products to the UK, invoicing sales in UK pounds.
Several years later the entity set up a branch in the UK as a small manufacturing function, incurring
expenses and receiving sales proceeds in £ sterling. With a fall in demand in Belgium by the end of
20X6 its activity in the UK came to represent 75% of the entity's activity.
Early in 20X7, the entity's management concluded that the UK was now its primary economic
environment, with 1 January 20X8 being the date when the entity's functional currency changed from
the euro to the pound.
The entity's equity and net assets at 31 December 20X7 were €80,000,000 and the exchange rate was
£1: €1.59.
Requirement
How might the change be reflected in the financial statements?
Solution
The entity's equity and net assets were £50,314,465 when the pound sterling became its functional
currency.
Where an entity's functional currency has changed as a result of changes in its trading operations during
a period, the entity is required to disclose that the change has arisen, along with the reason for the
change.
2.5 Functional currency of a hyperinflationary economy

If the functional currency is the currency of a hyperinflationary economy, the entity's financial
statements are restated in accordance with IAS 29 Financial Reporting in Hyperinflationary Economies
(covered later in this chapter). An entity cannot avoid restatement in accordance with IAS 29 by, for
example, adopting as its functional currency a currency other than the functional currency determined
in accordance with IAS 21.
3 Reporting foreign currency transactions
Section overview
This section deals with the IAS 21 rules governing the initial and subsequent recognition of items
denominated in foreign currency.
Foreign currency transactions are transactions which are denominated in foreign currencies, rather than
in the entity's functional currency. Such transactions arise when the entity:
 buys or sells goods or services whose price is denominated in a foreign currency;
 borrows or lends funds where the amounts payable or receivable are denominated in a foreign
currency; and
 otherwise acquires or disposes of assets or incurs or settles liabilities denominated in a foreign
currency.

Illustration: Foreign currency translation
An entity trades in gold and has a US dollar functional currency, as most of its revenues and expenses
are in US dollars. The entity is located in Frankfurt and as a result it also has significant transactions in
euros. It has issued sterling-denominated share capital to its UK parent. Transactions with the parent are
denominated in £. Which of the following transactions should management treat as foreign currency
transactions?
 Euro transactions
 US dollar transactions
 Sterling transactions
The euro and sterling transactions are foreign currency transactions. The fact that the entity is located in
Frankfurt does not preclude it from designating US dollars as its functional currency. All transactions
which are not denominated in the entity's functional currency are foreign currency transactions.
3.1 Foreign currency transactions: initial recognition

An entity is required to recognise foreign currency transactions in its functional currency. The entity
should achieve this by translating the foreign currency amount at the spot exchange rate between the
functional currency and the foreign currency at the date on which the transaction took place.
The date of the transaction is the date on which the transaction first met the relevant recognition
criteria.
Illustration: Initial recognition

Albion Ltd is a UK manufacturing company with sterling as its functional currency. The company has
ordered raw materials from a French supplier for €200,000. It recorded the transaction on 1 August
20X6, the date of the supplier's invoice. On that date the exchange rate was £1 = €1.72 and the
amount recorded as purchase price is £116,279.
3.1.1 Average rate

Where an entity has a high volume of transactions in foreign currencies, translating each transaction may
be an onerous task, so an average rate may be used. For example, a duty-free shop at Heathrow airport
may receive a large amount of dollars and euros every day and may opt to translate each currency into
sterling using an average weekly rate.
IAS 21 provides no further guidance on how an average rate should be determined, and therefore an
entity should develop a method which is easily implemented with regard to limitations in its accounting
systems. Application of an average monthly rate, based on actual daily rates, would seem a reasonable
approach. Consistent application of the process for determining an appropriate average rate should be
adopted each period.
However, as the average rate is an approximation of the rate of the day of the transaction, an average rate
should not be adopted if exchange rates or underlying transactions fluctuate significantly (eg, due to
seasonality), because in this case an average rate is not a good approximation.
Worked example: Use of average exchange rate

An entity, which has sterling as its functional currency, acquires a Ruritanian denominated bond on
1 January 20X1 for RU£1,000. The bond has five years to maturity and carries a variable market rate of
interest which is currently 6%. Interest is accrued on a daily basis for a calendar year. Interest is paid on
31 January in the following calendar year (that is, interest for 20X1 will be paid on 31 January 20X2).
Management classifies the bond as held to maturity. The bond is therefore carried at amortised cost.
The interest income and exchange differences are recognised in profit or loss. The exchange rate at the
date of acquisition was RU£1 = £1.50.
At 31 December 20X1, the exchange rate was RU£1 = £2.00. The average rate for the period is RU£1 =
£1.75 (based on average rates published by the Central Bank of Ruritania, which are daily weighted
average rates).

Requirement
C
What rate should management use for the translation of interest income that accrues on a daily basis H
when there is a significant fluctuation in the exchange rate? A
P
T
Solution
E
Management should use the daily weighted average exchange rate published by the Central Bank of R
Ruritania. Interest income accrues evenly through the period and the weighted average rate will
produce the same result as a daily actual rate calculation.
21
The use of an unweighted average rate would not be appropriate because exchange rates fluctuate
significantly.
Recognition of interest receivable:
DEBIT Held-to-maturity investment £105 (RU£60  1.75)
CREDIT Interest income £105
3.1.2 Multiple exchange rates

It may be the case that a country operates a two (or more) rate system, such as one for capital
transactions and another for revenue items. Where more than one exchange rate exists, the rate to be
applied is the one at which the transaction or balance would have been settled if settlement had taken
place at the measurement date. If there is a temporary lack of published exchange rates between two
currencies, the entity should apply the next available exchange rate published.
3.1.3 Suspension of rates

On certain occasions, developing countries experience economic problems that affect the convertibility
of their currency. There is no exchange rate to be used in this case to translate foreign currency
transactions. The standard requires companies to use the rate on the first subsequent date at which
exchanges could be made.
3.2 Subsequent measurement

A foreign currency transaction may give rise to assets or liabilities that are denominated in a foreign
currency. These assets and liabilities will need to be translated into the entity's functional currency at
each reporting date. How they will be translated depends on whether the assets or liabilities are
monetary or non-monetary items.
3.2.1 Monetary items

The essential feature of a monetary item, as the definition implies, is the right to receive (or an
obligation to deliver) a fixed or determinable number of units of currency. Examples of monetary assets
 Cash and bank balances
 Trade receivables and payables
 Loan receivables and payables
 Foreign currency bonds held as available for sale
 Foreign currency bonds held to maturity
 Pensions and other employee benefits to be paid in cash
 Provisions that are to be settled in cash
 Cash dividends that are recognised as a liability
 A contract to receive (or deliver) a variable number of the entity's own equity instruments or a
variable amount of assets in which the fair value to be received (or delivered) equals a fixed or
determinable number of units of currency

Foreign currency monetary items outstanding at the reporting date shall be translated using the
closing rate. The difference between this amount and the previous carrying amount in functional
currency is an exchange gain or loss (covered in more detail in section 3.3).
3.2.2 Non-monetary items

A non-monetary item does not give the right to receive or create the obligation to deliver a fixed or
determinable number of units of currency. Examples of non-monetary items include the following:
 Amounts prepaid for goods and services (eg, prepaid rent)
 Goodwill
 Intangible assets
 Inventories
 Property, plant and equipment
 Provisions to be settled by the delivery of a non-monetary asset
 Equity instruments that are held as available-for-sale financial assets
 Equity investments in subsidiaries, associates or joint ventures
Non-monetary items carried at historical cost are translated using the exchange rate at the date of
the transaction when the asset arose (historical rate). They are not subsequently retranslated in the
individual financial statements of the entity. The foreign currency carrying amount is determined
according to appropriate accounting standards (eg, IAS 2 for inventories, IAS 16 for property, plant and
equipment measured at cost).
Non-monetary items carried at fair value are translated using the exchange rate at the date when the
fair value was determined. The foreign currency fair value of a non-monetary asset is determined by
the relevant standards (eg, IAS 16 for property, plant and equipment and IAS 40 for investment
property).
Interactive question 1: Initial recognition

A UK company lends €10 million to its Portuguese supplier of Port wine to upgrade its production
facilities. At the time of the loan, in July 20X5, the exchange rate was £1 = €2. The loan is repayable on
31 December 20X5. Initially the loan will be translated and recorded in the UK company's financial
statements at £5 million. The amount that the company will ultimately receive will depend on the
exchange rate on the date when the loan is repaid.
At 31 December 20X5, the exchange rate was £1 = €2.50.
Requirement
Calculate the exchange gain or loss.
3.2.3 Issues in the measurement of non-monetary assets

(a) Subsequent depreciation should be translated on the same basis as the asset to which it relates, so
the rate at the date of acquisition for assets carried at cost and the rate at the last valuation date for
assets carried at revalued amounts. Application of the depreciation method to the translated
amount will achieve this.
(b) The carrying amount of inventories is the lower of cost and net realisable value in accordance with
IAS 2 Inventories. The carrying amount in the functional currency is determined by comparing:
(i) the cost, translated at the exchange rate at the date when that amount was determined; and
(ii) the net realisable value, translated at the exchange rate at the date when that value was
determined (eg, the closing date at the reporting date).

Worked example: Translation of inventory acquired in a foreign currency
C
Entity J's functional currency is the pound sterling. Entity J acquired inventories for $300,000 on 1 July H
20X5 when the exchange rate was $1.50: £1. At 31 December 20X5, its carrying amount is $300,000 A
and its net realisable value has risen to $340,000. The exchange rate at 31 December 20X5 is $1.80: £1. P
T
Requirement E
R
How should management translate the inventory acquired?
Solution 21
Expressed in dollars, the inventory value has gone up, its net realisable amount exceeding its carrying
amount. In sterling, the carrying amount using the acquisition date rate is £200,000 ($300,000/1.5) and
the net realisable amount using the closing rate is £189,000 ($340,000/1.8). Inventory is stated at the
lower of cost and net realisable value in the functional currency and the carrying amount at
31 December 20X5 is £189,000.
Impairment testing of foreign currency non-monetary assets

Similarly in accordance with IAS 36 Impairment of Assets, the carrying amount of an asset for which there
is an indication of impairment is the lower of:
 the carrying amount, translated at the exchange rate at the date when that amount was
determined; and
 the recoverable amount, translated at the exchange rate at the date when that value was
determined (eg, the closing rate at the reporting date).
The effect of this comparison may be that an impairment loss is recognised in the functional currency
but would not be recognised in the foreign currency or vice versa.
Worked example: Translation of impaired non-monetary item

An entity whose functional currency is the pound sterling acquired on 30 September 20X4 a non-
depreciable foreign currency asset costing $450,000. The exchange rate on 30 September 20X4 was
$1.50/£1 and the asset was recorded at the date of purchase at £300,000. There are indications that the
non-current asset has been impaired during the year.
At 31 December 20X5, the reporting date, the asset's recoverable amount in foreign currency is
estimated to be $400,000 when £1 = $1.25.
Requirement
How should the transaction be recorded?
Solution
Expressed in foreign currency, the asset has a carrying value of $450,000 and a recoverable amount of
$400,000 and is therefore impaired.
However, when it is expressed in sterling, the asset is not impaired, because its recoverable amount
exceeds its carrying amount. In sterling, the carrying amount, using the acquisition date rate, is
£300,000 ($450,000/1.5) and the recoverable amount, using the closing rate, is £320,000
($400,000/1.25). The depreciation of the foreign currency relative to pounds sterling has offset the fall
in the value of the asset due to impairment, therefore no impairment charge is required.

3.2.4 Measurement of financial assets
Initial measurement
Financial assets can be monetary or non-monetary and may be carried at fair value or amortised cost.
Where a financial instrument is denominated in a foreign currency, it is initially recognised at fair value
in the foreign currency and translated into the functional currency at spot rate. The fair value of the
financial instrument is usually the same fair value of the consideration given in the case of an asset or
received in the case of a liability.
Subsequent measurement
At each year end, the foreign currency amount of financial instruments carried at amortised cost is
translated into the functional currency using either the closing rate (if it is a monetary item) or the
historical rate (if it is a non-monetary item). Financial instruments carried at fair value are translated to
the functional currency using the closing spot rate.
Recognition of exchange differences
The entire change in the carrying amount of a non-monetary available-for-sale (AFS) financial asset,
including the effect of changes in foreign currency rates, is reported as other comprehensive income
(OCI) at the reporting date.
A change in the carrying amount of monetary available-for-sale financial assets on subsequent
measurements is analysed between the foreign exchange component and the fair value movement. The
foreign exchange component is recognised in profit or loss and the fair value movement is recognised
as other comprehensive income.
The entire change in the carrying amount of financial instruments measured at fair value through profit
or loss, including the effect of changes in foreign currency rates, is recognised in profit or loss.
Worked example: Translation of non-monetary asset

On 1 January 20X5 an entity whose functional currency is the pound sterling purchased a US dollar
denominated equity instrument at its fair value of $500,000. The entity classifies the instrument as
available-for-sale. The exchange rate at acquisition date was $1.90/£. The exchange rates and the fair
value of the instrument denominated in US dollars at different reporting dates are given below.
Equity
instrument
value
$/£1 $
31 December 20X5 1.80 480,000
31 December 20X6 1.60 450,000
Requirement
What is the fair value of the asset at 1 January 20X5, 31 December 20X5 and 31 December 20X6?
Solution
The asset is an AFS equity investment, therefore a non-monetary financial asset. All exchange differences
are reported in OCI.
Exchange Equity Equity Change in fair value

rate instrument instrument recognised as other
$/£1 value ($) value (£) comprehensive income
Recognised in Cumulative
the current gains or
period losses
1 January 20X5 1.9 500,000 263,158
31 December 20X5 1.8 480,000 266,667 3,509 3,509
31 December 20X6 1.6 450,000 281,250 14,583 18,092

3.3 Recognition of exchange differences
C
Exchange differences arise in the following circumstances: H
A
 On retranslation of a monetary item at the year end P
 When a monetary item is settled in cash (eg, a foreign currency payable is paid) T
 Where there is an impairment, revaluation or other fair value change in a non-monetary item E
R
3.3.1 Retranslation of monetary items

Where a monetary item arising from a foreign currency transaction remains outstanding at the reporting 21
date, an exchange difference arises, being the difference between:
 Initially recording the item at the rate ruling at the date of the transaction (or when it was
translated at a previous reporting date)
 The subsequent retranslation of the monetary item to the rate ruling at the reporting date
Such exchange differences should be reported as part of the profit or loss for the year.
3.3.2 Settlement of monetary items

Exchange differences arising on the settlement of monetary items (receivables, payables, loans, cash in a
foreign currency) should be recognised in profit or loss in the period in which they arise.
There are two situations to consider.
(1) The transaction is settled in the same period as that in which it occurred: all the exchange
difference is recognised in that period.
(2) The transaction is settled in a subsequent accounting period: an exchange difference is
recognised in each intervening period up to the period of settlement, determined by the change in
exchange rates during that period (as per section 3.3.1). A further exchange difference is
recognised in the period of settlement.
Worked example: Recognition of exchange differences on monetary item settled in

the same period
White Cliffs Co, whose year end is 31 December, buys some goods from Rinka SA of France on
30 September. The invoice value is €40,000 and is due for settlement on 30 November. The exchange
rate moved as follows.
€/£1
30 September 1.60
30 November 1.80
Requirement
State the accounting entries in the books of White Cliffs Co.
Solution
The purchase will be recorded in the books of White Cliffs Co using the rate of exchange ruling on
30 September.
DEBIT Purchases £25,000
CREDIT Trade payables £25,000
Being the £ cost of goods purchased for €40,000 (€40,000  €1.60/£1)
On 30 November, White Cliffs must pay €40,000. This will cost €40,000  €1.80/£1 = £22,222 and the
company has therefore made an exchange gain of £25,000 – £22,222 = £2,778.
DEBIT Trade payables £25,000
CREDIT Exchange gains: profit or loss £2,778

Worked example: Recognition of exchange differences on monetary item settled in a
subsequent accounting period
White Cliffs Co, whose year end is 31 December, buys some goods from Rinka SA of France on
30 September. The invoice value is €40,000 and is due for settlement in equal instalments on
30 November and 31 January. The exchange rate moved as follows.
€/£1
30 September 1.60
30 November 1.80
31 December 1.90
31 January 1.85
Requirement
State the accounting entries in the books of White Cliffs Co.
Solution
The purchase will be recorded in the books of White Cliffs Co using the rate of exchange ruling on
30 September.
DEBIT Purchases £25,000
CREDIT Trade payables £25,000
Being the £ sterling cost of goods purchased for €40,000 (€40,000  €1.60/£1)
On 30 November, White Cliffs must pay €20,000 to settle half the payable (£12,500). This will cost
€20,000  €1.80/£1 = £11,111 and the company has therefore made an exchange gain of £12,500 –
£11,111 = £1,389.
On 31 December, the reporting date, the outstanding liability of £12,500 will be recalculated using the
rate applicable at that date: €20,000  €1.90/£1 = £10,526. A further exchange gain of £1,974
(£12,500 – £10,526) has been made and will be recorded as follows.
The total exchange gain of £3,363 will be included in the operating profit for the year ending
31 December.
On 31 January, White Cliffs must pay the second instalment of €20,000 to settle the remaining liability
of £10,526. This will cost the company £10,811 (€20,000  €1.85/£1).
DEBIT Exchange losses: Profit or loss £285
3.3.3 Exceptions to the general rule

As set out above, exchange differences should normally be recognised as part of profit or loss for the
period. This treatment is required in an entity's own financial statements even in respect of differences
on certain monetary amounts receivable from, or payable to, a foreign operation. If the settlement of
these amounts is neither 'planned nor likely to occur', they are in effect part of the entity's net
investment in the foreign operation.
In the following cases the exchange differences on monetary items are not reported in profit or loss
because hedge accounting provisions under IAS 39 overrule the regulations of IAS 21.
(a) A monetary item designated as a hedge of a net investment in consolidated financial statements. In
this case any exchange difference that forms part of the gain or loss on the hedging instrument is
recognised as other comprehensive income.

(b) A monetary item designated as a hedging instrument in a cash flow hedge. In this case any
exchange difference that forms part of the gain or loss on the hedging instrument is recognised as C
other comprehensive income. H
A
(c) Exchange differences arising in respect of monetary items which are part of the net investment are P
recognised in profit or loss in the individual financial statements of the entity or foreign operation T
E
as appropriate. However, in the consolidated statement of financial position the exchange
R
differences are recognised in equity. This exemption arises only on consolidation and is dealt with
in the section on consolidation.
21
3.3.4 Non-monetary items
Where a non-monetary item (eg, inventory or a non-current asset) is recognised at historical cost (and
there is no impairment) then it is translated into the functional currency at the exchange rate on the
date of the transaction. It is not then retranslated at subsequent reporting dates in the individual
financial statements of the entity, and therefore no exchange differences arise.
However, exchange differences do arise on non-monetary items when there has been a change in their
underlying value (eg, fair value changes, revaluations or impairments). These are recognised as follows.
(a) When a gain or loss on a non-monetary item is recognised as other comprehensive income (for
example, where property denominated in a foreign currency is revalued) any related exchange
differences should also be recognised as other comprehensive income.
(b) When a gain or loss (eg, fair value change) on a non-monetary item is recognised in profit or loss, any
exchange component of that gain or loss is also recognised in profit or loss.
Several examples are given below to highlight the issues that arise in the recognition of exchange
differences on non-monetary items.
Interactive question 2: Rumble plc

Rumble plc is a retailer of fine furniture. On 19 October 20X5 Rumble purchased 100 identical antique
tables from a US supplier for a total of $3,600,000. Rumble has a year end of 31 December 20X5 and
uses sterling as its functional currency.
Exchange rates are as follows.
19 October 20X5 £1 = $1.80
15 December 20X5 £1 = $1.90
20 December 20X5 £1 = $1.95
31 December 20X5 £1 = $2.00
Average rate for 20X5 £1 = $1.60
3 February 20X6 £1 = $2.40
Requirement
Determine, according to IAS 21 The Effects of Changes in Foreign Exchange Rates, the impact of the above
transaction on the profits of Rumble for the year ended 31 December 20X5 and on the statement of
financial position at that date under each of the following alternative assumptions.
Assumption 1 All the tables were sold on 20 December 20X5 and were paid for by Rumble on
15 December 20X5.
Assumption 2 All the tables were sold on 3 February 20X6 and were paid for by Rumble on
15 December 20X5.
Assumption 3 All the tables were sold on 15 December 20X5 and were paid for by Rumble on
3 February 20X6.
Assumption 4 75 of the tables were sold on 15 December 20X5 with the remaining 25 tables being
sold on 3 February 20X6. All the tables were paid for by Rumble on 3 February 20X6.

Worked example: Translation of investment property
An entity whose functional currency is the pound sterling holds an investment property in Singapore.
The investment property is carried at fair value in accordance with IAS 40. The investment property had
a fair value at 31 December 20X2 of S$10,000,000 and S$12,000,000 at 31 December 20X3. The
exchange rates were as follows.
31 December 20X2 £1: S$1.65
31 December 20X3 £1: S$1.63
Requirement
How should management recognise the change in the value of this investment property?
Solution
Management should recognise the investment property at £6,060,606 and £7,361,963 at 31 December
20X2 and 31 December 20X3 respectively.
The change in value is calculated as:
31 December 20X2 (S$10,000,000/1.65) £6,060,606
31 December 20X3 (S$12,000,000/1.63) £7,361,963
Increase in fair value £1,301,357
The increase in fair value of £1,301,357 should be recognised in profit or loss as a gain on investment
property.
The investment property is a non-monetary asset. The movement in value attributable to movement in
exchange rates £74,363 ($10,000,000/1.65) – ($10,000,000/1.63) should not be recognised separately
because the asset is non-monetary.
Illustration: Translation of property – revaluations

A UK-based entity with a sterling functional currency has a property located in Spain which was
acquired at a cost of €6 million when the exchange rate was £1 = €1.50. At the reporting date the
property was revalued to €8 million. The exchange rate on the reporting date was £1 = €1.60. Ignoring
depreciation, the amount that would be recognised as other comprehensive income is:
€ €/£ £
Value at reporting date 8,000,000 1.6 5,000,000
Value at acquisition 6,000,000 1.5 4,000,000
Revaluation surplus recognised in equity 1,000,000
The revaluation surplus may be analysed as follows.

€ €/£ £ £
Change in fair value 2,000,000 1.6 1,250,000
Exchange component of change
6,000,000 1.6 3,750,000
6,000,000 1.5 4,000,000
(250,000)
Revaluation surplus recognised as other
comprehensive income 1,000,000
Interactive question 3: Translation of land: revaluations

Entity A, incorporated in Muritania (local currency Muritania lira), is the treasury department of Entity B
which has British pounds as its functional currency. The functional currency of Entity A is also the British
pound, as it is not autonomous from its parent. Entity A's management follows the revaluation model in
IAS 16 and measures its land and buildings at revalued amounts (based on periodic valuations as
necessary but not less frequent than every three years). A piece of land was acquired on 1 June 20X4
and is not depreciated. It has been revalued on 31 December 20X5 and 31 December 20X6 respectively
as follows.

Muritania lira Date Exchange rate £
Cost at acquisition 200,000 Bought on 1 June 20X4 M lira 1 = £1.30 260,000 C
Fair value 250,000 As at 31 December 20X5 M lira 1 = £1.00 250,000 H
Fair value 260,000 As at 31 December 20X6 M lira 1 = £1.20 312,000 A
P
Requirement T
E
How should management translate the land held at fair value in accordance with IAS 16? R
21
Worked example: Impairment in non-monetary item

A UK-based entity with a sterling functional currency has a property located in Spain which was
acquired at a cost of €6 million when the exchange rate was £1 = €1.50. The property is carried at cost.
At the reporting date the recoverable amount of the property as a result of an impairment review
amounted to €5 million. The exchange rate at the reporting date was £1 = €1.60.
Requirement
Ignoring depreciation, determine the amount of the impairment loss that would be reported in profit or
loss as a result of the impairment.
Solution
€ €/£ £ £
Carrying amount at reporting date 5,000,000 1.6 3,125,000
Historical cost 6,000,000 1.5 4,000,000
Impairment loss recognised in profit or loss ( 875,000)
The impairment loss may be analysed as follows.

Change in value due to impairment 1,000,000 1.6 (625,000)
Exchange component of change
6,000,000 1.6 3,750,000
6,000,000 1.5 4,000,000
(250,000)
Impairment loss recognised in profit or loss (875,000)
Worked example: Translation of financial instruments

Entity A, whose functional currency is the pound sterling, acquired on 30 September 20X4 two classes
of dollar-denominated financial instruments. (Entity A's accounting year end is 31 December.)
(a) Listed equity instruments for $10 million, classified as available-for-sale
(b) Non-listed equity instruments for $10 million, classified as available-for-sale
At 31 December, management believe that the cost of the unlisted investments is still a reasonable
approximation of their fair value. The fair value of the listed investments has increased to $14.4 million.
Requirement
How should the relevant requirements of IAS 39 and IAS 32 affect the translation of these financial
instruments into the functional currency at 31 December 20X4?
Exchange rates: 30 September 20X4 $1: £1
31 December 20X4 $1.20: £1
Solution
Management should recognise the financial instruments on 31 December 20X4 as follows.
(a) Listed equity instruments of £12 million. The listed shares are measured at fair value on
31 December 20X4, of $14.4 million and translated using the spot rate at the date of valuation,

which is $1.20: £1. The gain of £2 million ($14.4m/1.2 – $10m/1.0) should be recorded as other
comprehensive income.
(b) Non-listed equity instruments of £10 million. As the shares are recorded at their cost of $10 million,
the foreign currency value should be translated to pounds sterling using the spot rate at the date of
the transaction, which was $1: £1.
Illustration: Translation of a branch into the functional currency

An entity based in the UK with the pound sterling as its functional currency operates a branch in
Portugal where the functional currency is the euro. As the branch is an extension of the entity, the
functional currency of the branch is also the pound sterling, but as a matter of convenience the branch
records a number of transactions in euros. Assume that the €:£ exchange rates have been as follows.
1 January 20X3 €2.50: £1
1 January 20X4 €2.40: £1
30 June 20X5 €2.10: £1
30 September 20X5 €2.00: £1
31 December 20X5 €2.20: £1
Details of the branch balances at 31 December 20X5 requiring translation and the basis for calculating
their sterling equivalents are as follows. The branch made all its sales on 30 September 20X5, and half of
these were outstanding as trade receivables at the year end. All purchases were made on 30 June 20X5,
and half of these are unpaid at 31 December 20X5.
Item Basis Balance Rate

Plant – acquired on 1 January 20X3 € £
Cost Historical rate 50,000 €2.50: £1 20,000
Accumulated depreciation Historical rate (30,000) €2.50: £1 (12,000)
20,000 8,000
Plant – acquired on 1 January 20X4
Cost Historical rate 30,000 €2.40: £1 12,500
Accumulated depreciation Historical rate (12,000) €2.40: £1 (5,000)
18,000 7,500
Trade receivables Closing rate 50,600 €2.20: £1 23,000
Trade payables Closing rate 25,200 €2.20: £1 11,455
Revenue Actual rate 101,200 €2.00: £1 50,600
Purchases Actual rate 50,400 €2.10: £1 24,000
Depreciation charge for year

1 January 20X3 plant Historical rate 10,000 €2.50: £1 4,000
1 January 20X4 plant Historical rate 6,000 €2.40: £1 2,500
Note that both the accumulated depreciation and the charge for the year are translated at the rate
ruling when the relevant plant was acquired. Revenue and purchases are translated at the rate ruling
when the transaction occurred, but the receivables and payables relating to them (which will have been
initially recognised at those rates) are monetary items which are retranslated at closing rate at the end of
the year.

4 Foreign currency translation of financial statements C
H
A
Section overview P
T
This section presents the rules for the translation of financial statements from the functional currency to E
the presentation currency. R
We have discussed in the previous section the requirements of IAS 21 for the translation of foreign
currency transactions. In this section we shall discuss the IAS 21 translation requirements when foreign 21
activities are undertaken through foreign operations whose financial statements are based on a different
functional currency than that of the parent company. More specifically in this section we shall discuss
the appropriate exchange rate that should be used for the translation of the financial statements of the
foreign operation into the reporting entity's presentation currency.
Although an entity is required to translate foreign currency items and transactions into its functional
currency, it does not have to present its financial statements in this currency. Instead, IAS 21 permits an
entity a completely free choice over the currency in which it presents its financial statements. Where the
chosen currency, the entity's presentation currency, is not the entity's functional currency, this fact
should be disclosed in the financial statements, along with an explanation of why a different
presentation currency has been applied.
The financial statements of a foreign operation operating in a hyperinflationary economy must be
adjusted under IAS 29 before they are translated into the parent's reporting currency and then
consolidated. When the economy ceases to be hyperinflationary, and the foreign operation ceases to
apply IAS 29, the amounts restated to the price level at the date the entity ceased to restate its financial
statements should be used as the historical costs for translation purposes.
4.1 Translation to the presentation currency when the functional currency is a

non-hyperinflationary currency
The approach adopted for the translation into a presentation currency is also used for the preparation of
consolidated financial statements where a parent has a foreign subsidiary. The process is set out below.
The following procedures should be followed to translate an entity's financial statements from its
functional currency into a presentation currency.
(a) Translate all assets and liabilities (both monetary and non-monetary) in the current statement of
financial position using the closing rate at the reporting date.
(b) Translate income and expenditure in the current statement of profit or loss and other
comprehensive income using the exchange rates ruling at the transaction dates. An approximation
to actual rate is normally used, being the average rate.
(c) Report the exchange differences which arise on translation as other comprehensive income; and
where a foreign subsidiary is not wholly owned, allocate the relevant portion of the exchange
differences to the non-controlling interest.
Note that the comparative figures are the presentation currency amounts as presented the previous year.
4.1.1 Translation of equity

No guidance is provided as to how amounts in equity should be translated. Using the closing rate would
be consistent with the approach to the translation of assets and liabilities. Translation at historical rates
may seem more appropriate, given the one-off, capital nature of such items such as share capital. As
IAS 21 is not explicit in this respect, either approach may be adopted, although an entity should follow a
consistent policy between periods.

4.2 Exchange differences
The exchange differences comprise:
(a) Differences arising from the translation of the statement of profit or loss and other comprehensive
income at exchange rates at the transaction dates or at average rates and the translation of assets
and liabilities at the closing rate.
(b) Differences arising on the opening net assets' retranslation at a closing rate that differs from the
previous closing rate.
Resulting exchange differences are reported as other comprehensive income and classified as a
separate component of equity, because such amounts have not resulted from exchange risks to which
the entity is exposed, but purely through changing the currency in which the financial statements are
presented. To report such exchange differences in profit or loss would distort the results from the
trading operations, as shown in the functional currency financial statements, since these differences are
unrelated to the foreign operation's trading performance or financial operation.
Worked example: Translation to presentation currency

XYZ, a UK-based company with sterling as its functional currency, has created a new subsidiary in the
US on 1 January 20X5 with a share capital of US$55,000 subscribed in cash. The amounts in its 20X5 US
dollar functional currency financial statements are shown below.
US$
Statement of profit or loss
Revenue 500,000
Costs (200,000)
Profit 300,000
There was no other comprehensive income.
Initial share capital 55,000
Retained earnings (as above) 300,000
Equity = net assets 355,000
The entity owns no non-current assets (so there are no assets or depreciation charges to be translated at
the rate ruling when the asset was acquired) and all transactions took place on 30 June (so that a single
rate can be used for the statement of profit or loss transactions, rather than the various rates ruling when
the transactions took place).
Assume that the following exchange rates are relevant.
1 January 20X5 £1 = US$2.75
30 June 20X5 £1 = US$2.50
31 December 20X5 £1 = US$2
The entity translates share capital at the rate ruling when the capital was raised.
Requirement
Translate the financial statements of the subsidiary into the pound sterling presentation currency.
Solution
The statement of profit or loss is translated using the actual rate on the transaction date.
US$ Rate £
Revenue 500,000 Actual 200,000
Costs (200,000) Actual (80,000)
Profit 300,000 120,000

Other comprehensive income:
C
Exchange gain on retranslation 37,500
H
Total comprehensive income 157,500 A
P
The net assets of the subsidiary are translated using the closing rate and the initial share capital using T
the opening rate. The statement of financial position is shown below. E
R
US$ Rate £
Initial share capital 55,000 Opening 20,000
Retained earnings (as above) 300,000 Actual 120,000 21
Exchange differences 37,500
Equity = net assets 355,000 Closing 177,500
The exchange gain arising on consolidation has two components:

(a) An exchange gain arising on retranslating the opening net assets from the opening rate to the
closing rate
Rate £
Opening net assets = initial share
capital (US$55,000) Closing 27,500
Opening 20,000
7,500
(b) A further exchange gain arising from retranslating profits from the actual to the closing rate.
Rate £
Retained earnings (US$300,000) Closing rate 150,000
Actual rate (120,000)
30,000
Total exchange differences 37,500
The inclusion of the exchange gain or loss makes the accounting equation balance since:
Closing net assets = Opening net assets + Profit (translated at the

(translated at closing (translated at opening actual rate + exchange
rate) rate + exchange difference)
difference)
The calculation of the exchange difference is discussed in more detail in section 5.3.
4.3 Translation when the functional currency is a hyperinflationary currency

Where an entity's functional currency is that of a hyperinflationary economy and it uses a presentation
currency which is different from its functional currency, all the functional currency amounts restated
under IAS 29 Financial Reporting in Hyperinflationary Economies should be translated at the closing rate at
the current reporting date. The one exception is that where the presentation currency used is that of a
non-hyperinflationary economy, the comparative amounts should be as they were presented in the
previous period. There is no IAS 29 adjustment for the effect of hyperinflation in the current period.
Interactive question 4: Translation of a foreign operation

A UK-based company, Petra Ltd, set up a foreign subsidiary, Hellenic Marble, in Greece on
30 June 20X6. Petra Ltd subscribed €24,000 for share capital when the exchange rate was €2 = £1. The
subsidiary borrowed €72,000 and bought a non-monetary asset for €96,000. Petra Ltd prepared its
accounts on 31 December 20X6 and by that time the exchange rate had moved to €3 = £1. No activity
was undertaken by the subsidiary during the period and it had no profits or losses.
Requirement
Account for the above transactions.

5 Foreign currency and consolidation
Section overview
This section deals with the issues arising from consolidating financial statements and, in particular, the
treatment of exchange differences and goodwill.
5.1 Translation of a foreign operation

A reporting entity with foreign operations needs to translate the financial statements of those operations
into its own reporting currency before consolidation or inclusion through the equity method. The
method of translation described in section 4 above should be applied to the financial statements of a
foreign operation. The treatment is summarised here.
(a) Statement of profit or loss and other comprehensive income: translate using actual rates. An
average for a period may be used, but not where there is significant fluctuation and the average is
therefore unreliable.
(b) Statement of financial position: translate all assets and liabilities (both monetary and non-
monetary) using closing rates.
(c) Exchange differences are reported as other comprehensive income.
5.2 Consolidation
The incorporation of the results and financial position of a foreign operation with those of the reporting
entity follows normal consolidation procedures, such as the elimination of intra-group balances and
intra-group transactions of a subsidiary. However, an intra-group monetary asset (or liability) whether
short term or long term cannot be eliminated against the corresponding intra-group liability (or asset)
without showing the results of currency fluctuations in the consolidated financial statements. This is
because a monetary item represents a commitment to convert one currency into another and exposes
the reporting entity to a gain or loss through currency fluctuations. Accordingly, in the consolidated
financial statements of the reporting entity, such an exchange difference:
 continues to be recognised in profit or loss; or
 is classified as equity until the disposal of the foreign operations, if it is a monetary asset forming
part of the net investment in a foreign operation.
Worked example: Consolidated financial statements

The abridged statements of financial position and profit or loss of Darius Co and its foreign subsidiary,
Xerxes Inc, appear below.
Draft statement of financial position as at 31 December 20X9
Darius Co Xerxes Inc
£ £ € €
Assets
Non-current assets
Plant at cost 600 500
Depreciation (250) (200)
350 300
Investment in Xerxes
100 shares @ £0.25 per share 25 –
375 300
Current assets
Inventories 225 200
Receivables 150 100
375 300
750 600

Equity C
Ordinary £1/€1 shares 300 100 H
Retained earnings 300 280 A
P
600 380
T
Long-term loans 50 110 E
Current liabilities 100 110 R
750 600
Statements of profit or loss for the year ended 31 December 20X9 21

Darius Co Xerxes Inc
£ €
Tax (100) (80)
Profit after tax, retained 100 80
The following further information is given.

(1) Darius Co has had its interest in Xerxes Inc since the incorporation of the company.
(2) Depreciation is 8% per annum on cost.
(3) The carrying amount of equity of Xerxes at 31 December 20X8 was €300.
(4) There have been no loan repayments or movements in non-current assets during the year. The
opening inventory of Xerxes Inc was €120. Assume that inventory turnover times are very short.
(5) Exchange rates: €4 to £1 when Xerxes Inc was incorporated
€2.50 to £1 when Xerxes Inc acquired its long-term assets
€2 to £1 on 31 December 20X8
€1.60 to £1 average rate of exchange year ending 31 December 20X9
€1 to £1 on 31 December 20X9
Requirements
(a) Prepare the summarised consolidated statement of profit or loss and statement of financial position
of Darius Co using the £ as the presentation currency.
(b) Calculate the exchange difference and prepare a separate consolidated statement of profit or loss
and other comprehensive income for the year.
Solution
Statement of profit or loss of Xerxes for the year ended 31 December 20X9 translated using the
average rate (€1.60 = £1)
£
Tax (50)
Profit after tax, retained 50
Consolidated statement of profit or loss for the year ended 31 December 20X9
£
Profit before tax £(200 + 100) 300
Tax £(100 + 50) (150)
Profit after tax, retained £(100 + 50) 150
The statement of financial position of Xerxes Inc at 31 December 20X9, other than share capital and
reserves, should be translated at the closing rate of €1 = £1.
Summarised statement of financial position of Xerxes in £ at 31 December 20X9
£ £
Non-current assets (carrying amount) 300
Current assets
Inventories 200
Receivables 100
300
600

Non-current liabilities 110
Current liabilities 110
 Equity = 600 – 110 – 110 = 380 380

600
Since Darius Co acquired the whole of the issued share capital on incorporation, the post-acquisition
reserves including exchange differences will be the value of shareholders' funds arrived at above, less the
original cost to Darius Co of £25 (ie, €100 at the historical exchange rate of £1: €4). Post-acquisition
increase in equity = £380 – £25 = £355.
Summarised consolidated statement of financial position as at 31 December 20X9
£ £
Assets
Non-current assets (NBV) £(350 + 300) 650
Current assets
Inventories £(225 + 200) 425
Receivables £(150 + 100) 250
675
1,325
Equity
Ordinary £1 shares (Darius only) 300
Retained earnings £(300 + 355) 655
955
Non-current liabilities: loans £(50 + 110) 160
Current liabilities £(100 + 110) 210
1,325
Note: It is quite unnecessary to know the amount of the exchange differences when preparing the
consolidated statement of financial position.
Calculation of exchange differences
£
Xerxes's equity interest at 31 December 20X9 380
Equity interest at 1 January 20X9 (€300/2) ((150)
230
Less retained profit (50)
Exchange gain 180
Consolidated statement of profit or loss and other comprehensive income for the year ended
31 December 20X9
£
Profit after tax 150
Exchange difference on translation of foreign operations 180
Note: The post-acquisition reserves of Xerxes Inc at the beginning of the year must have been £150 –
£25 = £125 and the post-acquisition reserves of Darius Co must have been £300 – £100 = £200.
The consolidated post-acquisition reserves must therefore have been £325.
5.3 Analysis of exchange differences

The exchange differences in the above exercise could be reconciled by splitting them into their
component parts.
The total exchange difference arises from the following:
 Translating income/expense items using an average rate, whereas assets/liabilities are translated
at the closing rate
 Translating the opening net investment (opening net assets) in the foreign entity at a closing rate
different from the closing rate at which it was previously reported

Using the opening statement of financial position and translating at opening rate of €2 = £1 and the
closing rate of €1 = £1 will produce the exchange differences as follows. C
Exchange H
€2 = £1 €1 = £1 difference A
£ £ £ P
T
Non-current assets at carrying amount 170 340 170
E
Inventories 60 120 60 R
Net current monetary liabilities (25) (50) (25)
205 410 205
Equity 150 300 150 21
Loans 55 110 55
205 410 205
Translating the statement of profit or loss using average rate €1.60 = £1 and the closing rate €1 = £1
gives the following results.
Exchange
•€1.60 = £1 •€1 = £1 difference
£ £ £
Profit before tax, depreciation and
increase in inventory values 75 120 45
Increase in inventory values 50 80 30
125 200 75
Depreciation (25) (40) (15)
100 160 60
Tax (50) (80) (30)
Profit after tax, retained 50 80 30
The overall position is then:

£
Gain on non-current assets (£170  depreciation £15) 155
Loss on loan (55)
Gain on inventories (£60 + £30) 90
Loss on net monetary current assets/
liabilities (all other differences) (£45  £30  £25) (10)
Net exchange gain: as above 180

This can be simplified as:
£ £
Opening net assets of €300 at opening rate (€2: £1) 150
at closing rate (€1: £1) 300
150 gain
Retained profits of €80 at average rate (€1.60: £1) 50
at closing rate (€1: £1) 80
30 gain
180 gain
This exchange difference is recorded as other comprehensive income.

(a) The group share is included within total comprehensive income attributable to the shareholders of
the parent company (and so included in the group reserves calculation).
(b) The non-controlling interest share is included within total comprehensive income attributable to
the non-controlling interest.
5.4 Goodwill and fair value adjustments

Goodwill arising under IFRS 3 Business Combinations from the acquisition of a foreign operation should
initially be calculated in the functional currency of the subsidiary and then be treated as an asset of the
foreign operation and translated at the closing rate each year. The exchange difference arising is
recorded as other comprehensive income in the consolidated accounts and accumulated in group equity.

The carrying amount of goodwill in the presentation currency is therefore as affected by changes in
exchange rates as any other non-current asset. This may result in goodwill being allocated to an entity
for the purpose of foreign currency translation at a different level from that used for impairment testing,
which should continue to be determined based on IAS 36.
Adjustments made to the fair values of assets and liabilities of a foreign operation under IFRS 3 should be
treated in the same way as goodwill. The adjustments are recognised in the carrying amounts of the
assets and liabilities of the foreign operation in its functional currency. The adjusted carrying amounts
are then translated at the closing rate.
Illustration: Goodwill adjustment

On 31 December 20X4, ABC acquired 80% of DEF for £10 million when the carrying amount of DEF's
identifiable net assets was €8 million. The carrying amounts were the same as fair value except for land
which is not subject to depreciation and had a fair value of €1 million higher than carrying amount. The
carrying amount in DEF's financial statements was not altered.
The €/£ exchange rate was €2.40/£ at 31 December 20X4, and €2.50/£ at 31 December 20X5. The non-
controlling interest is measured using the proportion of net assets method.
The goodwill arising on consolidation was: €'000
Non-controlling interest 20% × (€8m + €1m) 1,800
25,800
Net assets of acquiree (€8m + €1m) (9,000)
Goodwill 16,800
The goodwill arising on acquisition is therefore €16.8m/2.4 = £7m. The fair value adjustment in sterling
amounted to €1m/2.4 = £416,667.
At 31 December 20X5, the goodwill is restated to £6.72 million (€16.8m/2.5) and the fair value
adjustment in sterling terms was £400,000 (€1m/2.5).
The requirement in an entity's own financial statements to recognise in profit or loss all exchange
differences in respect of monetary items which are part of an entity's net investment in a foreign
operation was dealt with earlier.
On consolidation, however, the differences should be recognised as other comprehensive income and
recorded in a separate component of equity. This treatment is required because exchange differences
arising from the translation of the operations' net assets will move in the opposite way. If there is an
exchange loss on the net investment, there will be an exchange gain on the net assets, and vice versa.
The two movements should be netted off, rather than one being recognised in profit or loss and the
other as other comprehensive income.
5.5 Net investment in foreign operation

When a monetary item is part of the net investment in a foreign operation (ie, there is an intra-group
loan outstanding) then the following rules apply on consolidation.
(a) If the monetary item is denominated in the functional currency of the parent entity, the exchange
difference will be recognised in the profit or loss of the foreign subsidiary.
(b) If the monetary item is denominated in the functional currency of the subsidiary, exchange
differences will be recognised in the profit or loss of the parent entity.
(c) When the monetary item is denominated in the functional currency of either entity, on
consolidation, the exchange difference will be removed from the consolidated profit or loss and it
will be recognised as other comprehensive income and recorded in equity in the combined
(d) If, however, the monetary item is denominated in a third currency which is different from either
entity's functional currency, then the translation difference should be recognised as part of profit or
loss. For example, the parent may have a functional currency of US dollars, the foreign operation a
functional currency of euros, and the loan made by the foreign operation may have been

denominated in UK sterling. In this scenario, the exchange difference results in a cash flow
difference and should be recognised as part of the results of the group. C
H
(e) A separate foreign currency reserve reported as part of equity may have a positive or negative A
carrying amount at the reporting date. Negative reserves are permitted under IFRSs. P
(f) If the foreign operation is subsequently disposed of, the cumulative exchange differences previously T
E
reported as other comprehensive income and recognised in equity should be reclassified and so
R
included in the profit or loss on disposal recognised in the statement of profit or loss.
Illustration: Exchange changes 21
Some years ago ABC, whose functional currency is pounds sterling, made a long-term loan of £100,000 to
its wholly owned subsidiary, DEF, whose functional currency is the euro. At 31 December 20X4, the
exchange rate was £1 = €3, and at 31 December 20X5 was £1 = €2.50.
At 31 December 20X4, €300,000 (£100,000 × 3) was a payable in DEF's financial statements. ABC carried
the receivable at £100,000, so on consolidation the two amounts cancelled out.
At 31 December 20X5, only €250,000 (£100,000 × 2.5) was a payable in DEF's financial statements, so in
20X5 DEF made an exchange gain of €50,000 in its own financial statements. On consolidation DEF's
payable still cancels out against ABC's £100,000 receivable.
However, on consolidation, the sterling equivalent of DEF's exchange gain (€50,000/2.5 = £20,000) is
eliminated from consolidated profit or loss and shown as part of total exchange differences reported as
5.6 Consolidation when subsidiaries have different reporting dates

Where the reporting date of entities included in the consolidated financial statements of the group are
different, and in accordance with IFRS 10 an earlier set of financial statements is used for consolidation
purposes, there is an issue as to which exchange rate should be used; the one at the date of the earlier
set of financial statements, or the one at the reporting date of the consolidated financial statements.
Under IAS 21, for all subsidiaries, associates and joint ventures which are consolidated or equity
accounted, the relevant exchange rate is that ruling at the date to which the foreign operation's financial
statements were prepared. This reflects the fact that the foreign operation's results are prepared to its
reporting date and exchange differences should be calculated in a consistent way. However, IAS 21 goes
on to state that, where the exchange rate has significantly changed in the period between the foreign
operation's year end and that of the group, an adjustment should be made. This is consistent with the
approach in IFRS 10 for significant events that have happened in this intervening period. The same
approach is used in applying the equity method to associates and joint ventures in accordance with
IAS 28 Investments in Associates and Joint Ventures.
5.7 Intra-group trading transactions

Where normal trading transactions take place between group companies located in different countries,
the transactions give rise to monetary assets or liabilities that may either have been settled during the
year or remain unsettled at the reporting date.
Illustration: Intra-group trading

A UK parent company has a wholly owned subsidiary in the US. During the year ended 31 December
20X5, the US company purchased plant and raw materials to be used in its manufacturing process from
the UK parent. Details of transactions are as follows.
$/£
Purchase plant costing £500,000 on 30 April 20X5 1.48
Paid for plant on 30 September 20X5 1.54
Purchased raw materials costing £300,000 on 31 October 20X5 1.56
Balance of £300,000 outstanding at 31 December 20X5 1.52
Average rate for the year 1.55

The following exchange gains/losses will be recorded in the US subsidiary's profit or loss for the year
$ $
Plant costing £500,000 @ 1.48 740,000
Paid £500,000 @ 1.54 770,000
Exchange loss – settled transaction (30,000)
Raw materials costing £300,000 @ 1.56 468,000

Outstanding £300,000 @ 1.52 456,000
Exchange gains – unsettled transaction 12,000
Net exchange loss recorded in profit or loss (18,000)
5.8 Intercompany dividends

Dividends paid in a foreign currency during a period by a subsidiary to its parent may lead to exchange
differences being reported in the parent's financial statements. This will be the case where the dividend is
recognised at the transaction date, being the date on which the parent recognises the receivable, but
receipt is not until a later date and exchange rates have moved during this period. As with other intra-
group exchange differences, these amounts should not be eliminated on consolidation.
5.9 Disposal of a foreign operation

On the disposal of a foreign operation, the cumulative amount of exchange differences, which has been
reported as other comprehensive income and is accumulated in a separate component of equity relating
to the foreign operation, shall be recognised in profit or loss, along with gain or loss on disposal when it
is recognised.
Disposal may occur either through sale, liquidation, repayment of share capital or abandonment of all, or
part of, the entity. The payment of the dividend is part of a disposal only if it constitutes a return of the
investment; for example, when the dividend is paid out of pre-acquisition profits. In the case of a partial
disposal, only the proportionate share of the related accumulated exchange difference is included in the
gain or loss. A write-down of the carrying amount of a foreign operation does not constitute a partial
disposal. Accordingly, no part of the deferred foreign exchange gain or loss is recognised in profit or loss at
the time of a write-down.
5.10 Tax effects of exchange differences

When there are tax effects arising from gains or losses on foreign currency transactions and exchange
differences arising on the translation of the financial statements of foreign operations IAS 12 Income
Taxes should be applied.
6 Disclosure
Section overview
This section presents the relevant disclosure requirements.
The disclosure requirements of IAS 21 are not particularly onerous and, assuming that an entity's
functional currency has not changed during the period, and its financial statements are presented in its
functional currency, it is only required to disclose the following:
 The amount of exchange differences reported in profit or loss for the period. This amount should
exclude amounts arising on financial instruments measured at fair value through profit or loss
under IAS 39.
 The net exchange differences reported in other comprehensive income. This disclosure should
include a reconciliation between the opening and closing amounts.
In addition, when the presentation currency is different from the functional currency, that fact should
be stated and the functional currency should be disclosed. The reason for using a different presentation
currency should also be disclosed.

Where there is a change in the functional currency of either the reporting entity or a significant
foreign operation, that fact and the reason for the change in functional currency should be disclosed. C
H
An entity may present its financial statements or other financial information in a currency that is A
different from either its functional currency or its presentation currency. For example, it may convert P
selected items only, or it may use a translation method that does not comply with IFRSs in order to deal T
with hyperinflation. In this situation the entity must: E
R
 clearly identify the information as supplementary information to distinguish it from information
that complies with IFRSs;
 disclose the currency in which the supplementary information is displayed; and 21
 disclose the entity's functional currency and the method of translation used to determine the
supplementary information.
For publicity or other purposes, an entity may wish to display its financial statements using a currency
which is neither its functional nor its presentation currency; such information is not presented in
accordance with IFRSs, so IAS 21 requires that it should be clearly identified as being supplementary.
7 Other matters
Section overview
This section discusses a number of other matters, such as non-controlling interests and taxation.
7.1 Non-controlling interests

(a) The figure for non-controlling interests in the statement of financial position will be the
appropriate proportion of the translated share capital and reserves of the subsidiary plus, where the
NCI is valued at fair value, its share of goodwill translated at the closing rate. In addition, it is
necessary to show any dividend declared but not yet paid to the NCI at the reporting date as a
liability. The dividend payable should be translated at the closing rate for this purpose.
(b) The non-controlling interest in profit or loss will be the appropriate proportion of profits
available for distribution. If the functional currency of the subsidiary is the same as that of the
parent, this profit will be arrived at after charging or crediting the exchange differences.
(c) The non-controlling interest in total comprehensive income includes the NCI proportion of the
exchange gain or loss on translation of the subsidiary financial statements. However, it does not
include any of the exchange gain or loss arising on the retranslation of goodwill.
Worked example: Consolidated financial statements

Extracts from the summarised accounts of Camrumite Inc are shown below.
Statement of financial position as at 31 December 20X3
€
Net monetary assets 5,000
15,000
Equity
Ordinary share capital and reserves 15,000
Statement of profit or loss for the year ended 31 December 20X3

€
Statement of changes in equity for the year ended 31 December 20X3

€
Dividend payable 1,680
Retained profit for the year 1,400

60% of the issued capital of Camrumite Inc is owned by Bates Co, a company based in the UK.
There have been no movements in long-term assets during the year.
The exchange rate has moved as follows.
1 January 20X3 €5 = £1
Average for the year ended 31.12.X3 €7 = £1
31 December 20X3 €8 = £1
You are required to calculate the figures for the non-controlling interest to be included in the
consolidated accounts of Bates Co.
The non-controlling interest is measured using the proportion of net assets method.
Solution
Translating the shareholders' funds using the closing rate as at 31 December 20X3 gives €15,000  8 =
£1,875. The non-controlling interest in the statement of financial position will be 40%  £1,875 = £750.
The dividend payable translated at the closing rate is €1,680  8 = £210. The amount payable to the
non-controlling shareholders is 40%  £210 = £84.
The profit after tax translated at the average rate is €3,080  7 = £440. The non-controlling interest in
profit is therefore 40%  £440 = £176.
The non-controlling share of the exchange difference is calculated as:
Opening net assets £ £
€15,000 – €1,400 = €13,600 At opening rate of €5: £1 2,720
At closing rate of €8: £1 1,700 1,020
Profits of €3,080 At average rate of €7: £1 440

At closing rate of €8: £1 385 55
Loss on retranslation of Camrumite's accounts 1,075
NCI share of loss £1,075 × 40% 430
Therefore the non-controlling interest in total comprehensive income is profit of £176 less exchange
losses of £430 = £254 loss
The non-controlling interest can be summarised as follows.
£
Balance at 1 January 20X3 (£2,720 × 40%) 1,088
Non-controlling interest in profit for the year 176
Non-controlling interest in exchange losses (430)
834
Balance at 31 December 20X3 750
Dividend payable to non-controlling interest 84
834
7.2 Tax effects

The tax effects of gains and losses on foreign currency translations are addressed by IAS 12 and covered
in Chapter 22.
7.3 First time adoption

IFRS 1 First Time Adoption of International Financial Reporting Standards includes an exemption that allows
the cumulative translation difference on the retranslation of subsidiaries' net assets to be set to zero for
all subsidiaries at the date of transition to IFRS.
This means that it does not have to be separately disclosed and recycled in profit or loss when the
subsidiaries are disposed of.

However, translation differences arising from the date of transition would have to be separately
disclosed as other comprehensive income, included in a separate component of equity and reclassified C
to profit or loss on the investment's disposal. H
A
In addition, the requirement to retranslate goodwill and fair value adjustments does not have to be P
applied retrospectively to business combinations before transition to IFRS. T
E
R
8 Reporting foreign currency cash flows

21
Section overview
This section addresses the treatment of foreign currency cash flows in the statement of cash flows.
Transactions in foreign currency

(a) Where an entity enters into foreign currency transactions which result in an inflow or outflow of
cash, the entity should translate cash flows into its functional currency at the transaction date.
(b) Although transactions should be translated at the date on which they occurred, for practical
reasons IAS 21 permits the use of an average rate where it approximates to actual.
Foreign subsidiaries
A similar approach is required where an entity has a foreign subsidiary. The transactions of the subsidiary
should be translated into the reporting entity's functional currency at the transaction date.
Reporting translation differences
Although the translation of foreign currency amounts does not affect the cash flow of an entity,
translation differences relating to cash and cash equivalents are part of the changes in cash and cash
equivalents during a period. Such amounts should therefore form part of the statement of cash flows.
IAS 7 requires the effect of foreign currency to be reported separately from operating, investing and
financing activities. No specific location for the disclosure is provided; disclosure at the base of the
statement of cash flows would seem an appropriate presentation.
Where an entity adopts the indirect method of calculating cash flows from operating activities and it has
foreign currency amounts which have been settled during the period, no further adjustment is required
at the period end. This is because any foreign exchange difference will already include the amount of
the original foreign currency transaction and the actual settlement figure. An overseas purchase will be
recorded using the purchase date exchange rate and a payable will be recorded. On settlement, any
adjustment to the actual cash flow paid will be recognised in profit or loss as part of the entity's
operating activities.
Unsettled foreign currency amounts in relation to operating activities, such as trade receivables and
payables, are not adjusted at the period end because such amounts are retranslated at the reporting
date and the exchange difference is reported in profit or loss already. Where an entity uses the indirect
method for calculating its operating cash flows, it starts with the profit figure which will include the
retranslation difference, and the movement in the period for receivables and payables will also include a
similar amount. Since the two amounts effectively eliminate each other, no adjustment is required.
Further disclosures
It is important to note that the standard requires disclosure of significant cash and near-cash balances
that the entity holds but which are not available to the group as, for example, under a situation in
which exchange controls prohibit the conversion of cash transactions or balances.
Worked example: Foreign currency cash flows

On 15 November, an entity imported some plant and equipment costing $400,000 from an overseas
supplier, with $250,000 being paid on 31 December 20X5 and $150,000 being paid on
31 January 20X6.

The $/£ spot exchange rates were as follows.
$/£
15 November 20X5 2.0:1
31 December 20X5 1.9:1
31 January 20X6 1.8:1
Requirement
How should these transactions be reported within the statement of cash flows?
Solution
The purchase will initially be recorded at the rate ruling at the transaction date:
$400,000 / 2.0 = £200,000, with a trade payable of the same amount also being recognised.
At 31 December 20X5, the cash outflow will be recorded at the rate ruling at the transaction date:
$250,000 / 1.9 = £131,579
and the remaining trade payable, being a monetary liability, is translated at the same rate:
$150,000 / 1.9 = £78,947
The plant and equipment, a non-monetary asset, is carried at the historical rate of £200,000.
Only cash flows appear in the statement of cash flows, so £131,579 will be shown within investing
activities.
9 Reporting in hyperinflationary economies
Section overview
 IAS 29 requires financial statements of entities operating within a hyperinflationary economy to be
restated in terms of measuring units current at the reporting date.
 Financial statements should be restated based on a measuring unit current at the reporting
date:
– Monetary assets/liabilities do not need to be restated.
– Non-monetary assets/liabilities must be restated by applying a general prices index.
– Items of income/expense must be restated.
– Gain/loss on net monetary items must be reported in profit or loss.
In a hyperinflationary economy, money loses its purchasing power very quickly. Comparisons of
transactions at different points in time, even within the same accounting period, are misleading. It is
therefore considered inappropriate for entities to prepare financial statements without making
adjustments for the fall in the purchasing power of money over time.
IAS 29 Financial Reporting in Hyperinflationary Economies applies to the primary financial statements of
entities (including consolidated accounts and statements of cash flows) whose functional currency is the
currency of a hyperinflationary economy. In this section, we will identify the hyperinflationary currency
as $H.
The standard does not define a hyperinflationary economy in exact terms, although it indicates the
characteristics of such an economy; for example, where the cumulative inflation rate over three years
approaches or exceeds 100%.
Worked example: Indicators of hyperinflation

What other factors might indicate a hyperinflationary economy?

Solution
C
These are examples, but the list is not exhaustive. H
A
(a) The population prefers to retain its wealth in non-monetary assets or in a relatively stable foreign P
T
currency. Amounts of local currency held are immediately invested to maintain purchasing power. E
R
(b) The population regards monetary amounts not in terms of the local currency but in terms of a
relatively stable foreign currency. Prices may be quoted in that currency.
21
(c) Sales/purchases on credit take place at prices that compensate for the expected loss of purchasing
power during the credit period, even if that period is short.
(d) Interest rates, wages and prices are linked to a price index.
The reported value of non-monetary assets, in terms of current measuring units, increases over time.
For example, if a non-current asset is purchased for $H1,000 when the price index is 100, and the price
index subsequently rises to 200, the value of the asset in terms of current measuring units (ignoring
accumulated depreciation) will rise to $H2,000.
In contrast, the value of monetary assets and liabilities, such as a debt for $H300 units, is unaffected
by changes in the prices index, because it is an actual money amount payable or receivable. If a
customer owes $H300 when the price index is 100, and the debt is still unpaid when the price index
has risen to 150, the customer still owes just $H300. However, the purchasing power of monetary assets
will decline over time as the general level of prices goes up.
9.1 Requirement to restate financial statements in terms of measuring units

current at the reporting date
In most countries, financial statements are produced on the basis of either of the following:
 Historical cost, except to the extent that some assets (eg, property and investments) may be
revalued
 Current cost, which reflects the changes in the values of specific assets held by the entity
In a hyperinflationary economy, neither of these methods of financial reporting are meaningful unless
adjustments are made for the fall in the purchasing power of money. IAS 29 therefore requires that the
primary financial statements of entities in a hyperinflationary economy should be produced by
restating the figures prepared on either a historical cost basis or a current cost basis in terms of
measuring units current at the reporting date.
Definition
Measuring units current at the reporting date: This is a unit of local currency with a purchasing
power as at the reporting date, in terms of a general prices index.
Financial statements that are not restated (ie, that are prepared on a historical cost basis or current cost
basis without adjustments) may be presented as additional statements by the entity, but this is
discouraged. The primary financial statements are those that have been restated.
After the assets, liabilities, equity and statement of profit or loss and other comprehensive income of the
entity have been restated, there will be a net gain or loss on monetary assets and liabilities (the 'net
monetary position') and this should be recognised separately in profit or loss for the period.
9.2 Making the adjustments

IAS 29 recognises that the resulting financial statements, after restating all items in terms of measuring
units current at the reporting date, will lack precise accuracy. However, it is more important that
certain procedures and judgements should be applied consistently from year to year.

9.3 Statement of financial position: historical cost
Where the entity produces its accounts on a historical cost basis, the following procedures should be applied.
(a) Items that are not already expressed in terms of measuring units current at the reporting date
should be restated, using a general prices index, so that they are valued in measuring units
current at the reporting date.
(b) Monetary assets and liabilities are not restated, because they are already expressed in terms of
measuring units current at the reporting date.
(c) Assets that are already stated at market value or net realisable value need not be restated,
because they too are already valued in measuring units current at the reporting date.
(d) Any assets or liabilities linked by agreement to changes in the general level of prices, such as
indexed-linked loans or bonds, should be adjusted in accordance with the terms of the agreement
to establish the amount outstanding as at the reporting date.
(e) All other non-monetary assets, ie, tangible long-term assets, intangible long-term assets
(including accumulated depreciation/amortisation), investments and inventories, should be
restated in terms of measuring units as at the reporting date, by applying a general prices index.
The method of restating these assets should normally be to multiply the original cost of the assets by a
factor: (prices index at reporting date/prices index at date of acquisition of the asset). For example, if an
item of machinery was purchased for $H2,000 when the prices index was 400 and the prices index at
the reporting date is 1,000, the restated value of the long-term asset (before accumulated depreciation)
would be:
$H2,000  [1,000/400] = $H5,000
If, in the above example, the non-current asset has been held for half its useful life and has no residual
value, the accumulated depreciation would be restated as $H2,500. (The depreciation charge for the
year should be the amount of depreciation based on historical cost, multiplied by the same factor as
above: 1,000/400).
If an asset has been revalued since it was originally purchased (eg, a property), it should be restated in
measuring units at the reporting date by applying a factor: (prices index at reporting date/prices index
at revaluation date) to the revalued amount of the asset.
If the restated amount of a non-monetary asset exceeds its recoverable amount (ie, its net realisable
value or market value), its value should be reduced accordingly.
The owners' equity (all components) as at the start of the accounting period should be restated using a
general prices index from the beginning of the period.
9.4 Statement of profit or loss and other comprehensive income: historical

cost
In the statement of profit or loss and other comprehensive income, all amounts of income and expense
should be restated in terms of measuring units current at the reporting date. All amounts therefore
need to be restated by a factor that allows for the change in the prices index since the item of income
or expense was first recorded.
9.5 Gain or loss on net monetary position

In a period of inflation, an entity that holds monetary assets (cash, receivables) will suffer a fall in the
purchasing power of these assets. By the same token, in a period of inflation, the value of monetary
liabilities, such as a bank overdraft or bank loan, declines in terms of current purchasing power.
(a) If an entity has an excess of monetary assets over monetary liabilities, it will suffer a loss over
time on its net monetary position, in a period of inflation, in terms of measuring units as at 'today's
date'.
(b) If an entity has an excess of monetary liabilities over monetary assets, it will make a gain on its
net monetary position, in a period of inflation.

10 Audit focus C
H
Section overview A
P
This section provides an overview of the particular issues associated with auditing overseas subsidiaries. T
The audit of group accounts in general is covered in Chapter 20. E
R
The inclusion of one or more foreign subsidiaries within a group introduces additional risks, including
the following: 21
 Non-compliance with the accounting requirements of IAS 21
 Potential misstatement due to the effects of high inflation
 Possible difficulty in the parent being able to exercise control, for example due to political
instability
 Currency restrictions limiting payment of profits to the parent
 There may be threats to going concern due to economic and/or political instability
 Non-compliance with local taxes or misstatement of local tax liabilities
Audit procedures
These would include the following:
 Check that the balances of the subsidiary have been appropriately translated to the group
reporting currency:
– Assets and liabilities at the closing rate at the end of the reporting period.
– Income and expenditure at the rate ruling at the transaction date. An average would be a
suitable alternative provided there have been no significant fluctuations.
 Confirm consistency of treatment of the translation of equity (closing rate or historical rate).
 Check that the consolidation process has been performed correctly eg, elimination of intra-group
balances.
 Check the basis of the calculation of the non-controlling interest.
 Confirm that goodwill has been translated at the closing rate.
 Check the disclosure of exchange differences as a separate component of equity.
 Assess whether disclosure requirements of IAS 21 have been satisfied.
 If the foreign operation is operating in a hyperinflationary economy confirm that the financial
statements have been adjusted under IAS 29 Financial Reporting in Hyperinflationary Economies
before they are translated and consolidated.
 Involve a specialist tax audit team to review the calculation of tax balances against submitted and
draft tax returns.
Interactive question 5: Overseas subsidiary

Saturn plc trades in the UK preparing accounts to 31 March annually. Several years ago Saturn plc
acquired 80% of the issued ordinary share capital of Venus Inc which trades in Zorgistan. This country is
experiencing hyperinflation and severe political instability as a result. The local currency is the zorg but
Venus Inc has determined that its functional currency is the US$. The presentation currency of the group
is £. Venus Inc is audited by a reputable local firm of auditors.
Requirement
Identify the issues the auditor would need to consider in respect of the audit of the Saturn group

Summary
IAS 21 The Effects of Changes in Foreign Exchange Rates
Entity financial Group financial

statements statements
Determine functional Goodwill and fair value

currency adjustments on acquisition
of foreign subsidiary are
• Primary indicators
• Expressed in functional
• Secondary indicators currency of subsidiary
• Translated at closing rate
Statement of Statement of profit or loss and Statement of

financial position other comprehensive income cash flows
Initial recognition Exchange differences on Foreign currency cash flows
• Use spot exchange rate • Monetary items in profit • Record in entity's functional
between functional and or loss unless net investment currency by applying exchange
foreign currency on date of in foreign currency rate between functional and
the transaction foreign currency at date of
• Non-monetary items in cash flows
other comprehensive income
Subsequent reporting or profit according to • Cash flows of foreign subsidiary
dates where gain in loss recognised translated at the exchange rates
between functional and foreign
• Monetary items at • Net investment in foreign currency at the dates of the
closing rate entity initially in other cash flows
• Non-monetary items at and income statement on
historical cost at rate disposal
of transaction
• Non-monetary items at
fair value at exchange
rate when fair value
determined
IAS 29 Financial Reporting in Hyperinflationary Economies
Economies ceasing to Selection and use of

Historical cost financial
be hyperinflationary the general price index
statements
• Statements of financial
position
• Statement of profit or
loss and other
• Gain or loss on net
monetary position

Self-test
C
Answer the following questions. H
A
1 What is the difference between conversion and translation of foreign currency amounts? P
T
2 Define 'monetary' items according to IAS 21. E
R
3 How should foreign currency transactions be recognised initially in an individual entity's accounts?
4 What factors must management take into account when determining the functional currency of a
foreign operation? 21
5 How should goodwill and fair value adjustments be treated on consolidation of a foreign
operation?
6 When can an entity's functional currency be changed?
7 Zephyria
The Zephyria Company acquired a foreign subsidiary on 15 August 20X6. Goodwill arising on the
acquisition was N$175,000.
Consolidated financial statements are prepared at the year end of 30 September 20X6 requiring
the translation of all foreign operations' results into the presentation currency of pounds sterling.
The following rates of exchange have been identified:
Historical rate at the date of acquisition N$1.321:£
Closing rate at the reporting date N$1.298:£
Average rate for Zephyria's complete financial year N$1.302:£
Average rate for the period since acquisition N$1.292:£
Requirement
In complying with IAS 21 The Effects of Changes in Foreign Exchange Rates, at what amount should
the goodwill be included in the consolidated financial statements?
8 Cacomistle
The Cacomistle Company operates in the mining industry. It acquired an overseas mining
subsidiary, The Vanbuyten Company, on 10 September 20X7. The functional currency of
Vanbuyten is the N$.
An initial review of the assets of Vanbuyten immediately after the acquisition found that it was
necessary to make a downward fair value adjustment to the carrying amount of one of its mines
amounting to N$225,000, due to adverse geological conditions. The mine had been acquired by
Vanbuyten on 4 October 20X3.
Cacomistle's consolidated financial statements were prepared to 31 December 20X7 and required
translation into the presentation currency which was pounds sterling.
Exchange rates were as follows:
4 October 20X3 N$1.292: £1
10 September 20X7 N$1.321: £1
31 December 20X7 N$1.298: £1
Average rate for 20X7 N$1.302: £1
Requirement
At what amount should the fair value adjustment be recognised in Cacomistle's consolidated
financial statements for the year ending 31 December 20X7 according to IAS 21 The Effects of
Changes in Foreign Exchange Rates?

9 Longspur
The Longspur Company is an aircraft manufacturer and its functional currency is pounds sterling.
Longspur ordered an item of plant from an overseas supplier at an agreed invoiced cost of
N$250,000 on 31 March 20X7.
The equipment was delivered and was available for use on 30 April 20X7. It has a 10-year life span
and no residual value.
31 March 20X7 £1: N$2.10
30 April 20X7 £1: N$2.07
31 December 20X7 £1: N$1.90
Average rate for 20X7 £1: N$2.05
Requirement
At what amount should depreciation on the equipment be recognised in Longspur's financial
statements for the year ending 31 December 20X7 under IAS 21 The Effects of Changes in Foreign
Exchange Rates?
10 Orton
The Orton Company is a retailer of artworks and sculptures. Orton has a year end of
31 December 20X7 and uses pounds sterling as its functional currency. On 28 October 20X7,
Orton purchased 10 paintings from a supplier for N$920,000 each, a total of N$9,200,000.
28 October 20X7 £1: N$1.80
19 December 20X7 £1: N$1.90
31 December 20X7 £1: N$2.00
8 February 20X8 £1: N$2.40
Orton sold seven of the paintings for cash on 19 December 20X7 with the remaining three
paintings being sold on 8 February 20X8. All 10 of the paintings were paid for by Orton on
8 February 20X8.
Requirement
What exchange gain arises from the transaction relating to the paintings in Orton's financial
statements for the year ended 31 December 20X7 according to IAS 21 The Effects of Changes in
Foreign Exchange Rates?
11 Alder
On 1 January 20X7 The Alder Company made a loan of £9 million to one of its foreign subsidiaries,
The Culpeo Company. The loan in substance is a part of Alder's net investment in that foreign
operation. The functional currency of Culpeo is the R$.
Alder's consolidated financial statements were prepared to 31 December 20X7 and the
presentation currency is pounds sterling.
1 January 20X7 R$2.00: £1
31 December 20X7 R$1.80: £1
Requirement
How would the exchange gain or loss on the intra-group loan be recognised in the consolidated
financial statements of Alder for the year ending 31 December 20X7 according to IAS 21 The Effects
of Changes in Foreign Exchange Rates?
12 Porcupine
The Porcupine Company has a wholly owned foreign subsidiary, The Jacktree Company, with net
assets at 1 January 20X7 of N$300 million. Jacktree made a profit for the year ending
31 December 20X7 of N$150 million. The functional currency of Jacktree is the N$.
Porcupine's consolidated financial statements were prepared to 31 December 20X7 and the
presentation currency is pounds sterling.

C
1 January 20X7 N$2.00: £1 H
31 December 20X7 N$3.00: £1 A
Average rate for 20X7 N$2.50: £1 P
T
Requirement E
R
How would the exchange gain or loss on the investment in Jacktree be recognised in the
consolidated financial statements of Porcupine for the year ending 31 December 20X7 according
to IAS 21 The Effects of Changes in Foreign Exchange Rates?
21
13 Soapstone
On 31 December 20X6 The Soapstone Company acquired 60% of the ordinary shares in The Frew
Company for £700. Soapstone's functional currency is pounds sterling, while Frew's is the R$.
The summarised financial statements of Frew and the £:R$ exchange rates are as follows.
31 December 20X6 31 December 20X7
Identifiable assets less liabilities (= equity) R$500 R$730
Exchange rate £2.00: R$1 £3.00: R$1
The carrying amount of Frew's assets and liabilities are the same as their fair values and there has
been no impairment of goodwill.
The average exchange rate during 20X7 was £2.50: R$1. There was no change in Frew's share
capital during the year and it paid no dividends.
Requirement
Determine the following amounts that will appear in Soapstone's consolidated financial statements
for the year ended 31 December 20X7 in accordance with IAS 21 The Effects of Changes in Foreign
Exchange Rates.
(a) The carrying amount at 31 December 20X7 of the goodwill acquired in the business
combination, assuming that the non-controlling interest is valued as a proportion of the net
assets of the entity
(b) Soapstone's share of Frew's profit for the period
(c) The total foreign exchange gain reported as other comprehensive income in 20X7
14 Jupiter
Jupiter plc trades in the UK preparing accounts to 31 March annually.
On 31 December 20X6 Jupiter plc acquired 90% of the issued ordinary capital of Mars Inc which
trades in Intergalatica where the currency is the Gal. At 31 March 20X7 the following statements of
financial position were prepared.
Jupiter plc Mars Inc
£'000 Gal'000
Financial asset investments 85,000 –
Net current assets 212,800 145,500
446,300 342,900
Capital – ordinary £1/1 Gal 300,000 150,000
Retained earnings – at 31 March 20X7 53,300 132,900
353,300 282,900
Long-term loans 93,000 60,000
446,300 342,900
Relevant data is as follows.
(a) The profit of both companies accrues reasonably evenly throughout the year. Jupiter plc and
Mars Inc had retained earnings of £18.9 million and 24.9 million Gal respectively for the year
ended 31 March 20X7.
(b) The parent company's long-term loans include an amount borrowed from a Swiss bank (to
build a new factory). 50.4 million Swiss francs were borrowed on 1 July 20X5 when the

exchange rate was 2.1 francs = £1. The rate at 31 March 20X7 was 2.3 francs = £1. The loan
is recorded at the historical amount received in the statement of financial position.
(c) When finalising the purchase price of Mars Inc it was agreed that non-current assets were
already at fair value but that receivables required a write-down of 50,000,000 Gals. This has
not been adjusted in the books of the subsidiary. These receivables were still outstanding at
31 March 20X7.
(d) The non-current assets of Mars were acquired as follows:
Gal'000
5 May 20X5 100,400
1 February 20X7 97,000
(e) Rates of exchange were as follows:
Gal = £1
5 May 20X5 6.0
31 December 20X6 5.4
1 February 20X7 4.7
31 March 20X7 4.2
Average for the three months to 31 March 20X7 4.8
(f) The company has determined that goodwill at the year end has been impaired by 10% of its
value in Gals. The impairment event arose on 31 March 20X7.
(g) Jupiter measures the non-controlling interest using the proportion of net assets method.
Requirement
Prepare the consolidated statement of financial position of Jupiter group as at 31 March 20X7 in
accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates.
Foreign currency cash flows
15 Cardamom
The Cardamom Company operates in the heavy engineering sector and has the pound sterling as
its functional currency.
On 30 September 20X7 Cardamom imported a crane from an overseas supplier, The Venilia
Company. The total cost of the crane was R$3,000,000. Under the terms of the contract
Cardamom was to pay Venilia R$2,000,000 on 31 October 20X7 and R$1,000,000 on
31 March 20X8. Cardamom does not hedge its foreign currency cash flows.
The R$/£ spot exchange rates were as follows.
R$/£
30 September 20X7 3.0: 1
31 October 20X7 2.5: 1
31 December 20X7 2.2: 1
31 March 20X8 2.0: 1
Requirement
What should be the cash outflow in the statement of cash flows of Cardamom for the year ending
31 December 20X7 under Investing Activities in respect of the purchases of the crane, in
accordance with IAS 7 Statement of Cash Flows?
16 Rostock
The Rostock Company operates in Sidonia and its functional currency is the N$. The Sidonian
economy has deteriorated to such an extent that it became necessary for Rostock to apply IAS 29
Financial Reporting in Hyperinflationary Economies, with effect from 1 January 20X7. At that date
Rostock's statement of financial position was summarised as follows.
N$ N$
Property, plant and equipment 27,600 Share capital 8,000
Trade receivables 10,800 Revaluation reserve 7,000
Cash 1,300 Retained earnings 11,300
Trade payables (13,400)
26,300 26,300

The share capital was issued on the date the company was formed, 1 January 20X5. The property,
plant and equipment was acquired on the same date and revalued on 30 September 20X5. The C
trade payables were acquired on 30 September 20X6 and the trade receivables on 31 December H
A
20X6.
P
The general price index of Sidonia has been as follows. T
20X5 20X6 20X7 E
R
1 January 500 700 900
30 September 600 800
31 December 700 900
Average for the year 580 780 21
Requirement
What amount should be recognised in the statement of financial position of Rostock at
1 January 20X7 in respect of retained earnings after the adjustments required by IAS 29?
Audit focus
17 Winstanley International Restaurants
Winstanley International Restaurants plc (WIR) is a listed company based in the UK which operates
a chain of restaurants. While most of its activities are in the UK, WIR has significant, and growing,
operations in the Far East, Africa, North America and Europe. WIR's overseas activities are managed
through an autonomous subsidiary in each country where WIR has restaurants.
You are a senior in the firm that audits WIR and you will be attending, in two days' time on
2 February 20X8, the final audit planning meeting in respect of the financial statements for the
year ending 31 December 20X7. The engagement manager, Fiona Vood, has given you the
following instructions ahead of the meeting:
'I realise that you have not had any previous contact with this client, but the senior who carried out the
interim audit formed a personal relationship with the WIR finance director and has now left the firm.
The finance director has also resigned. There are various issues with this client that worry me. I would
like you to prepare a written summary of the most important concerns, as a basis for discussion at the
planning meeting.
One of the areas of concern raised at the interim audit was the financial reporting treatment of foreign
exchange issues. Unfortunately, a new finance director has not yet been appointed and WIR staff have
little expertise in this area. The board also has some concerns about the impact that foreign exchange
movements will have on the financial statements.
I would therefore like you to provide a written explanation for the audit planning meeting of the
financial reporting treatment of the matters connected with foreign exchange outlined in briefing notes
1 and 2 that I have provided (see Exhibit), including relevant calculations of the impact on WIR's
I am also concerned about the current position of Landran National Restaurants (LNR), which is one of
the WIR group's largest subsidiaries. As you probably know, the country of Landra has been undergoing
significant economic turmoil and I'm afraid that this may be impacting on LNR. I'd be grateful if you
could let me have details of the possible financial reporting issues that may affect the group's
consolidated financial statements. Further details about LNR are in briefing note 3.
I'm not satisfied with the explanations the last senior obtained from the finance director about certain
large payments. Details of these explanations are in briefing note 4; I reckon we need to do further work
on them.
As well as the tasks I've given you above, I would also like you, for each issue 1–4 in the briefing notes,
to set out a schedule which briefly describes the key audit risks and audit procedures.
Lastly, I've had an email from the Chief Executive saying that the board has decided to include a social
and environmental report in the group accounts for the first time. He's wondering if we can help the
company prepare the report and report on it as part of our audit. I think it may be a good idea, but I
need some notes on the issues so that I can respond to the Chief Executive.'
Requirement
Respond to the instructions from the engagement manager.

Exhibit
Briefing notes
(1) WIR, the parent company, made an undated loan to one of its foreign subsidiaries, Rextex Inc,
of $4.8 million on 1 March 20X7. The loan was denominated in $ which is the functional
currency of Rextex. WIR has made it clear that the loan is part of a long-term commitment to
financing the activities of this subsidiary. The exchange rate on 1 March 20X7 was £1:$2 and
the exchange rate on 31 December 20X7 was £1:$1.6. Please cover both the treatment in the
group financial statements and in the WIR parent company financial statements.
(2) On 30 September 20X7 WIR purchased a cold storage depot in Lanvia in order to store food
purchased from the region. The transaction had been personally authorised and dealt with by
the finance director, with initial board approval. After the purchase was agreed, the finance
director had visited Lanvia to take custody of the title documents. WIR does not have a
subsidiary in Lanvia.
The depot contract was invoiced in Lanvian Crona (LCr) for LCr15 million. Payment was to be
made in LCr in two equal instalments on 30 November 20X7 and on 31 January 20X8. As you
may know, the LCr has appreciated significantly against the £ as a result of the Lanvian
Government creating an independent Central Bank. Current and historical exchange rates are:
30 September 20X7 LCr2.50/£1
30 November 20X7 LCr2.10/£1
31 December 20X7 LCr2.00/£1
31 January 20X8 (today) LCr1.95/£1
During the interim audit the senior went to Lanvia to inspect the new depot and the purchase
documentation.
(3) Landran National Restaurants is, in terms of revenue, WIR's second biggest subsidiary. It is a
chain of high-quality restaurants, operating in the country of Landra. Over the last few years
Landra has been affected by considerable economic uncertainty; inflation is currently running
at 95% and is expected to go on rising rapidly for the next few years. Landra's local stock
market is almost dormant; because of the impact of inflation, rich investors have preferred to
invest in property in Landra or in overseas stock markets. The uncertainty has impacted
significantly on LNR's business; it has been forced to link staff wages to the country's price
index, and its suppliers are insisting that either LNR pays immediately in cash or, if it takes
credit, that the payments are adjusted to take account of the price inflation between LNR
purchasing supplies and the suppliers being paid.
LNR's financial statements have been prepared on an unmodified historical cost basis in
accordance with local accounting practice.
(4) Several large payments have been made to unidentified agents and described as commissions
in respect of obtaining large catering contracts. Most of these payments have been made in
cash, some of which were in foreign currencies; however, some payments have been made by
cheque. Inquiries relating to the payee of the cheque have revealed that they are in the name
of a nominee and the beneficiary cannot be identified. There is no supporting documentation
for any of the payments.
Before his departure the former finance director told the audit senior that such commissions
are common practice and the agent represents valuable contacts whose identity must be kept
confidential as otherwise WIR's competitors would be able to 'poach' work from them.

C
Technical reference H
A
P
T
E
Functional currency R
 Currency that influences sales prices and costs IAS 21.9
Initial recognition 21
 Foreign currency transaction to be recorded in functional currency at spot IAS 21.21

exchange rate at date of transaction
Reporting at subsequent reporting dates IAS 21.23
 Foreign currency monetary items using the closing rate

 Foreign currency non-monetary items measured at historical cost in foreign
currency translated at exchange rate at date of transaction
 Foreign currency non-monetary items measured at fair value in foreign currency
translated at exchange rate at date when fair value determined
Recognition of exchange differences

 Exchange differences arising on settlement or translation of monetary items at IAS 21.28
rate different from those at which they were translated on initial recognition
recognised in profit or loss in period in which they arise (unless these arise in
relation to an entity's net investment in a foreign operation – see IAS 21.32
below)
 When gain or loss on a non-monetary item is recognised directly in other IAS 21.30
comprehensive income any exchange component of gain or loss should also be
recognised in other comprehensive income
 Exchange differences arising on a monetary item that forms part of a reporting IAS 21.32
entity's net investment in a foreign operation shall be recognised:
– In profit or loss in the separate financial statements of reporting entity or
the individual financial statements of foreign operation
– In other comprehensive income (a separate component of equity) in the
consolidated financial statements and reclassified from equity to profit or
loss on disposal
Change in functional currency
 Translation procedures to be applied prospectively from date of change IAS 21.35
Use of presentation currency other than the functional currency

 Translation into presentation currency for consolidation IAS 21.38–39
Translation of foreign operation

 Any goodwill arising on the acquisition of a foreign operation and any fair value IAS 21.44
adjustments shall be expressed in the functional currency of the foreign
operation and translated at the closing rate

IAS 7.25–26
 Non-cash transactions
– The statement of cash flows does not record non-cash transactions IAS 7.43
 Disclosures IAS 7.50
– Components of cash and cash equivalents Appendix A
– Reconciliation of the amounts in the statement of cash flows with the

equivalent balance in the statement of financial position
– Information (together with a commentary) which may be relevant to the
users

 Scope IAS 29.1
 Restatement of financial statements IAS 29.5–10
 Historical cost financial statements
– Statement of financial position IAS 29.11–25
– Statement of profit or loss and other comprehensive income IAS 29.26
– Gain or loss on net monetary position IAS 29.27–28
 Current cost financial statements
– Statement of financial position IAS 29.29
– Statement of profit or loss and other comprehensive income IAS 29.30
– Gain or loss on net monetary position IAS 29.31
 Taxes IAS 29.32
 Statement of cash flows IAS 29.33
 Corresponding figures IAS 29.34
 Consolidated financial statements IAS 29.35
 Selection and use of the general price index IAS 29.37
 Economies ceasing to be hyperinflationary IAS 29.38
 Disclosures IAS 29.39–40

C
Answers to Interactive questions H
A
P
T
E
The £ value of the loan is recorded as £4 million (€10/2.5). The UK company suffered an exchange loss
of £1 million.
21

Assumption 1: All the tables were sold on 20 December 20X5 and were paid for on
15 December 20X5.
Purchases = $3,600,000 ÷ 1.8 = £2m
Purchases are recorded at the exchange rate on the date of the original transaction.
Exchange gain on settlement of payable = ($3,600,000 ÷ 1.8) – ($3,600,000 ÷ 1.9) = £105,263
The dollar has weakened between the date of the transaction and the date of settlement; so the cost of
settling the trade payable in terms of pounds has reduced thereby producing an exchange gain which is
No balances are outstanding, as all the inventories have been sold and the trade payable is settled
before the year end.
Assumption 2: All the tables were sold on 3 February 20X6 and were paid for on
15 December 20X5.
Purchases = $3,600,000 ÷ 1.8 = £2m
Exchange gain on settlement of payable = £105,263
The impact on profit or loss is as for Assumption 1, as the trade payable was settled on the same day.
Inventories = $3,600,000 ÷ 1.8 = £2m
All the purchases were held in inventory at the year end. As a non-monetary item, inventories remain at
their original cost (ie, at the exchange rate at the date of the original purchase).
Assumption 3: All the tables were sold on 15 December 20X5 and were paid for on
3 February 20X6.
Profit or loss
Purchases = $3,600,000 ÷ 1.8 = £2m
Exchange gain on year-end retranslation of payable = ($3,600,000 ÷ 1.8) – ($3,600,000 ÷ 2.0) =
£200,000
The exchange gain is now determined with respect to the value of the trade payable at the year end (as
a monetary item trade payables are translated at the year-end exchange rate). The dollar has weakened
between the date of the transaction and the year end, so the cost of settling the trade payable in terms
of pounds has reduced, thereby producing an exchange gain, which is recognised in profit or loss. The
remainder of any exchange gain/loss between the year end and the date of eventual settlement is
recognised in the 20X6 financial statements.

Inventories = Nil. All the inventory is sold during the year.
Trade payables = ($3,600,000 ÷ 2.0) = £1,800,000
As a monetary item, trade payables are translated at the year-end exchange rate.
Assumption 4: 75 of the tables were sold on 15 December 20X5 with the remaining 25 tables sold
on 3 February 20X6. All the tables were paid for on 3 February 20X6.
Purchases = $3,600,000 ÷ 1.8 = £2m
Exchange gain on year-end retranslation of payable = ($3,600,000 ÷ 1.8) – ($3,600,000 ÷ 2.0) =
£200,000
The explanation of the exchange gain is as for Assumption 3.
Inventories = 25% × ($3,600,000 ÷ 1.8) = £500,000
25% of the purchases were still held in inventory at the year end. As a non-monetary item these
inventories remain at their original cost (ie, at the exchange rate at the date of the original purchase).

Management should value the land at £312,000 at 31 December 20X6.
The land is initially recognised at its original cost translated at the spot rate between Muritania lira and
the pound (ie, £260,000) on acquisition. The value remains unchanged at 31 December 20X4 because
management determined there was no need for a revaluation in this period.
At 31 December 20X5, the land is valued at £250,000, which is the fair value as at 31 December 20X5
translated at the exchange rate on the same date, when the fair value was determined (IAS 21.23).
Entity A recognises a loss of £10,000 profit or loss on 31 December 20X5, because a decrease of the
carrying amount as a result of a revaluation is recognised in profit or loss (IAS 16.40).
At 31 December 20X6, the land is valued at £312,000. Entity A recognises a gain of £10,000 in profit or
loss. The gain of £10,000 is the reversal of the revaluation decrease as at 31 December 20X5.
The revaluation surplus of £52,000 is recognised in equity (IAS 16.39).

Petra Ltd will record its initial investment at £12,000 which is the cost of the shares (€24,000) translated
at the rate of exchange on the acquisition date. The statement of financial position of Hellenic Marble at
31 December 20X6 will be:
Exchange
€'000 rate £'000
Non-monetary asset 96 3 32
Share capital and retained earnings 24 8

Loan 72 3 24
32
The share capital and retained earnings is the balancing item and is reconciled as follows:
Translation of closing equity (€24,000 @ €3/£1) £8,000
Translation of opening equity (€24,000 @ €2/£1) £12,000
Loss therefore £4,000

C
In relation to the financial statements of Venus Inc: H
A
 The extent to which the work of the component auditors can be relied on. The indication is that P
the firm is reputable; however, differences in local practices will still need to be taken into account. T
Additional audit procedures may be required as a result to satisfy UK requirements. E
R
 The accounting framework adopted and more specifically the accounting policies adopted by
Venus.
 Whether the component auditors have considered the effect of the high inflation on the ability of 21
the business to continue operating. While the functional currency of Venus is the US$, the
company may not be completely immune from the effects of exchange rates for local transactions.
In addition, extreme inflation may have resulted in falling sales if local sales have fallen dramatically
due to lack of affordability.
In relation to the group accounts:
 The nature of the investment ie, whether the political instability in Zorgistan is such that control
cannot be exercised and therefore the investment is not a subsidiary.
 Whether IAS 21 has been complied with in terms of the translation of the subsidiary's accounts into
pounds.
 Materiality of the subsidiary to the group as a whole. This would be of particular relevance if the
subsidiary were to face going concern issues.

1  Conversion is the process of physically exchanging one currency for another.

 Translation is the restatement of the value of one currency in another currency.
2 Money held and assets and liabilities to be received or paid in fixed or determinable amounts of
money.
3 Use the exchange rate at the date of the transaction. An average rate for a period can be used if
the exchange rates did not fluctuate significantly.
4 Primary factors used in the determination of the functional currency include the currency of the
country that influences sales price for goods and services, labour, material and other costs and
whose competitive forces and regulations determine these prices and costs.
Secondary indicators include the currency in which funding and receipts from operating activities
arise.
5 Treat as assets/liabilities of the foreign operation and translate at the closing rate.
6 Only if there is a change to the underlying transactions relevant to the entity.
7 Zephyria
£134,823
Goodwill is translated at the closing rate. Therefore N$175,000/1.298 = £134,823. See IAS 21
IN15 and 57.
8 Cacomistle
£173,344
Because IAS 21.47 treats fair value adjustments to the carrying amount of assets and liabilities
arising on the acquisition of a foreign operation as assets and liabilities of the foreign operation, it
requires them to be translated at the closing rate.
The correct answer is thus N$225,000/1.298 = £173,344.
9 Longspur
£8,052
IAS 21.21 and 22 require that an asset should be recorded initially at the date of the transaction,
which is the date it first qualifies for recognition. For property, plant and equipment, this is when
the asset is delivered, which in this case is 30 April 20X7.
The equipment is a non-monetary asset and thus its carrying amount stays at the original
translated value per IAS 21.23(b). Depreciation on a non-monetary asset is charged from when it
becomes available for use and is treated in the same way as the related assets, so there is no
change from the exchange rate at initial recognition. The correct answer is therefore:
(N$250,000/10 years)  8/12 = N$16,667 translated at £1:N$2.07 = £8,052.
10 Orton
£511,111
Exchange gain = (N$9,200,000/1.8) – (N$9,200,000/2.0) = £511,111
The exchange gain is determined with respect of the value of the trade payable at the year end (as
per IAS 21.23(a) monetary items such as trade payables are translated at the year-end exchange
rate). The N$ has weakened between the date of the transaction and the year end, so the cost of
settling the trade payable in terms of £ has reduced, thereby producing an exchange gain.
There is no gain or loss in respect of the revenue for the paintings sold, which is recorded at the
transaction date rate (IAS 21.21). There is no gain or loss on the paintings held in inventory which
in the year-end statement of financial position are translated at the transaction date rate
(IAS 21.23(b)).

11 Alder
C
The loan would initially be recorded in the financial statements of Culpeo at the rate ruling on the H
transaction date (IAS 21.21), so £9m  2.0 = R$18m. Under IAS 21.23 the amount payable at the A
year end is £9m  1.8 = R$16.2m. The difference is a gain (ie, reduction in a liability) of P
R$1.8 million in the financial statements of Culpeo. T
E
This gain will be translated at the closing rate and is equal to £1.0 million (R$1.8m/1.8). Since the R
loan is part of the net investment, it is recognised as a separate component of equity as required by
IAS 21.15 and IAS 21.32–33.
21
12 Porcupine
£60 million loss, recognised in equity
IAS 21.39 and 41 require that exchange differences in translation to the presentation currency are
recognised directly in equity.
£m £m
Net assets at 1 January 20X7 at last year's rate N$300 @ 2.0 150
Net assets at 1 January 20X7 at this year's rate N$300 @ 3.0 100 50 loss
Profit at average rate N$150 @ 2.5 60
Profit at 31 December 20X7 N$150 @ 3.0 50 10 loss
60 loss
13 Soapstone
(a) The goodwill acquired is calculated as: R$
Consideration transferred (£700/2) 350
Non-controlling interest (R$500 × 40%) 200
550
Net assets of acquiree (500)
Goodwill 50
Translated at acquisition (R$50 × 2) = £100
Retranslated at 31 December 20X7 (R$50 × 3) = £150
(b) As there has been no change in Frew's share capital during 20X7, the (R$730 – R$500) =
R$230 increase in equity represents Frew's profit for 20X7. This is translated at the £2.50: R$1
average rate as an approximation to the rates ruling at the date of each transaction, to give
£575, of which Soapstone's 60% share is £345 (IAS 21.39(b)–40).
(c) The amount reported as other comprehensive income is made up of the exchange difference
on the retranslation of Frew's accounts plus the exchange difference on the retranslation of
goodwill:
Retranslation of Frew's accounts
£ £
Net assets at 1 January 20X6 at opening rate R$500 @ 2.0 1,000
Net assets at 1 January 20X6 at closing rate R$500 @ 3.0 1,500 500 gain
Profit at average rate R$230 @ 2.5 575
Profit at closing rate R$230 @ 3.0 690 115 gain
615 gain
Retranslation of goodwill
£150 – £100 = £50 gain (part (a))
The overall exchange gain recognised as other comprehensive income is therefore £615 + £50
= £665.
Of this:
 £615  40% = £246 is attributable to the non-controlling interest
 (£615  60%) + £50 = £419 is attributable to the shareholders of the parent

14 Jupiter
Consolidated statement of financial position as at 31 March 20X7
£'000
Tangible non-current assets (148,500 + 47,000) 195,500
Goodwill (W4) 54,641
Net current assets (212,800 + 22,738) 235,538
485,679
Share capital 300,000
Retained earnings (W5) 50,484
Foreign exchange reserve (W6) 24,451
374,935
Long-term loans (90,913 (W3) + 14,286) 105,199
485,679
WORKINGS
(1) Translation of the statement of financial position of Mars Inc
Gal'000 Gal'000 Rate £'000
Tangible non-current assets 197,400 4.2 CR 47,000
Net current assets 145,500
Less receivables w/d 50,000
95,500 4.2 CR 22,738
292,900 69,738
Share capital 150,000 5.4 HR 27,778
Pre-acquisition reserves (W2) 76,675 5.4 HR 14,199
Post-acquisition reserves (24,900  3/12) 6,225 ß 13,475
(incl exchange differences to date) 232,900 55,452
Long-term liabilities 60,000 4.2 CR 14,286
292,900 69,738
(2) Pre-acquisition reserves

Gal'000
Balance at 31 March 20X7 132,900
Less earnings post-acquisition (24,900  3/12) (6,225)
Reserves at 31 December 20X6 126,675
Less write-down of receivables (50,000)
Pre-acquisition reserves 76,675
(3) Jupiter plc loans (retranslated at closing rate)

£'000 £'000
Long-term liability per SFP 93,000
Revaluation of Swiss franc loan
SF50.4m / 2.1 24,000
SF50.4m / 2.3 (21,913)
Gain on remeasurement 2,087
Remeasured long-term liabilities 90,913
(4) Goodwill
Gal'000 £'000
Consideration transferred (£85m × 5.4) 459,000
(Gal 150m + Gal 76.675m) × 10% 22,668
481,668
Net assets of acquiree (150m + 76.675m) (226,675)
Goodwill 254,993 @ HR 5.4 47,221
Impairment (25,499) @ CR 4.2 (6,071)
Exchange gain (β) 13,491
Carrying value 229,494 @ CR 4.2 54,641

Proof of exchange gain: £'000
Initial value of goodwill Gal 254,993,000 @ HR 5.4 47,221 C
H
@ CR 4.2 60,712
A
Overall exchange gain 13,491 P
T
(5) Consolidated retained earnings E
£'000 R
Jupiter plc 53,300
Share of post-acquisition profits in Mars
(90% × Gal 24.9m × 3/12m) @ AR 4.8 1,168
21
Gain on Swiss franc loan (W3) 2,087
Impairment of goodwill (W4) (25,499/4.2) (6,071)
50,484
(6) Foreign exchange reserve

£'000
Exchange gain on goodwill (W4) 13,491
Group share of exchange gain on retranslation of subsidiary (W8) 10,960
24,451
(7) Non-controlling interest (from W1)

£'000
10% × (69,738 – 14,286) 5,545
(8) Exchange difference on retranslation of subsidiary

£'000 £'000
Opening net assets (acquisition) @ HR 5.4 41,977
Gal 226,675,000
@ CR 4.2 53,970 Gain 11,993
Retained profits since acquisition
Gal 24.9m × 3/12 = Gal 6.225m @ AR 4.8 1,297
@ CR 4.2 1,482 Gain 185
Gain 12,178
Group share £12,178,000 × 90% 10,960
15 Cardamom
£800,000
IAS 7.25 requires cash flows from foreign currency transactions to be recorded by reference to the
exchange rate at the date of the cash flow.
Only the October 20X7 flow falls within the year ended 31 December 20X7, so the outflow is
R$2,000,000 at 2.5 = £800,000
16 Rostock
N$25,700
The only asset requiring adjustment is the PPE, from date of revaluation to 1 January 20X7, so it is
restated to N$41,400 (N$27,600 × 900/600) (IAS 29.18). The other assets and the trade payables
are monetary items which require no adjustment (IAS 29.12). So the restated equity is N$40,100
(N$41,400 – N$27,600 + N$26,300).
At the beginning of the first period of application of IAS 29, share capital is restated from the date
of contribution, the revaluation surplus is eliminated and retained earnings are the balancing figure
(IAS 29.24). Retained earnings are N$25,700 (N$40,100 – N$8,000 × 900/500).

Audit focus
17 Winstanley International Restaurants
To: Fiona Vood
From: A Senior
Date: 31 January 20X8
Subject: Winstanley Audit – International transactions and balances
1 Parent company loan
1.1 Financial reporting
Where a parent company makes a loan to a subsidiary then the amount outstanding is an intra-
group monetary item. The entity with the currency exposure needs to recognise an exchange
difference on the intra-group balance. In this case, as the loan is denominated in dollars, then the
currency risk lies with WIR rather than Rextex.
1.1.1 Parent company financial statements
The loan is a monetary item. The normal rules of IAS 21 apply in the case of the parent company
accounts. Assuming that the £ is the functional currency of WIR (as 'most of its activities are in the
UK') then the exchange difference should be recognised in profit or loss.
Specifically there is a foreign exchange gain on the loan receivable of £600,000 [($4.8m/2) –
($4.8m/1.6)]
The receivable will thus be recorded in the WIR individual company statement of financial position
at £3 million.
It is possible that the loan may have been eligible to be treated as a fair value hedge of exchange
rate risk of the investment, but it does not appear that adequate documentation was put in place
at inception.
1.1.2 Consolidated financial statements
In the consolidated financial statements the loan from a parent to a subsidiary can be regarded as
part of a net investment in a foreign operation. This is only permitted by IAS 21 where settlement is
neither planned nor likely to occur in the foreseeable future.
As the WIR loan is undated, and there is no intention for repayment in the short or medium term, it
would therefore appear that the loan to Rextex qualifies as a net investment in a foreign operation.
As a consequence, IAS 21 requires that the exchange gain of £600,000 recognised in profit of the
WIR parent company accounts must, on consolidation, be removed from consolidated profit or
loss, recognised as other comprehensive income and recorded in equity in the combined statement
of financial position.
1.2 Audit risk and audit procedures
A key risk is that the loan from WIR to Rextex fails the IAS 21 test for a net investment in a foreign
operation. The consequence of this would be that the loan would be a normal monetary item and
the exchange gain taken to profit in the consolidated financial statements in the normal way.
The key audit risks are that:
 the loan might be improperly classified and thus the exchange gain on the loan wrongly
recognised as other comprehensive income; and
 the company may wish the exchange gain to be recognised in profit or loss (rather than as
other comprehensive income) and therefore change the terms of the loan before the year end
in order to make it more temporary. It would thus not be treated as a net investment in a
foreign subsidiary.

Other audit risks and audit procedures are as follows:
C
Audit risks Audit procedures H
A
Use of inappropriate exchange rates Verify exchange rates by confirming dates of the P
initial loan agreement and funds transfer T
E
Consider any impairment of loan Review going concern of Rextex (budgets, R
liquidity, cash flow)
Review terms of loan for evidence of Review correspondence between WIR and Rextex 21
permanency or ability of WIR directors to and board minutes for evidence that the loan
change the terms of the loan in the near future may be repayable in the near future
Review the terms of the loan
Post year end changes in exchange rates Verify exchange rates after the end of the
affecting loan value reporting period. If material consider disclosure
as a non-adjusting event per IAS 10
2 Purchase of warehouse
2.1 Financial reporting
According to IAS 21 an entity is required to translate foreign currency items and transactions into
its functional currency.
WIR initially records both the non-current asset and the liability at £6 million (LCr15m/2.5).
£m £m
DEBIT Warehouse – non-current asset 6
CREDIT Liability 6
The non-current asset needs no further translating.
By the date of the first payment there has been an appreciation in the LCr against the £. As a result
the actual amount in £s that WIR needs to settle the first instalment will increase, thereby resulting
in an exchange loss.
Amount required to settle is LCr7.5m/2.1 = £3,571,429
The exchange loss is thus £571,429 (£3,571,429 – £3m)
The remainder of the liability is still outstanding at the year-end date. As a monetary liability, it
needs retranslating at the rate of exchange ruling at the reporting date as £3.75 million (ie,
LCr7.5m/2).
The resulting exchange loss of £750,000 (ie, LCr7.5m/2.5 – LCr7.5m/2) should be shown as part
of profit or loss.
The settlement date and exchange rate on that date are not relevant for the financial statements of
the year ending 31 December 20X7.
Audit risks Audit procedures
There are concerns over the role of the FD Interview other board members and finance staff to
due to the following: assess competence, integrity and degree of control
 The resignation in the year exercised by the FD
 The personal relationship with the last Review samples of transactions authorised by the FD
audit senior
 Personal control over the acquisition of
a major asset
 The 'commissions' paid (discussed
further below) Review the measures taken to compensate for the
 There is no replacement FD yet in post absence of an FD

Internal controls over the transaction – Review board minutes for authorisation
given major involvement of FD
Speak to members of the board and finance staff to
assess role of the ex-FD in the contract (was there
any meaningful segregation of duties?)
Re-examine audit working papers of previous audit
senior given personal involvement. Consider
reperforming audit procedures
Timing of payments Review contract to ascertain payment terms and
dates. Verify actual payments made after they have
occurred
Business risk – impairment Given the doubts over the FD, ascertain the business
case for warehouse (ie, why it was needed in this
location) and assess its fair value on the basis of (i)
any independent valuations carried out during
purchase process (ii) utilisation of the warehouse
since purchase (eg, amount of inventories held
there).
3 Landra – hyperinflationary economy

3.1 Financial reporting issues
Landra appears to have several of the characteristics of a hyperinflationary economy:
 Many of the richest people in Landra are accumulating wealth in property, or investing it in
stable markets overseas.
 Suppliers are adjusting the credit payments required from LNR.
 The staff in Landran restaurants are having to be paid in amounts linked to a price index.
 Based on the information available, inflation is likely to exceed 100% over three years.
If Landra is judged to be a hyperinflationary economy, then the financial statements of LNR will
have to be restated before they are translated into WIR's currency for consolidation purposes. The
historical cost financial statements will have to be stated in terms of the measuring units current at
the reporting date.
3.2 Audit risks and audit procedures
The decision on whether the accounts should be translated because the Landran economy is
hyperinflationary is not always straightforward. IAS 29 does not specify a cut-off point in terms of
an exact rate but gives examples of indications that hyperinflation exists. IAS 29 also indicates that
precise accuracy in restating amounts is not possible, but what is important is consistent
application of its principles. Thus if the accounts are restated, the expectation should be that they
will be restated for a number of years. The adjustments required will need to be verified.
In addition, the poor economic conditions in the country may cast doubt on whether the
subsidiary can continue to operate as a going concern. As an upmarket chain of restaurants, it may
be badly hit by the economic problems.

Audit risks and audit procedures may include:
C
Audit risks Audit procedures H
A
Landra may be incorrectly treated Examine economic forecasts by bodies such as the Bank of P
as a hyperinflationary economy England for information about future economic trends in T
E
Landra, particularly the rate of inflation R
Obtain information about the Landra Government's current
economic policies, in particular any plans they have to reduce
inflation 21
Review reports and press coverage of the situation in Landra

and attempt to ascertain whether the problems LNR is facing
are widespread
Adjustments may be calculated Assess whether the price index used to make IAS 29
wrongly adjustments is a reliable indicator of inflation, and ascertain
the reasons for the choice made if index used is not Landran
consumer prices index
Assess whether the classification of statement of financial
position items into monetary and non-monetary for the
purposes of making adjustments is appropriate
Ascertain whether non-monetary items in the statement of
financial position, the statement of profit or loss and relevant
items in the statement of cash flows have been adjusted into
measuring units current at the end of the reporting period
Reperform the adjustment calculations and verify the
adjustments used to the price index
Ensure that monetary items, and other assets stated at market
value or net realisable value, have not been adjusted (already
expressed in terms of the monetary unit current at the end of
the reporting period)
Reperform the calculation of monetary gain or loss
Confirm that the comparative figures have been restated in
line with current measuring units
Confirm that the consolidated accounts fulfil the disclosure
requirements of IAS 29
LNR may be wrongly treated as a Obtain budget and forecast information and review for signs
going concern of cash shortages
Consider whether the assumptions take appropriate account
of current economic difficulties in Landra
Ascertain whether LNR directors' assessment of going concern
extends to 12 months from the date of the financial
statements and request assessment be extended to this length
if not
Also consider the UK-specific requirement that the directors
should disclose if their going concern assessment covered a
period less than one year from the date of the approval of the
financial statements, in which case this should be disclosed in
the auditor's report
Assess the availability of local finance if LNR is likely to require
it
Obtain written representations from WIR's directors of plans
by WIR to provide financial support for LNR

Assess the likely effectiveness of any other plans that LNR's

directors have to deal with going concern difficulties
Assess whether uncertainties that exist about the future of LNR
are material in the context of the group financial statements
Consider the need for adjustments to the figures consolidated
if the going concern basis is not appropriate for LNR
Consider the need for modification of the audit opinion on the
grounds of material misstatement or the inclusion of a
'Material Uncertainty Related to Going Concern' section
4 Payments to agents
Even if the commission payments are legal, the accounting records that relate to these payments
are inadequate, and we only have the unsupported word of the ex-FD. This does not represent
sufficient evidence by itself; we should expect to see stronger evidence in the form of proper
payment records. Now that the FD has left, no one else may have any knowledge about what the
payments are for.
In addition, what the FD described as commissions for obtaining work may in fact be bribes. The
lack of documentation means that we cannot be certain that the payments are in fact
commissions. They may represent a diversion of funds to the FD or possibly money laundering.
The fact that the FD was able to make these payments without anyone checking also casts doubt
on how effective the rest of the board has been in monitoring the effectiveness of the internal
control systems. Although as auditors we do not have to give an opinion on the effectiveness of
internal controls, we do have to assess the review carried out by the directors. We also need to
consider the strength of the evidence of representations by the board, since the failure to control
the FD may indicate a lack of knowledge of key accounting areas.
The main audit risks and procedures include the following:
Money paid to payees who have Ascertain details about the nominee payees, through internet
no entitlement to them searches or through international contacts
Having gained the client's permission, attempt to contact the
payees and ask for an explanation of these payments
Discuss the legal position with the current directors, pointing
out that the audit report may need to be qualified on the
grounds of failure to provide explanations
If possible, obtain written representations from other directors;
however, directors may not be able to provide those
representations and even if they can, the representations by
themselves will not be sufficient audit evidence
Ask the directors to encourage other staff to disclose any
knowledge they have of these payments, pointing out that
auditors have an obligation to keep legitimate business matters
confidential
Consider issuing a qualified opinion or disclaimer on grounds
of uncertainty because of an inability to obtain sufficient
appropriate evidence. Also consider reporting by exception on
failure to keep proper accounting records
Consider issuing a qualified audit opinion on the grounds of
material misstatement or an adverse opinion if the accounts do
not fairly reflect what the payments appear to be

C
Bribery/money laundering Ascertain whether payments can be linked to specific bookings H
A
or specific contracts P
Identify the countries to which the payments are being sent, T
E
and ascertain whether doubtful business practices are R
widespread there
Examine expenditure in other categories where reasons for
expenditure appear doubtful or payees are unclear 21
Consider taking legal advice or reporting to the proper

authority if there appears to be suspicion of illegal activity, or it
is in the public interest to do so
Corporate governance Review board's statement about the review of internal control
insufficiently/incorrectly described effectiveness (assuming one has been carried out) and consider
in accounts whether it fairly reflects what has taken place
Review disclosures of processes dealing with internal control
problems such as the payments authorised by the finance
director and consider whether disclosures fairly describe these
processes
Consider whether the directors have sufficient knowledge to
be able to make representations required for audit
5 Social and environmental statement

5.1 Ethical issues
Helping the client on the social and environmental report is likely to be recurring work. We should
therefore first assess whether this work, together with the other work we do for the client, would
earn us fees that are greater than 10% of total practice or partner fees, and would therefore be a
self-interest threat. In addition we need to consider whether the provision of the non-audit work
would breach the 70% benchmark in relation to average fees paid in the last three consecutive
years.
Secondly, we should consider carefully the work we are being asked to do. Helping management
to prepare a policy statement might constitute a threat to independence on a number of grounds.
Even if our work was limited to preparing factual statements and analysis, we would still face a
threat to independence. As auditors we would be checking the consistency of a statement we
helped prepare against the financial statements. If we had a more active role, helping management
prepare commentary and statements of opinion, we could be accused of acting as the client's
advocate.
Our work should therefore be confined to reporting on the statement that management prepares.
However, we need to consider whether we have the knowledge and competence necessary to issue
an opinion in the terms the client wants, and to carry out the work necessary to support that
opinion.
In addition, the audit committee should have ultimate responsibility for deciding whether we can
provide non-audit services, not the board. Part of the audit committee's remit under governance
guidance is to assess annually the independence of the external auditors, and specifically assess for
each non-audit service the competence of the audit firm to provide it and the safeguards in place
to stop it compromising its independence.
5.2 Audit and assurance issues
Reporting on the statement should not be considered as part of the audit. Instead we should treat
it as an assurance engagement and issue a separate engagement letter in respect of it.
As auditors we are appointed to report on the financial statements. The social and environmental
report is not part of the financial statements; instead it will be one of the documents issued with the
financial statements. As such, our responsibility is to read it to identify any material inconsistencies

with the financial statements. We are not required to express an opinion on the contents of this
report.
Although social and environmental issues will have some impact on the audit, this is only insofar as
they affect the financial statements. Possible impacts include contingent liabilities and provisions in
respect of legal action, or expenditure on cleaning up sites. There are likely to be a number of
other aspects of the report which will not impact on the financial statements and we therefore
would not consider these.
We thus need to undertake additional work to be able to issue a full report on social and
environmental issues. The work we do and the content of the report would depend on the terms of
the engagement. The report is likely to include as a minimum:
 the objectives of the review
 opinions
 basis on which the opinions have been reached
 work performed

CHAPTER 22
Income taxes
Introduction
Topic List
1 Current tax revised
2 Deferred tax – an overview
3 Identification of temporary differences
4 Measurement of deferred tax assets and liabilities
5 Recognition of deferred tax in the financial statements
6 Common scenarios
7 Group scenarios
8 Presentation and disclosure
9 Deferred tax summary and practice
10 Audit focus
Technical reference
1171
Introduction
 Explain, determine and calculate how current and deferred tax is recognised and appraise
accounting standards that relate to current tax and deferred tax
of details
Specific syllabus references for this chapter are: 8(a), 14(c), 14(d), 14(f)

1 Current tax revised
Section overview
Current tax is the amount payable to the tax authorities in relation to the trading activities of the
current period.
1.1 Background
Accounting for current tax is ordinarily straightforward. Complexities arise, however, when we consider
the future tax consequences of what is going on in the financial statements now. This is an aspect of tax
called deferred tax, which has not been covered in earlier studies and which we will look at in the next
C
section. IAS 12 Income Taxes covers both current and deferred tax. The parts of this study manual H
relating to current tax are fairly brief, as this has been covered at Professional Level. A
P
T
1.2 Recognition of current tax liabilities and assets E
R
Current tax is the amount payable to the tax authorities in relation to the current trading activities.
IAS 12 requires any unpaid tax in respect of the current or prior periods to be recognised as a liability.
Conversely, any excess tax paid in respect of current or prior periods over what is due should be 22
recognised as an asset to the extent it is probable that it will be recoverable.
The tax rate to be used in the calculation for determining a current tax asset or liability is the rate that is
expected to apply when the asset is expected to be recovered, or the liability to be paid. These rates
should be based on tax laws that have already been enacted (are already part of law) or substantively
enacted (have already passed through sufficient parts of the legal process that they are virtually certain
to be enacted) by the reporting date.
1.3 Measurement
Measurement of current tax liabilities (assets) for the current and prior periods is very simple. They are
measured at the amount expected to be paid to (recovered from) the tax authorities. The tax rates
(and tax laws) used should be those enacted (or substantively enacted) by the reporting date.
1.4 Recognition of current tax

Normally, current tax is recognised as income or expense and included in the net profit or loss for the
period. However, where tax arises from a transaction or event which is recognised as other
comprehensive income or recognised directly in equity (in the same or a different period) rather than
in profit or loss, then the related tax should also be reported within other comprehensive income or
reported directly in equity. An example of such a situation is where, under IAS 8 Accounting Policies,
Changes in Accounting Estimates and Errors, an adjustment is made to the opening balance of retained
earnings due to either a change in accounting policy that is applied retrospectively, or to the correction
of a material error. Any related tax is therefore also recognised directly in equity.
1.5 Presentation
In the statement of financial position, tax assets and liabilities should be shown separately.
Current tax assets and liabilities may only be offset under the following conditions.
 The entity has a legally enforceable right to set off the recognised amounts.
 The entity intends to settle the amounts on a net basis, or to realise the asset and settle the liability
at the same time.
The tax expense (income) related to the profit or loss from ordinary activities should be shown on the
face of the statement of profit or loss and other comprehensive income as part of profit or loss for the
period. The disclosure requirements of IAS 12 are extensive and we will look at these later in the
chapter.
Income taxes 1173

2 Deferred tax – an overview
Section overview
 Deferred tax is an accounting measure used to match the tax effects of transactions with their
accounting impact and thereby produce less distorted results. It is not a tax levied by the
Government that needs to be paid.
 You have studied current tax at Professional Level, but deferred tax is new to Advanced Level, so
you should focus on deferred tax.
 Note that UK tax is not specifically examinable, but examples from UK tax are sometimes
used in this chapter for illustrative purposes.
 The rules to determine the tax base in the jurisdiction in the question, will be given to you in
the exam.
2.1 What is deferred tax?

When a company recognises an asset or liability, it expects to recover or settle the carrying amount of
that asset or liability. In other words, it expects to sell or use up assets, and to pay off liabilities. What
happens if that recovery or settlement is likely to make future tax payments larger (or smaller) than they
would otherwise have been if the recovery or settlement had no tax consequences? In these
circumstances, IAS 12 requires companies to recognise a deferred tax liability (or deferred tax asset).
2.2 Accounting profits vs taxable profits

Although accounting profits form the basis for computing taxable profits, on which the tax liability for
the year is calculated, accounting profits and taxable profits are often different for two main reasons:
(1) Permanent differences
(2) Temporary differences
2.2.1 Permanent differences

These arise when items of revenue or expense included in the accounting profit are excluded from the
computation of taxable profits. For example:
 Client entertaining expenses are not tax allowable in the UK.
 UK companies are not taxed on dividends from other UK companies and overseas companies.
Note that IAS 12 does not refer to the term 'permanent differences'; this is a UK GAAP term.
2.2.2 Temporary differences

These arise when items of revenue or expense are included in both accounting profits and taxable
profits, but not in the same accounting period. For example, both depreciation and capital allowances
write off the cost of a non-current asset, though not necessarily at the same rate and over the same
period.
Illustration: Temporary differences 1

A company buys an item of machinery on the first day of the financial year, 1 January 20X0, at a cost of
£100,000 and applies straight-line depreciation at a rate of 10%. Capital allowances are available at
20% reducing balance.
y/e 31 December Depreciation (10% SL) Capital allowances (20% RB)
20X0 £10,000 £20,000
20X1 £10,000 £16,000
20X2 £10,000 £12,800
20X3 £10,000 £10,240 and so on

Therefore in 20X0, accounting profits are reduced by £10,000 but taxable profits are reduced by
£20,000, so providing one reason why the tax charge is not equal to the tax rate multiplied by the
accounting profit.
At this point it could be said that the temporary difference is equal to the £10,000 difference between
depreciation and capital allowances.
In the long run, the total taxable profits and total accounting profits will be the same (except for
permanent differences). In other words, temporary differences which originate in one period will reverse
in one or more subsequent periods.
Deferred tax is an accounting adjustment to smooth out the discrepancies between accounting profit
and the tax charge caused by temporary differences. C
H
A
2.3 Calculating and accounting for deferred tax P
T
In order to calculate deferred tax, the following steps must be taken: E
R
(1) Identify temporary differences
(2) Apply the tax rate to the temporary differences to calculate the deferred tax asset or liability
(3) Recognise the resulting deferred tax amount in the financial statements
22
Identification of temporary differences
Above we have considered temporary differences as being the result of income or expenditure being
recognised in accounting and taxable profit in different periods.
IAS 12, however, requires that a 'net assets approach' rather than an 'income statement approach' is
taken to calculate temporary differences.
Applying this approach to the illustration seen above, we would simply compare the carrying amount
and the tax written-down value rather than depreciation and capital allowances in order to calculate the
temporary difference:
£
Carrying amount (£100,000 – £10,000) 90,000
Tax written-down value (£100,000 – £20,000) 80,000
Temporary difference 10,000
The identification of temporary differences is covered in more detail in section 3.

Apply the tax rate to temporary differences to calculate deferred tax asset or liability
The tax rate to be used is not necessarily the current tax rate. It should be the rate which is expected to
apply to the period when the asset is realised or liability settled.
This is covered in more detail in section 4.
Record deferred tax in the financial statements
Depending on the circumstances, a deferred tax asset or liability may arise in the statement of financial
position. The corresponding entry is normally recorded in:
 the tax charge in profit or loss; or
 other comprehensive income.
This is covered in more detail in section 5.
Income taxes 1175

3 Identification of temporary differences
Section overview
Temporary differences are calculated as the difference between the carrying amount of an asset or
liability and its tax base. Temporary differences may be classified as:
 taxable
 deductible
3.1 Calculation of temporary differences

Temporary differences are calculated as the difference between:
 the carrying amount of the asset or liability in the statement of financial position; and
 the 'tax base' of the asset or liability.
3.1.1 Tax base
Definition
Tax base: The amount attributed to an asset or liability for tax purposes.
Assets
The tax base of an asset is the value of the asset in the current period for tax purposes. This is either:
 the amount that will be tax deductible in the future against taxable economic benefits when the
carrying amount of the asset is recovered; or
 if those economic benefits are not taxable, the tax base is equal to the carrying amount of the
asset.
Liabilities
 The tax base of a liability is its carrying amount less any amount that will be tax deductible in the
future.
 For revenue received in advance, the tax base of the resulting liability is its carrying amount less
any amount of the revenue that will not be taxable in future periods.
IAS 12 guidance
IAS 12 states that in the following circumstances, the tax base of an asset or liability will be equal to its
carrying amount:
 Accrued expenses that have already been deducted in determining an entity's tax liability for the
current or earlier periods
 A loan payable that is measured at the amount originally received and this amount is the same as
the amount repayable on final maturity of the loan
 Accrued income that will never be taxable
Illustration: Tax base

Current liabilities include accrued fines and penalties with a carrying amount of £100. These fines and
penalties are not deductible for tax purposes.
The tax base of the accrued fines and penalties is £100 (ie, equal to the carrying amount because the
amount which will be deducted for tax purposes in a future period is nil).
As the tax base equals the statement of financial position carrying amount, there is no temporary
difference and no deferred tax implications.

Worked example: Tax base
Scenario 1 – An entity's current assets include insurance premiums paid in advance of £20,000, for
which a tax deduction will be allowed in future periods.
The tax base of the insurance premiums is £20,000, because the whole carrying amount will be
deductible for tax purposes in future periods.
Scenario 2 – An entity has recognised a current liability of £400,000 in respect of income received in
advance, which will be taxed in future periods.
The tax base of the liability is its £400,000 carrying amount.
Scenario 3 – An entity has recognised a defined benefit liability of £500,000 in respect of a defined
benefit retirement plan, but no tax deduction is allowed until contributions are paid into the plan.
C
The tax base of the liability is nil, because the whole carrying amount will be deductible for tax purposes H
in future periods. A
P
Scenario 4 – Two years ago, an entity recognised a non-current asset at its £1 million cost. Tax T
depreciation is allowed on the full cost at 15% per annum on a straight-line basis. E
R
The tax base of the non-current asset is £700,000. 15% of cost has been allowed for tax purposes in
each of the two years; the tax base is therefore the 70% of cost which will be deductible for tax
purposes in future periods. 22
Interactive question 1: Tax base

State the tax base of each of the following items.
(a) Current liabilities include accrued expenses with a carrying amount of £1,000. The related expense
will be deducted for tax purposes on a cash basis.
(b) Current liabilities include interest revenue received in advance, with a carrying amount of £10,000.
The related interest revenue was taxed on a cash basis.
(c) Current assets include prepaid expenses with a carrying amount of £2,000. The related expense
has already been deducted for tax purposes.
(d) A loan payable has a carrying amount of £1 million. The repayment of the loan will have no tax
consequences.
3.2 Types of temporary difference

IAS 12 makes a distinction between two types of temporary difference:
(1) Taxable temporary differences
(2) Deductible temporary differences
3.2.1 Taxable temporary differences

 Taxable temporary differences arise where the carrying amount exceeds the tax base.
 They result in a deferred tax liability.
Income taxes 1177

Definitions
Taxable temporary differences: Temporary differences that will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability
is recovered or settled.
Deferred tax liabilities: The amounts of income taxes payable in future periods in respect of taxable
temporary differences.
Worked example: Temporary differences

Scenario 1 – An entity recognised a non-current asset at its £1 million cost two years ago. Tax
depreciation is allowed on the full cost at 15% per annum straight line, while accounting depreciation is
at 10% per annum straight line.
The tax base of the non-current asset is £700,000, but the carrying amount is £800,000. The taxable
temporary difference is therefore the difference of £100,000.
Scenario 2 – An entity has issued £400,000 of debt redeemable in five years, incurring £20,000 of issue
expenses. The issue expenses have been deducted from the liability and are being amortised over the
five-year life of the debt. To date, £5,000 has been amortised, but the whole £20,000 has been allowed
as a tax deduction.
The tax base of the liability is its £400,000 carrying amount less the £nil amount which is deductible for
tax purposes in future periods. The carrying amount is £385,000 and the taxable temporary difference is
therefore the difference of £15,000.
3.2.2 Deductible temporary differences

 Deductible temporary differences arise where the tax base exceeds the carrying amount.
 These result in a deferred tax asset.
Definitions
Deductible temporary differences: Temporary differences that will result in amounts that are
deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled.
Deferred tax assets: The amounts of income taxes recoverable in future periods in respect of:
 deductible temporary differences; and
 the carry forward of unused tax losses/unused tax credits.
Illustration: Temporary differences 2

A factory was purchased for £4 million and has been given cumulative capital allowances of £1 million.
It therefore has a tax base of £3 million.
Assumption 1 If the carrying amount of the factory in the statement of financial position is
£3.5 million, then there is a taxable temporary difference of £500,000. (Note:
Where capital allowances claimed are cumulatively greater than accounting
depreciation, this is sometimes referred to as 'accelerated' as the tax allowances
have been awarded sooner than accounting depreciation has been recognised.)
Assumption 2 If, instead, the carrying amount of the factory in the statement of financial position
is £2 million, then there is a deductible temporary difference of £1 million.

3.3 Temporary differences with no deferred tax impact
A deferred tax liability or asset should be recognised for all taxable and deductible temporary differences
unless they arise from:
 the initial recognition of goodwill; or
 the initial recognition of an asset or liability in a transaction which:
– is not a business combination; and
– at the time of the transaction, affects neither accounting nor taxable profit.
Examples of initial recognition of assets or liabilities with no deferred tax effect
Examples of initial recognition of assets or liabilities in a transaction which does not affect either
accounting or taxable profit at the time of the transaction are:
C
(a) An intangible asset with a finite life which attracts no tax allowances. In this case, taxable profit is H
never affected, and amortisation is only charged to accounting profit after the transaction. A
P
(b) A non-taxable government grant related to an asset which is deducted in arriving at the carrying T
amount of the asset. For tax purposes it is not deducted from the tax base. E
R
Although a deductible temporary difference arises in both cases (on initial recognition in the second
case, and subsequently in the first case), this is not permitted to be recognised as a deferred tax asset, as
it would make the financial statements less transparent. 22
Worked example: Initial recognition

As another example of the principles behind initial recognition, suppose Petros Co intends to use an
asset which cost £10,000 in 20X7 throughout its useful life of five years. Its residual value would then be
nil. The tax rate is 40%. Any capital gain on disposal would not be taxable (and any capital loss not
deductible). Depreciation of the asset is not deductible for tax purposes.
Requirement
State the deferred tax consequences in each of the years 20X7 and 20X8.
Solution
20X7
To recover the carrying amount of the asset, Petros will earn taxable income of £10,000 and pay tax of
£4,000. The resulting deferred tax liability of £4,000 would not be recognised because it results from
the initial recognition of the asset.
20X8
The carrying value of the asset is now £8,000. In earning taxable income of £8,000, Petros will pay tax
of £3,200. Again, the resulting deferred tax liability of £3,200 is not recognised, because it results from
the initial recognition of the asset.
Income taxes 1179

3.4 Summary
The following diagram summarises the calculation and types of temporary difference:
Tax treatment
differs from
accounting
treatment
Temporary differences
Tax base < Tax base = Tax base >

carrying amount carrying amount carrying amount
Taxable Deductible
No deferred tax
temporary temporary
implications
difference difference
Deferred tax Deferred tax

liability asset

Worked example: Tax base of assets
(a) A machine cost £100,000. For tax purposes, capital allowances of £30,000 have already been
deducted in the current and prior periods; and the remaining cost will be deductible in future
periods. Assume that revenue generated by using the machine is taxable, any gain on disposal of
the machine will be taxable and any loss on disposal will be deductible for tax purposes. The
carrying amount of the machine for accounting purposes is £82,000.
The tax base of the machine is £70,000 as this remains to be deducted in future periods. There is a
taxable temporary difference of £12,000 (ie, £82,000 – £70,000).
(b) Interest receivable has a carrying amount of £1,000. The related interest revenue will be taxed on a
cash basis.
The tax base of the interest receivable is nil, as the accrual is not recognised for tax purposes. There C
is therefore a taxable temporary difference of £1,000. H
A
(c) Trade receivables have a carrying amount of £10,000. Assume that the related revenue has already P
been included in taxable profit. T
E
The tax base of the trade receivables is £10,000. (Note: The difference between this case and the R
previous example is that in this case the amount has been included in both the accounting profit
and the taxable profit for the period, thus there is no future taxable impact.) As the tax base equals
the carrying amount, there is no temporary difference and no deferred tax. 22
(d) A loan receivable has a carrying amount of £8,000. The repayment of the loan will have no tax
consequences.
The tax base of the loan is £8,000, as there are no future tax consequences. Thus, as the tax base
equals the carrying value, there is no temporary difference and no deferred tax.
Worked example: Tax base of liabilities

In the following cases show and explain:
(a) the tax base
(b) temporary differences:
(i) Current liabilities include accrued expenses with a carrying amount of £2,000. The related
expense will be deducted for tax purposes on a cash basis.
(ii) Current liabilities include accrued expenses with a carrying amount of £3,000. The related
expense has already been deducted for tax purposes.
(iii) A loan payable has a carrying amount of £5,000. The repayment of the loan will have no tax
consequences.
(iv) Current liabilities include interest revenue received in advance, with a carrying amount of
£7,000. The related interest revenue was taxed on a cash basis.
Solution
(i) The tax base of the accrued expenses is nil. This is because the expenses have been recognised in
accounting profit, but the tax impact is yet to take effect. There is therefore a deductible temporary
difference of £2,000.
(ii) The tax base of the accrued expenses is £3,000, ie, the carrying value (£3,000) less the amount
which will be deducted for tax purposes in future periods (nil, as relief has already been obtained).
There is no temporary difference, and no deferred tax arises.
(iii) The tax base of the loan is £5,000, as there are no future tax consequences. Thus, as the tax base
equals the carrying value, there is no temporary difference and no deferred tax.
(iv) The tax base of the interest received in advance is nil (ie, the carrying value (£7,000) less the
amount which will not be taxable in future periods (£7,000, as it has all been charged already). As
a result there is a deductible temporary difference of £7,000.
Income taxes 1181

4 Measurement of deferred tax assets and liabilities
Section overview
The tax rate is applied to temporary differences in order to calculate the deferred tax asset or liability.
The tax rate should be applied to temporary differences in order to calculate deferred tax:
 Taxable temporary differences × tax rate = deferred tax liability
 Deductible temporary differences × tax rate = deferred tax asset
Worked example: Calculation of deferred tax

A company purchased an asset costing £1,500. At the end of 20X8 the carrying amount is £1,000. The
cumulative capital allowances are £900 and the current tax rate is 25%.
Requirement
Calculate the deferred tax liability for the asset.
Solution
The tax base of the asset is £1,500 – £900 = £600.
The carrying amount exceeds the tax base and therefore there is a taxable temporary difference of
£1,000 – £600 = £400. The entity must therefore recognise a deferred tax liability of £400 × 25% =
£100.
(In order to recover the carrying amount of £1,000, the entity must earn taxable income of £1,000, but
it will only be able to deduct £600 as a taxable expense. The entity must therefore pay income tax of
£400  25% = £100 when the carrying amount of the asset is recovered.)
4.1 Tax rate

The tax rates that should be used to calculate deferred tax are the ones that are expected to apply in the
period when the asset is realised or the liability settled. The best estimate of this tax rate is the rate
which has been enacted or substantively enacted by the reporting date.
For example, in the UK 2015 Budget which became the Finance Act 2015, the rate of corporation tax
was cut to 20%. Note that UK tax is not examinable; it is mentioned for illustrative purposes only.
The Accounting Standards Board (ASB) has stated that substantive enactment occurs when any future
steps in the enactment process will not change the outcome. Specifically, in relation to the UK, the ASB
has stated that this occurs when the House of Commons passes a resolution under the Provisional
Collection of Taxes Act 1968.
Note that the tax rates used in this chapter are assumptions or hypothetical rates rather than real
rates.
Worked example: Tax rate

A Muldovian company enters into a long-term contract to build a motorway in that country. During the
year ended 31 December 20X3, the entity recognises £4 million of income on this contract even though
it is not expected to receive the related cash until the year ending 31 December 20X5.
Under the tax rules of Muldovia, companies are charged tax on a cash receipts basis.
The tax rate for companies in Muldovia was 30% in the year to 31 December 20X3, but their
Government has voted in favour of a reduction to 29% in 20X4. There is currently discussion of the rate
dropping to 28% in 20X5, but as yet there is no agreement.

Requirement
What rate of tax should be used to determine the deferred tax balance?
Solution
A rate of 29% should be used. The rate is that expected to apply when the asset is realised, thus the rate
of 30% in 20X3, when the temporary difference originated, is not relevant. The 28% would be used if it
had been enacted or substantively enacted, but it is only under discussion. Thus, our best estimate of
the rate applying in 20X5, based on laws already enacted or substantively enacted, is the rate for 20X4
(ie, the previous year) of 29%.
C
4.1.1 Progressive rates of tax H
A
In some countries, different tax rates apply to different levels of taxable income. In this case, an average P
rate expected to apply to the taxable profit of the entity in the period in which the temporary difference T
is expected to reverse should be identified and used to calculate the temporary difference. E
R
4.1.2 Different rates of tax

Some countries also apply different rates of tax to different types of income eg, one rate to profits and 22
another to gains.
Where this is the case, the tax rate used to calculate the deferred tax amount should reflect the manner in
which the entity expects to recover the carrying amount of assets or settle the carrying amount of
liabilities.
Worked example: Manner of recovery/settlement

Richcard Co has an asset with a carrying amount of £10,000 and a tax base of £6,000. If the asset were
sold, a tax rate of 20% would apply. A tax rate of 30% would apply to other income.
Requirement
State the deferred tax consequences if the entity:
(a) Sells the asset without further use
(b) Expects to retain the asset and recover its carrying amount through use
Solution
(a) A deferred tax liability is recognised of £(10,000 – 6,000)  20% = £800.
(b) A deferred tax liability is recognised of £(10,000 – 6,000)  30% = £1,200.
Interactive question 2: Recovery 1

Emida Co has an asset which cost £100,000. In 20X9 the carrying amount was £80,000 and the asset
was revalued to £150,000. No equivalent adjustment was made for tax purposes. Cumulative
depreciation for tax purposes is £30,000 and the tax rate is 30%. If the asset is sold for more than cost,
the cumulative tax depreciation of £30,000 will be included in taxable income but sale proceeds in
excess of cost will not be taxable.
Requirement
State the deferred tax consequences of the above, assuming the following:
(a) The entity expects to recover the carrying amount through continued use of the asset.
(b) The entity expects to recover the carrying amount of the asset through sale.
Income taxes 1183

The manner of recovery may also affect the tax base of an asset or liability. Tax base should be
measured according to the expected manner of recovery or settlement.
Interactive question 3: Recovery 2

The facts are as in Recovery 1 above except that, if the asset is sold for more than cost, the cumulative
tax depreciation will be included in taxable income (taxed at 30%) and the sale proceeds will be taxed
at 40% after deducting an inflation-adjusted cost of £110,000.
Requirement
State the deferred tax consequences of the above, assuming that:
(a) The entity expects to recover the carrying amount through continued use of the asset.
(b) The entity expects to recover the carrying amount of the asset through sale.
4.2 Discounting
IAS 12 states that deferred tax assets and liabilities should not be discounted because the complexities
and difficulties involved will affect reliability. Discounting would require detailed scheduling of the
timing of the reversal of each temporary difference, but this is often impracticable. If discounting were
permitted, this would affect comparability.
Note, however, that where carrying amounts of assets or liabilities are discounted (eg, a pension
obligation), the temporary difference is determined based on a discounted value.
5 Recognition of deferred tax in the financial statements
Section overview
The deferred tax amount calculated is recorded as a deferred tax balance in the statement of financial
position with a corresponding entry to the tax charge, other comprehensive income or goodwill.
5.1 Principles of recognition

As with current tax, deferred tax should normally be recognised as income or an expense amount within
the tax charge, and included in the net profit or loss for the period. Only the movement in the deferred
tax asset / liability on the statement of financial position is recorded:
DEBIT Tax charge X
CREDIT Deferred tax liability X
or
DEBIT Deferred tax asset X
CREDIT Tax charge X
Note that the recognition of a deferred tax asset may be restricted (see section 5.2).
Worked example: Deferred tax in the financial statements

An entity purchases a machine for £64,000 at the beginning of the year to 31 December 20X1. It has a
useful life of five years, and on 31 December 20X5 the asset is disposed of at a zero residual value. The
entity uses straight-line depreciation. The accounting year end is 31 December.
Assume that the machine qualifies for capital allowances, at a rate of 20% per annum on a reducing
balance basis.
Assume that the rate of tax is 30%.

Requirement
Show the deferred tax balance in the statement of financial position and the deferred tax charge for
each year of the asset's life.
Solution
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Carrying amount 51,200 38,400 25,600 12,800 0
Tax base 51,200 40,960 32,768 26,214 0
Taxable/(deductible) temporary
difference 0 (2,560) (7,168) (13,414) 0
Opening deferred tax liability/(asset) 0 0 (768) (2,150) (4,024) C
Deferred tax expense/(credit) 0 (768) (1,382) (1,874) 4,024 H
Closing deferred tax liability/(asset) 0 (768) (2,150) (4,024) 0 A
P
T
E
5.1.1 Exceptions to recognition in profit or loss R
(a) Deferred tax relating to items dealt with as other comprehensive income (such as a revaluation)
should be recognised as tax relating to other comprehensive income within the statement of profit
22
or loss and other comprehensive income.
(b) Deferred tax relating to items dealt with directly in equity (such as the correction of an error or
retrospective application of a change in accounting policy) should also be recognised directly in
equity.
(c) Deferred tax resulting from a business combination is included in the initial cost of goodwill (this is
covered in more detail later in the chapter).
Where it is not possible to determine the amount of current/deferred tax that relates to other
comprehensive income and items credited/charged to equity, such tax amounts should be based on a
reasonable pro-rata allocation of the entity's current/deferred tax.
5.1.2 Components of deferred tax

Deferred tax charges will consist of two components:
(a) Deferred tax relating to temporary differences
(b) Adjustments relating to changes in the carrying amount of deferred tax assets/liabilities (where
there is no change in temporary differences) eg, changes in tax rates/laws, reassessment of the
recoverability of deferred tax assets, or a change in the expected recovery of an asset
5.2 Deferred tax assets

A deferred tax asset must satisfy the recognition criteria given in IAS 12. These state that a deferred tax
asset should only be recognised to the extent that it is probable that taxable profit will be available
against which it can be used.
This is an application of prudence.
Worked example: Recognition of deferred tax asset

Pargatha Co recognises a liability of £10,000 for accrued product warranty costs on 31 December 20X7.
Assume that these product warranty costs will not be deductible for tax purposes until the entity pays
claims. The tax rate is 25%.
Requirement
State the deferred tax implications of this situation.
Income taxes 1185

Solution
The carrying amount of the liability is (£10,000).
The tax base of the liability is nil (carrying amount of £10,000 less the amount that will be deductible
for tax purposes in respect of the liability in future periods).
When the liability is settled for its carrying amount, the entity's future taxable profit will be reduced by
£10,000 and so its future tax payments by £10,000  25% = £2,500.
The carrying amount of (£10,000) is less than the tax base of nil and therefore the difference of £10,000
is a deductible temporary difference.
The entity should therefore recognise a deferred tax asset of £10,000  25% = £2,500 provided that it
is probable that the entity will earn sufficient taxable profits in future periods to benefit from a
reduction in tax payments.
5.2.1 Future taxable profits

When can we be sure that sufficient taxable profit will be available, against which a deductible
temporary difference can be used?
IAS 12 states that this is assumed when:
 there are sufficient taxable temporary differences;
 the taxable and deductible temporary differences relate to the same entity and same tax authority;
 the taxable temporary differences are expected to reverse either:
– in the same period as the deductible temporary differences; or
– in periods in which a tax loss arising from the deferred tax asset can be used.
Insufficient taxable temporary differences
Where there are insufficient taxable temporary differences, a deferred tax asset may only be recognised
to the extent that:
(a) it is probable that taxable profits will be sufficient in the same period as the reversal of the
deductible temporary difference (ignoring taxable amounts arising from future deductible
temporary differences); and
(b) tax planning opportunities exist that will allow the entity to create taxable profit in the appropriate
periods.
If an entity has a history of recent losses, then this is evidence that future taxable profit may not be
available.
5.2.2 Reassessment of unrecognised deferred tax assets

For all unrecognised deferred tax assets, at each reporting date an entity should reassess the availability
of future taxable profits and whether part or all of any unrecognised deferred tax assets should now be
recognised. This may be due to an improvement in trading conditions which is expected to continue.

6 Common scenarios
Section overview
There are a number of common examples which result in a taxable or deductible temporary difference.
However, this list is not exhaustive.
6.1 Taxable temporary differences

6.1.1 Accelerated capital allowances
 These arise when capital allowances for tax purposes are received before deductions for accounting
depreciation are recognised in the statement of financial position (accelerated capital allowances). C
H
 The temporary difference is the difference between the carrying amount of the asset at the A
reporting date and its tax written-down value (tax base). P
T
 The resulting deferred tax is recognised in profit or loss. E
R
Interactive question 4: Initial recognition

Jonquil Co buys equipment for £50,000 at the start of 20X1 and depreciates it on a straight-line basis 22
over its expected useful life of five years. For tax purposes, the equipment is depreciated at 25% per
annum on a straight-line basis. Tax losses may be carried back against the taxable profit of the previous
five years. In 20X0, the entity's taxable profit was £25,000. The tax rate is 40%.
Requirement
Assuming nil profits/losses after depreciation in years 20X1 to 20X5, show the current and deferred tax
impact in years 20X1 to 20X5 of the acquisition of the equipment.
6.1.2 Interest revenue

 In some jurisdictions, interest revenue may be included in profit or loss on an accruals basis, but
taxed when received.
 The temporary difference is equivalent to the income accrual at the reporting date, as the tax base
of the interest receivable is nil.
 The resulting deferred tax is recognised in profit or loss.
6.1.3 Development costs

 Development costs may be capitalised for accounting purposes in accordance with IAS 38 while
being deducted from taxable profit in the period incurred (ie, they receive immediate tax relief).
 The temporary difference is equivalent to the amount capitalised at the reporting date, as the tax
base of the costs is nil since they have already been deducted from taxable profits.
 The resulting deferred tax is recognised in profit or loss.
6.1.4 Revaluations to fair value – property, plant and equipment

IFRS permits or requires some assets to be revalued to fair value, eg, property, plant and equipment
under IAS 16 Property, Plant and Equipment.
Temporary difference
In some jurisdictions a revaluation will affect taxable profit in the current period. In this case, no
temporary difference arises, as both carrying value and the tax base are adjusted.
In other jurisdictions, including the UK, the revaluation does not affect taxable profits in the period of
revaluation and consequently, the tax base of the asset is not adjusted. Hence a temporary difference arises.
Income taxes 1187

This should be provided for in full based on the difference between carrying amount and tax base.
An upward revaluation will therefore give rise to a deferred tax liability, even if:
 the entity does not intend to dispose of the asset; or
 tax due on any future gain can be deferred through rollover relief.
This is because the revalued amount will be recovered through use which will generate taxable income
in excess of the depreciation allowable for tax purposes in future periods.
Manner of recovery
The carrying amount of a revalued asset may be recovered:
 through sale
 through continued use
The manner of recovery may affect the tax rate applicable to the temporary difference and/or the tax
base of the asset. Interactive questions 2 and 3 within section 4.1.2 of this chapter provide illustrations
of this.
Recording deferred tax
As the underlying revaluation is recognised as other comprehensive income, so the deferred tax thereon
is also recognised as part of tax relating to other comprehensive income. The accounting entry is
therefore:
DEBIT Tax on other comprehensive income X
Non-depreciated revalued assets

SIC 21 Income Taxes – Recovery of Revalued Non-Depreciable Assets requires that deferred tax should be
recognised even where non-current assets are not depreciated (eg, land). This is because the carrying
value will ultimately be recovered on disposal.
Worked example: Revaluation

A building in the UK was acquired on 1 January 20X2 at a cost of £500,000. It has been depreciated at a
rate of 2% straight line and has also attracted tax allowances at a rate of 4% straight line. On
31 December 20X6, the building is revalued to £650,000. The tax rate is 30%.
Requirement
What are the deferred tax implications of the revaluation?
Solution
 The carrying amount of the building before the revaluation was £500,000 – (5 × 2% × £500,000) =
£450,000.
 The tax base of the building before the revaluation was £500,000 – (5 × 4% × £500,000) =
£400,000.
 The temporary difference of £50,000 would have resulted in a deferred tax liability of 30% ×
£50,000 = £15,000.
 As a result of the revaluation, the carrying amount of the building is increased to £650,000.
 The tax base does not change.
 The temporary difference therefore increases to £250,000 (£650,000 – £400,000), resulting in a
total deferred tax liability of 30% × £250,000 = £75,000.
 As a result of the revaluation, additional deferred tax of £60,000 must therefore be recognised.
 This could also be calculated by applying the tax rate to the difference between carrying amount of
£450,000 and valuation of £650,000.

6.1.5 Revaluations to fair value – other assets
IFRSs permit or require certain other assets to be revalued to fair value, for example:
 Certain financial instruments under IAS 39 Financial Instruments: Recognition and Measurement
 Investment properties under IAS 40 Investment Property
Where the revaluation is recognised in profit or loss (eg, fair value through profit or loss instruments,
investment properties) and the amount is taxable/allowable for tax, then no deferred tax arises as both
the carrying value and the tax base are adjusted.
Where the revaluation is recognised as other comprehensive income (eg, available-for-sale
instruments) and does not therefore impact taxable profits, then the tax base of the asset is not adjusted
and deferred tax arises. This deferred tax is also recognised as other comprehensive income.
C
6.1.6 Retirement benefit costs H
A
In the financial statements, retirement benefit costs are deducted from accounting profit as the service P
is provided by the employee. They are not deducted in determining taxable profit until the entity T
pays either retirement benefits or contributions to a fund. Thus a temporary difference may arise. E
R
(a) A deductible temporary difference arises between the carrying amount of the net defined benefit
liability and its tax base. The tax base is usually nil.
(b) The deductible temporary difference will normally reverse. 22
(c) A deferred tax asset is recognised for this temporary difference to the extent that it is recoverable;
that is, sufficient profit will be available against which the deductible temporary difference can be
used.
(d) If there is a net defined benefit asset, for example when there is a surplus in the pension plan, a
taxable temporary difference arises and a deferred tax liability is recognised.
Under IAS 12, both current and deferred tax must be recognised outside profit or loss if the tax relates
to items that are recognised outside profit or loss. This could make things complicated as it interacts
with IAS 19 Employee Benefits.
IAS 19 (revised) requires recognition of remeasurement (actuarial) gains and losses in other
comprehensive income in the period in which they occur.
It may be difficult to determine the amount of current and deferred tax that relates to items recognised
in profit or loss or in other comprehensive income. As an approximation, current and deferred tax are
allocated on an appropriate basis, often pro rata.
Illustration 1: Defined benefit asset with a remeasurement loss

Defined Current Deferred
benefit tax relief tax liability
asset (28%) (28%)
£'000 £'000 £'000
Brought forward 1,000 – (280)
Contributions 600 (168) –
Profit or loss: net pension cost (500) 140 –
OCI: actuarial loss (200) 28 28
(700) 168 28
Carried forward 900 – 252
Income taxes 1189

Illustration 2: Defined benefit liability with a remeasurement loss
Defined Current Deferred
benefit tax relief tax asset
liability (28%) (28%)
£'000 £'000 £'000
Brought forward (2,000) – 560
Contributions 1,200 (336) –
Profit or loss: net pension cost (1,000) 280 –
OCI: actuarial loss (400) 56 56
(1,400) 336 56
Carried forward (2,200) – 616
Worked example: Deferred tax and retirement benefits

Note: Look back to Chapter 18 on employee benefits to refresh your memory of how to account for
pensions. In this example we look at how employee benefits and deferred tax interact.
Operating expenses in the draft accounts for Celia include £405,000 relating to the company's defined
benefit pension scheme. This figure represents the contributions paid into the scheme in the year. No
other entries have been made relating to this scheme. The figures included on the draft statement of
financial position represent opening balances as at 1 October 20X5:
£
Pension scheme assets 2,160,000
Pension scheme liabilities (2,530,000)
(370,000)
Deferred tax asset 121,000
(249,000)
After the year end, a report was obtained from an independent actuary. This gave valuations as at
30 September 20X6 of:
£
Pension scheme assets 2,090,200
Pension scheme liabilities (2,625,000)
Other information in the report included:

Yield on high-quality corporate bonds 10%
Current service cost £374,000
Payment out of scheme relating to employees transferring out £400,000
Reduction in liability relating to transfers £350,000
Pensions paid £220,000
All receipts and payments into and out of the scheme can be assumed to have occurred on
30 September 20X6.
Celia recognises any gains and losses on remeasurement of defined benefit pension plans directly in
other comprehensive income in accordance with IAS 19 (revised 2011).
In the tax regime in which Celia operates, a tax deduction is allowed on payment of pension benefits.
No tax deduction is allowed for contributions made to the scheme. Assume that the rate of tax
applicable to 20X5, 20X6 and announced for 20X7 is 30%.
Requirements
(a) Explain how each of the above transactions should be treated in the financial statements for the
year ended 30 September 20X6.
(b) Prepare an extract from the statement of profit or loss and other comprehensive income showing
other comprehensive income for the year ended 30 September 20X6.

Solution
Pensions
(a) The contributions paid have been charged to profit or loss in contravention of IAS 19 Employee
Benefits.
Under IAS 19, the following must be done:
 Actuarial valuations of assets and liabilities revised at the year end
 All gains and losses recognised
In profit or loss – Current service cost
– Transfers
– Net interest on net defined benefit liability
C
In other comprehensive income – Remeasurement gains and losses H
A
Deferred tax must also be recognised. The deferred tax is calculated as the difference between the P
IAS 19 net defined benefit liability less its tax base (ie, nil, as no tax deduction is allowed until the T
pension payments are made). IAS 12 Income Taxes requires deferred tax relating to items charged E
or credited to other comprehensive income (OCI) to be recognised in other comprehensive income R
hence the amount of the deferred tax movement relating to the losses on remeasurement charged
directly to OCI must be split out and credited directly to OCI.
22
(b) Amounts recognised in other comprehensive income (extract)
£
Actuarial loss on defined benefit obligation (W1) (38,000)
Return on plan assets (excluding amounts in net interest) (W1) (70,800)
(108,800)
Deferred tax credit relating to actuarial losses on defined benefit plan (W2) 32,640
Other comprehensive income for the year (76,160)
WORKINGS
(1) Pension scheme
Pension Pension
scheme scheme
assets liabilities
£ £
At 1 October 20X5 2,160,000 2,530,000
Interest cost on obligation (10%  2,530,000) 253,000
Interest on plan assets (10%  2,160,000) 216,000
Contributions 405,000
Transfers (400,000) (350,000)
Pensions paid (220,000) (220,000)
Loss on remeasurement recognised in OCI (70,800) 38,000
At 30 September 20X6 2,090,200 2,625,000
(2) Deferred tax on pension liability

Net pension liability (2,625,000 – 2,090,200) (534,800)
Tax base (no deduction until benefits paid) (0)
(534,800)
Deferred tax asset @ 30% 160,440

Deferred tax asset b/f (121,000)
39,400
Credited to OCI re losses ((70,800 + 38,000) × 30%) (32,640)
Credit to profit or loss for the year 6,800
Income taxes 1191

6.1.7 Dividends receivable from UK and overseas companies
(a) Dividends received from UK and overseas companies are not taxable on UK companies.
(b) Overseas dividends are thus a permanent difference and so there is no deferred tax payable.
(Previously dividends received by a UK company from an overseas company were taxable and
hence were a temporary difference.)
6.2 Deductible temporary differences

6.2.1 Tax losses
Where tax losses arise, for example in the UK as trading losses or non-trading loan relationship deficits,
then the manner of recognition of these in the financial statements depends on how they are expected
to be used.
(a) If losses are carried back to crystallise a refund, then a receivable is recorded in the statement of
financial position and the corresponding credit is to the current tax charge.
(b) If losses are carried forward to be used against future profits or gains, then they should be
recognised as deferred tax assets to the extent that it is probable that future taxable profit will be
available against which the losses can be used.
Unused tax credits carried forward against taxable profits will also give rise to a deferred tax asset to the
extent that profits will exist against which they can be used.
Recognition of deferred tax asset
The existence of unused tax losses is strong evidence that future taxable profit may not be available.
The following should be considered before recognising any deferred tax asset:
 Whether an entity has sufficient taxable temporary differences against which the unused tax losses
can be offset
 Whether it is probable that the entity will have taxable profits before the unused tax losses expire
 Whether the tax losses result from identifiable causes which are unlikely to recur
 Whether tax planning opportunities are available to create taxable profit
Group tax relief
Where the acquisition of a subsidiary means that tax losses which previously could not be used can now
be used against the profits of the subsidiary, a deferred tax asset may be recognised in the financial
statements of the parent company. This amount is not taken into account in calculating goodwill arising
on acquisition.
6.2.2 Provisions
 A provision is recognised for accounting purposes when there is a present obligation, but it is not
deductible for tax purposes until the expenditure is incurred.
 In this case, the temporary difference is equal to the amount of the provision, since the tax base is
nil.
 Deferred tax is recognised in profit or loss.
6.2.3 Share-based payments

Share-based transactions may be tax deductible in some jurisdictions. However, the amount deductible
for tax purposes does not always correspond to the amount that is charged to profit or loss under
IFRS 2.
In most cases it is not just the amount but also the timing of the expense allowable for tax purposes that
will differ from that required by IFRS 2.
For example, an entity recognises an expense for share options granted under IFRS 2, but does not
receive a tax deduction until the options are exercised. The tax deduction will be based on the share
price on the exercise date and will be measured on the basis of the options' intrinsic value ie, the
difference between market price and exercise price at the exercise date. In the case of share-based
employee benefits under IFRS 2, the cost of the services as reflected in the financial statements is
expensed and therefore the carrying amount is nil.

The difference between the carrying amount of nil and the tax base of share-based payment expense
received to date is a deferred tax asset, provided the entity has sufficient future taxable profits to use this
deferred tax asset.
The deferred tax asset temporary difference is measured as:
£
Carrying amount of share-based payment expense 0
Less tax base of share-based payment expense (X)
(estimated amount tax authorities will permit as a deduction in future
periods, based on year-end information)
Temporary difference (X)
Deferred tax asset at X%
C
If the amount of the tax deduction (or estimated future tax deduction) exceeds the amount of the H
related cumulative remuneration expense, this indicates that the tax deduction also relates to an equity A
item. P
T
The excess is therefore recognised directly in equity. The diagrams below show the accounting for E
equity-settled and cash-settled transactions. R
Equity-settled transaction
22
Estimated
future
tax
deduction
Greater Smaller
than than
Cumulative Cumulative
remuneration remuneration
expense expense
The tax benefit The excess over The tax

is recorded in the cumulative benefit is
profit or loss expense recorded
up to the amount is recorded in profit
of the cumulative in equity or loss
expense
Cash-settled transaction
Estimated All
future Recorded in
tax profit or loss
deduction
Income taxes 1193

Worked example: Deferred tax
On 1 January 20X2, an entity granted 5,000 share options to an employee vesting two years later on
31 December 20X3. The fair value of each option measured at the grant date was £3.
Tax law in the jurisdiction in which the entity operates allows a tax deduction of the intrinsic value of
the options on exercise. The intrinsic value of the share options was £1.20 at 31 December 20X2 and
£3.40 at 31 December 20X3, on which date the options were exercised.
Assume a tax rate of 30%.
Requirement
Show the deferred tax accounting treatment of the above transaction at 31 December 20X2,
31 December 20X3 (before exercise), and on exercise.
Solution
31 Dec 20X3
31 Dec 20X2 before exercise
£ £
Carrying amount of share-based payment expense 0 0
Less tax base of share-based payment expense (3,000) (17,000)
(5,000  £1.2 ÷ 2)/(5,000  £3.40)
Temporary difference (3,000) (17,000)
Deferred tax asset @ 30% 900 5,100
Deferred tax (Cr profit) (5,100 – 900 – (Working) 600) 900 3,600
Deferred tax (Cr Equity) (Working) 0 600
On exercise, the deferred tax asset is replaced by a current tax asset.
The double entry is: £
DEBIT deferred tax (profit) 4,500
DEBIT deferred tax (equity) 600 reversal
CREDIT deferred tax asset 5,100
DEBIT current tax asset 5,100
CREDIT current tax (profit) 4,500
CREDIT current tax (equity) 600
WORKING £ £
Accounting expense recognised (5,000  £3 ÷ 2)/(5,000  £3) 7,500 15,000
Tax deduction (3,000) (17,000)
Excess temporary difference 0 (2,000)
Excess deferred tax asset to equity @ 30% 0 600
Interactive question 5: Share option scheme and deferred tax

Frost plc has the following share option scheme at 31 May 20X7:
Fair value
of options
Director's Options at grant Exercise Vesting
name Grant date granted date price date
£ £
Edmund 1 June 20X5 40,000 3.00 4.00 6/20X7
Houston
Kieran Bullen 1 June 20X6 120,000 2.50 5.00 6/20X9
The price of the company's shares at 31 May 20X7 is £8 per share and at 31 May 20X6 was £8.50 per
share.
The directors must be working for Frost on the vesting date in order for the options to vest.
No directors have left the company since the issue of the share options and none are expected to leave
before June 20X9. The shares can be exercised on the first day of the month in which they vest.

In accordance with IFRS 2 an expense of £60,000 has been charged to profits in the year ended
31 May 20X6 in respect of the share option scheme. The cumulative expense for the two years ended
31 May 20X7 is £220,000.
Tax allowances arise when the options are exercised and the tax allowance is based on the option's
intrinsic value at the exercise date.
Requirement
What are the deferred tax implications of the share option scheme?
C
H
6.2.4 Recognition of deferred tax assets for unrealised losses A
P
This amendment was issued in January 2016 in order to clarify when a deferred tax asset should be T
recognised for unrealised losses. For example, an entity holds a debt instrument that is falling in value, E
without a corresponding tax deduction, but the entity knows that it will receive the full nominal amount R
on the due date, and there will be no tax consequences of that repayment. The question arises of
whether to recognise a deferred tax asset on this unrealised loss.
22
The IASB clarified that unrealised losses on debt instruments measured at fair value and measured
at cost for tax purposes give rise to a deductible temporary difference regardless of whether the
debt instrument's holder expects to recover the carrying amount of the debt instrument by sale or by
use.
This may seem to contradict the key requirement that an entity recognises deferred tax assets only if it is
probable that it will have future taxable profits. However, the amendment also addresses the issue of
what constitutes future taxable profits, and clarifies the following:
(a) The carrying amount of an asset does not limit the estimation of probable future taxable profits.
(b) Estimates for future taxable profits exclude tax deductions resulting from the reversal of deductible
(c) An entity assesses a deferred tax asset in combination with other deferred tax assets. Where tax law
restricts the utilisation of tax losses, an entity would assess a deferred tax asset in combination with
other deferred tax assets of the same type.
The amendment is effective from January 2017.
Worked example: Deferred tax asset and unrealised losses

(Adapted from IAS 12, Illustrative Example 7)
Humbert owns a debt instrument with a nominal value of £2,000,000. The fair value of the financial
instrument at the company's year end of 30 June 20X4 is £1,800,000. Humbert has determined that
there is a deductible temporary difference of £200,000. Humbert intends to hold the instrument until
maturity on 30 June 20X5, and expects that the £2,000,000 will be paid in full. This means that the
deductible temporary difference will reverse in full.
Humbert has, in addition, £60,000 of taxable temporary differences that will also reverse in full in 20X5.
The company expects the bottom line of its tax return to show a tax loss of £40,000.
Requirement
Discuss, with calculations, whether Humbert can recognise a deferred tax asset under IAS 12 Income
Taxes.
Income taxes 1195

Solution
The first stage is to use the reversal of the taxable temporary difference to arrive at the amount to be
tested for recognition.
Under IAS 12 Humbert will consider whether it has a tax liability from a taxable temporary difference
that will support the recognition of the tax asset:
£'000
Deductible temporary difference 200
Reversing taxable temporary difference (60)
Remaining amount (recognition to be determined) 140
At least £60,000 may be recognised as a deferred tax asset.

The next stage is to calculate the future taxable profit. Following the amendment, this is done using a
formula, the aim of which is to derive the amount of tax profit or loss before the reversal of any
temporary difference:
£'000
Expected tax loss (per bottom line of tax return) (40)
Less reversing taxable temporary difference (60)
Add reversing deductible temporary difference 200
Taxable profit for recognition test 100
Finally, the results of the above two steps should be added, and the tax calculated:
Humbert would recognise a deferred tax asset of (£60,000 + £100,000) × 20% = £32,000. This deferred
tax asset would be recognised even though the company has an expected loss on its tax return.
7 Group scenarios
Section overview
 In relation to business combinations and consolidations, IAS 12 gives examples of circumstances
that give rise to taxable temporary differences and to deductible temporary differences in an
appendix.
 As already mentioned, however, the initial recognition of goodwill has no deferred tax impact.
7.1 Taxable temporary differences

7.1.1 Fair value adjustments on consolidation
IFRS 3 Business Combinations requires assets acquired on acquisition of a subsidiary to be recognised at
their fair value rather than their carrying amount in the individual financial statements of the subsidiary.
The fair value adjustment does not, however, have any impact on taxable profits or the tax base of the
asset. This is much like a revaluation in an individual company's accounts.
Therefore an upwards fair value adjustment made to an asset will result in the carrying value of the asset
exceeding the tax base and so a taxable temporary difference will arise.
The resulting deferred tax liability is recorded in the consolidated accounts by:
DEBIT Goodwill (group share) X
Worked example: Fair value adjustments

On 1 September 20X8, Hunt acquired 80% of the ordinary share capital of Harrison for consideration
totalling £150,000. At the date of acquisition, Harrison's statement of financial position showed net

assets of £180,000, although the fair value of inventory was assessed to be £10,000 above its carrying
amount.
Requirement
Explain the deferred tax implications, assuming a tax rate of 30%.
Solution
 The carrying amount of the inventory in the group accounts is £10,000 more than its tax base
(being carrying amount in Harrison's own accounts).
 Deferred tax on this temporary difference is 30% × £10,000 = £3,000.
 A deferred tax liability of £3,000 is recognised in the group statement of financial position.
C
 Goodwill is increased by (£3,000  80%) = £2,400. H
A
P
T
E
7.1.2 Undistributed profits of subsidiaries, branches, associates and joint ventures R
(a) The carrying amount of, for example, a subsidiary in consolidated financial statements is equal to
the group share of the net assets of the subsidiary plus purchased goodwill.
22
(b) The tax base is usually equal to the cost of the investment.
(c) The difference between these two amounts is a temporary difference. It can be calculated as the
parent's share of the subsidiary's post-acquisition profits which have not been distributed.
Worked example: Temporary difference in subsidiary holding

Askwith purchased 80% of the ordinary share capital of Embsay for £110,000 when the net assets of
Embsay were £100,000, giving rise to goodwill of £30,000. At 31 December 20X6 the following is
relevant:
(1) Goodwill has not been impaired.
(2) The net assets of Embsay amount to £120,000.
Requirement
What temporary difference arises on this investment at 31 December 20X6?
Solution
 The tax base of the investment in Embsay is the cost of £110,000. The carrying value is the share of
net assets (80% × £120,000) + goodwill of £30,000 = £126,000.
 The temporary difference is therefore £126,000 – £110,000 = £16,000.
 This is equal to the group share of post-acquisition profits: 80% × £20,000 change in net assets
since acquisition.
Recognition of deferred tax

A deferred tax liability should be recognised on the temporary difference unless:
 the parent/investor/venturer is able to control the timing of the reversal of the temporary
difference; and
 it is probable that the temporary difference will not reverse (ie, the profits will not be paid out) in
the foreseeable future.
This can be applied to different levels of investment as follows:
(a) Subsidiary
As a parent company can control the dividend policy of a subsidiary, deferred tax will not arise in
relation to undistributed profits.
Income taxes 1197

(b) Associate
An investor in an associate does not control that entity and so cannot determine its dividend
policy. Without an agreement requiring that the profits of the associate should not be distributed
in the foreseeable future, therefore, an investor should recognise a deferred tax liability arising from
taxable temporary differences associated with its investment in the associate. Where an investor
cannot determine the exact amount of tax, but only a minimum amount, then the deferred tax
liability should be that amount.
(c) Joint venture
In a joint venture, the agreement between the parties usually deals with profit sharing. When a
venturer can control the sharing of profits and it is probable that the profits will not be distributed
in the foreseeable future, a deferred liability is not recognised.
7.1.3 Changes in foreign exchange rates

Where a foreign operation's taxable profit or tax loss (and therefore the tax base of its non-monetary assets
and liabilities) is determined in a foreign currency, changes in the exchange rate give rise to taxable or
deductible temporary differences.
These relate to the foreign entity's own assets and liabilities, rather than to the reporting entity's
investment in that foreign operation, and so the reporting entity should recognise the resulting deferred
tax liability or asset. The resulting deferred tax is charged or credited to profit or loss.
However, a deferred tax asset should only be recognised to the extent that both these are probable:
(a) That the temporary difference will reverse in the foreseeable future
(b) That taxable profit will be available against which the temporary difference can be used
7.2 Deductible temporary differences

7.2.1 Unrealised profits on intra-group trading
(a) From a tax perspective, one group company selling goods to another group company is taxed on
the resulting profit in the period that the sale is made.
(b) From an accounting perspective no profit is realised until the recipient group company sells the
goods to a third party outside the group. This may occur in a different accounting period from that
in which the initial group sale is made.
(c) A temporary difference therefore arises equal to the amount of unrealised intra-group profit. This is
the difference between the following:
(i) Tax base, being cost to the recipient company (ie, cost to selling company plus unrealised
intra-group profit on sale to the recipient company)
(ii) Carrying value to the group, being the original cost to the selling company, since the intra-
group profit is eliminated on consolidation
(d) Deferred tax is provided at the receiving company's tax rate.
7.2.2 Fair value adjustments

IFRS 3 requires assets and liabilities acquired on acquisition of a subsidiary to be brought in at their fair
value rather than the carrying amount. The fair value adjustment does not, however, have any impact
on taxable profits or the tax base of the asset.
Therefore a fair value adjustment which increases a recognised liability or creates a new liability will
result in the tax base of the liability exceeding the carrying value and so a deductible temporary
difference will arise.
A deductible temporary difference also arises where an asset's carrying amount is reduced to a fair value
less than its tax base.
The resulting deferred tax asset is recorded in the consolidated accounts by:
DEBIT Deferred tax asset X
CREDIT Goodwill X

7.3 Deferred tax assets of an acquired subsidiary
Deferred tax assets of a subsidiary may not satisfy the criteria for recognition when a business
combination is initially accounted for but may be realised subsequently.
These should be recognised as follows:
(a) If recognised within 12 months of the acquisition date and resulting from new information about
circumstances existing at the acquisition date, the credit entry should be made to goodwill. If the
carrying amount of goodwill is reduced to zero, any further amounts should be recognised in profit
or loss.
(b) If recognised outside the 12-month 'measurement period' or not resulting from new information
about circumstances existing at the acquisition date, the credit entry should be made to profit or
loss.
C
H
A
Interactive question 6: Recognition P
In 20X2 Jacko Co acquired a subsidiary, Jilly Co, which had deductible temporary differences of T
E
£3 million. The tax rate at the date of acquisition was 30%. The resulting deferred tax asset of R
£0.9 million was not recognised as an identifiable asset in determining the goodwill of £5 million
resulting from the business combination. Two years after the acquisition, Jacko Co decided that future
taxable profit would probably be sufficient for the entity to recover the benefit of all the deductible 22
Requirement
State the accounting treatment of the recognition of the deferred tax asset in 20X4.
Interactive question 7: Fair value adjustment

Oscar acquired 80% of the ordinary shares in Dorian Limited (Dorian) on 1 July 2005.
At acquisition, a property owned and occupied by Dorian had a fair value £30 million in excess of its
carrying value. This property had a remaining useful life at that time of 20 years.
Oscar is preparing its financial statements as at 30 June 2015.
The tax rate in the jurisdiction in which Oscar operates is 16%.
Requirements
(a) How should this fair value difference be recorded in the consolidated financial statements at
30 June 2015?
(b) What is the deferred tax implication of the fair value adjustment?
Worked example: Deferred tax and groups 1

In recent years, Morpeth Ltd has made the following acquisitions of other companies:
 On 1 January 20X6, it acquired 90% of the share capital of Skipton, resulting in goodwill of
£1.4 million.
 On 1 July 20X6 it acquired the whole of the share capital of Bingley for £6 million. At this date the
fair value of the net assets of Bingley was £4.5 million and their tax base was £4 million.
Income taxes 1199

The following information is relevant to Morpeth Group's year ended 31 December 20X6:
Skipton
(a) Skipton has made a provision amounting to £1.8 million in its accounts in respect of litigation. This
is tax allowable only when the cost is actually incurred. The case is expected to be settled within
12 months.
(b) Skipton has a number of investments classified as at fair value through profit or loss in accordance
with IAS 39 Financial Instruments: Recognition and Measurement. The remeasurement gains and
losses recognised in profit or loss for accounting purposes are not taxable/tax allowable until such
date as the investments are sold. To date the cumulative unrealised gain is £2.5 million.
(c) Skipton has sold goods to Morpeth in the year making a profit of £1 million. A quarter of these
goods remain in Morpeth's inventory at the year end.
Bingley
(a) At its acquisition date, Bingley had unrelieved brought-forward tax losses of £0.4 million. It was
initially believed that Bingley would have sufficient taxable profits to use these losses and a deferred
tax asset was recognised in Bingley's financial statements at acquisition. Subsequent events have
proven that the future taxable profits will not be sufficient to use the full brought-forward loss.
(b) At acquisition Bingley's retained earnings amounted to £3.5 million. The directors of Morpeth
Group have decided that in each of the next four years to the intended listing date of the group,
they will realise earnings through dividend payments from the subsidiary amounting to £600,000
per annum. Bingley has not declared a dividend for the current year. Tax is payable on remittance
of dividends.
(c) £300,000 of the purchase price of Bingley has been allocated to intangible assets. The recognition
and measurement criteria of IFRS 3 and IAS 38 do not appear to have been met; however, the
directors believe that the amount is allowable for tax and have calculated the tax charge
accordingly. It is believed that this may be challenged by the tax authorities.
Requirement
What are the deferred tax implications of the above issues for the Morpeth Group?
Solution
Acquisitions
Any fair value adjustments made for consolidation purposes will affect the group deferred tax charge for
the year.
A taxable temporary difference will arise where the fair value of an asset exceeds its carrying value, and
the resulting deferred tax liability should be recorded against goodwill.
A deductible temporary difference will arise where the fair value of a liability exceeds its carrying value,
or an asset is revalued downwards. Again the resulting deferred tax amount (an asset) should be
recognised in goodwill.
In addition, it may be possible to recognised deferred tax assets in a group which could not be
recognised by an individual company. This is the case where tax losses brought forward, but not
considered to be an asset, due to lack of available taxable profits to set them against, can now be used
by another group company.
Goodwill
Goodwill arose on both acquisitions. According to IAS 12, however, no provision should be made for
the temporary difference arising on this.
Skipton
(a) A deductible temporary difference arises when the provision is first recognised. This results in a
deferred tax asset calculated as £540,000 (30% × £1.8m). The asset may, however, only be
recognised where it is probable that there will be future taxable profits against which the future
tax-allowable expense may be set. There is no indication that this is not the case for Skipton.

(b) A taxable temporary difference arises where investments are revalued upwards for accounting
purposes but the uplift is not taxable until disposal. In this case the carrying value of the
investments has increased by £2.5 million, and this has been recognised in profit or loss. The tax
base has not, however changed. Therefore, a deferred tax liability should be recognised on the
£2.5 million, and, in line with the recognition of the underlying revaluation, this should be
(c) This intra-group transaction results in unrealised profits of £250,000 which will be eliminated on
consolidation. The tax on this £250,000 will, however, be included within the group tax charge
(which is comprised of the sum of the individual group companies' tax charges). From the
perspective of the group there is a temporary difference. Deferred tax should be provided on this
difference using the tax rate of Morpeth (the recipient company).
Bingley
C
(a) Unrelieved tax losses give rise to a deferred tax asset only where the losses are regarded as H
A
recoverable. They should be regarded as recoverable only where it is probable that there will be
P
future taxable profits against which they may be used. It is indicated that the future profits of T
Bingley will not be sufficient to realise all of the brought-forward loss, and therefore the deferred E
tax asset is calculated only on that amount expected to be recovered. R
(b) Deferred tax is recognised on the unremitted earnings of investments, except where:
(i) The parent is able to control the payment of dividends 22
(ii) It is unlikely that the earnings will be paid out in the foreseeable future
Morpeth controls Bingley and is therefore able to control its dividend payments; however, it is
indicated that £2.4 million will be paid as dividends in the next four years. Therefore a deferred tax
liability related to this amount should be recognised.
(c) The directors have assumed that the £300,000 relating to intangible assets will be tax allowable,
and the tax provision has been calculated based on this assumption. However, this is not certain,
and extra tax may have to be paid if this amount is not allowable. Therefore a liability for the
additional tax amount should be recognised.
Interactive question 8: Intangible

Jenner Holdings (Jenner) operates in the recruitment industry. On 1 February 20X0, Jenner acquired
60% of Rannon. It is now 31 March 20X4, and the consolidated financial statements of Jenner are being
prepared.
On the date of acquisition, £40,800,000 of the purchase consideration was allocated to the domain
name 'www.alphabettajob.com' which Rannon had registered some years earlier.
www.alphabettajob.com is well known in the recruitment industry and a popular job search website and
as a result Jenner was able to establish a fair value using an income-based valuation method. The
domain name is not recognised in Rannon's individual financial statements and has a tax base of nil.
The Jenner Group amortises acquired domain names over 10 years. The tax rate applicable to the profits
of both companies is 17%.
Requirement
Prepare journals and explanations to show how this domain name should be treated in the consolidated
financial statements of the Jenner Group as at 31 March 20X4.
Interactive question 9: Deferred tax and groups

Menston, a limited company, has two wholly owned subsidiaries, Burley, another UK company and
Rhydding, which is located in Estomania. The following information is relevant to the year ended
31 August 20X8:
(a) Rhydding has made a tax-adjusted loss equivalent to £6.5 million. This loss can only be relieved
through carry forward against future profits of Rhydding.
Income taxes 1201

(b) During the year Burley has sold goods to Menston for £12 million, based on a 20% mark-up. Half
of these goods are still in Menston's stock room at the year end.
Assume that the tax rate applicable to the group companies based in the UK is 30%; the Estomanian tax
rate is 20%.
Requirement
What are the deferred tax implications of these issues?
Interactive question 10: Deferred tax scenarios

Angelo, a public limited company, has three 100% owned subsidiaries, Claudio, Lucio and Escalus SA, a
foreign subsidiary.
(a) The following details relate to Claudio:
(i) Angelo acquired its interest in Claudio on 1 January 20X3. The fair values of the assets and
liabilities acquired were considered to be equal to their carrying amounts, with the exception
of freehold property which was considered to have a fair value of £1 million in excess of its
book value. The directors have no intention of selling the property.
(ii) Claudio has sold goods at a price of £6 million to Angelo since acquisition and made a profit
of £2 million on the transaction. The inventories of these goods recorded in Angelo's
statement of financial position at the year end, 30 September 20X3, were £3.6 million.
(b) Lucio undertakes various projects from debt factoring to investing in property and commodities.
The following details relate to Lucio for the year ended 30 September 20X3:
(i) Lucio has a portfolio of readily marketable government securities which are held as current
assets for financial trading purposes. These investments are stated at market value in the
statement of financial position with any gain or loss taken to profit or loss. These gains and
losses are taxed when the investments are sold. Currently the accumulated unrealised gains
are £8 million.
(ii) Lucio has calculated it requires an allowance for credit losses of £2 million against its total loan
portfolio. Tax relief is available when a specific loan is written off.
(c) Escalus SA has unremitted earnings of €20 million which would give rise to additional tax payable
of £2 million if remitted to Angelo's tax regime. Angelo intends to leave the earnings within Escalus
for reinvestment.
(d) Angelo has unrelieved trading losses as at 30 September 20X3 of £10 million.
Current tax is calculated based on the individual company's financial statements (adjusted for tax
purposes) in the tax regime in which Angelo operates. Assume an income tax rate of 30% for Angelo
and 25% for its subsidiaries.
Requirement
Explain the deferred tax implications of the above information for the Angelo group of companies for
the year ended 30 September 20X3.
Interactive question 11: Foreign branch

Investa has a foreign branch which has the same functional currency as Investa (the pound sterling). The
branch's taxable profits are determined in dinars. On 1 May 20X3, the branch acquired a property for
6 million dinars. The property had an expected useful life of 12 years with a zero residual value. The
asset is written off for tax purposes over eight years. The tax rate in Investa's jurisdiction is 30% and in

the branch's jurisdiction is 20%. The foreign branch uses the cost model for valuing its property and
measures the tax base at the exchange rate at the reporting date.
Investa would like an explanation (including a calculation) as to why a deferred tax charge relating to
the asset arises in the group financial statements for the year ended 30 April 20X4 and the impact on
the financial statements if the tax base had been translated at the historical rate.
The exchange rate was 5 dinars: £1 on 1 May 20X3 and 6 dinars: £1 on 30 April 20X4.
Requirement
Provide the explanation and calculation requested.
C
H
A
P
8 Presentation and disclosure T
E
R
Section overview
The detailed presentation and disclosure requirements for current and deferred tax are given below. 22
8.1 Disclosure requirements

The tax expense (income) related to profit (or loss) from ordinary activities should be presented on the
face of the statement of profit or loss and other comprehensive income.
The following are the main items that should be disclosed separately:
(a) Current tax expense (income)
(b) Any adjustments recognised in the period for current tax of prior periods
(c) The amount of deferred tax expense (income) relating to temporary differences
(d) The amount of deferred tax expense (income) relating to changes in tax rates or the imposition of
new taxes
(e) Prior period deferred tax or current tax adjustments
(f) The aggregate current and deferred tax relating to items that are charged or credited to equity
(g) An explanation of the relationship between tax expense (income) and accounting profit which can
be done in either (or both) of the following ways:
(i) A numerical reconciliation between tax expense and the product of accounting profit
multiplied by the applicable tax rate(s), disclosing also the basis on which the applicable tax
rate(s) is (are) computed
(ii) A numerical reconciliation between the average effective tax rate and the applicable tax rate,
disclosing also the basis on which the applicable tax rate is computed
(h) An explanation of changes in the applicable tax rate(s) compared to the previous accounting
period
(i) The amount of deductible temporary differences, unused tax losses and unused tax credits for
which no deferred tax asset is recognised in the statement of financial position
8.2 The statement of financial position

Tax assets and tax liabilities should be presented separately from other assets and liabilities in the
statement of financial position. Deferred tax assets and liabilities should be distinguished from current
tax assets and liabilities.
Income taxes 1203

Deferred tax assets (liabilities) should not be classified as current assets (liabilities). This is the case even
if the deferred tax assets/liabilities are expected to be realised within twelve months.
There is no requirement in IAS 12 to disclose the tax base of assets and liabilities on which deferred tax
has been calculated.
8.2.1 Offsetting
Where appropriate deferred tax assets and liabilities should be offset in the statement of financial
position.
An entity should offset deferred tax assets and deferred tax liabilities if, and only if:
 the entity has a legally enforceable right to set off current tax assets against current tax liabilities;
and
 the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same
taxation authority.
There is no requirement in IAS 12 to provide an explanation of assets and liabilities that have been
offset.
8.2.2 Other disclosures

An entity should disclose any tax-related contingent liabilities, and contingent assets, in accordance with
IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Contingent liabilities and contingent assets
may arise, for example, from unresolved disputes with the taxation authorities.
Similarly, where changes in tax rates or tax laws are enacted or announced after the reporting date, an
entity should disclose any significant effect of those changes on its current and deferred tax assets and
liabilities (see IAS 10 Events after the Reporting Period).
Interactive question 12: Tax adjustment

In the notes to the financial statements of Tacks for the year ended 30 November 20X2, the tax expense
included an amount in respect of 'Adjustments to current tax in respect of prior years' and this expense
has been treated as a prior year adjustment. These items related to adjustments arising from tax audits
by the authorities in relation to previous reporting periods.
The issues that resulted in the tax audit adjustment were not a breach of tax law but related
predominantly to transfer pricing issues, for which there was a range of possible outcomes that were
negotiated during 20X2 with the taxation authorities. Further at 30 November 20X1, Tacks had
accounted for all known issues arising from the audits to that date and the tax adjustment could not
have been foreseen as at 30 November 20X1, as the audit authorities changed the scope of the audit.
No penalties were expected to be applied by the taxation authorities.
Requirement
What is the correct treatment of the above issue in the financial statements for the year ended
30 November 20X2?

9 Deferred tax summary and practice
Section overview
 The calculation and recording of deferred tax can be set out in an eight-step process.
 Deferred tax at Advanced Level will be much more demanding than at Professional Level.
9.1 Summary
The following is a summary of the steps required to calculate and record deferred tax in the financial
statements. C
H
Procedure Comment A
P
Step 1 Determine the carrying amount of each asset and This is merely the carrying value T
E
liability in the statement of financial position. determined by other standards.
R
Step 2 Determine the tax base of each asset and This is the amount attributed to each asset
liability. or liability for tax purposes.
22
Step 3 Determine any temporary differences (these are These will be either:
based on the difference between the figures in  Taxable temporary differences; or
Step 1 and Step 2).  Deductible temporary differences.
Step 4 Determine the deferred tax balance by The tax rate to be used is that expected to
multiplying the tax rate by any temporary apply when the asset is realised or the
differences. liability settled, based on laws already
enacted or substantively enacted by the
statement of financial position date.
Step 5 Recognise deferred tax assets/liabilities in the Apply recognition criteria in IAS 12.
Step 6 Recognise deferred tax, normally in profit or loss This will be the difference between the
(but possibly as other comprehensive income or in opening and closing deferred tax balances in
equity or goodwill). the statement of financial position.
Step 7 Offset deferred tax assets and liabilities in the Offset criteria in IAS 12 must be satisfied.
statement of financial position where appropriate.
Step 8 Comply with relevant presentation and disclosure See relevant presentation and disclosure
requirements for deferred tax in IAS 12. requirements sections above.
The method described is referred to as the liability method, or full provision method.
(a) The advantage of this method is that it recognises that each temporary difference at the reporting
date has an effect on future tax payments, and these are provided for in full.
(b) The disadvantage of this method is that, under certain types of tax system, it gives rise to large
liabilities that may fall due only far in the future.
9.2 Exam-standard question practice

While UK tax is not specifically examinable at Advanced Level, deferred tax is still an important topic,
and will be tested in much more demanding questions than those encountered at Professional Level.
The interactive question below is exam-standard and, in addition to testing deferred tax in depth, also
tests foreign currency translation of a non-monetary asset and impairment of a previously revalued
asset, a financial instrument and a provision. Finally it asks for a re-draft of a statement of financial
position following adjustments, which is a typical feature of Question 2 of the Corporate Reporting
exam.
Income taxes 1205

Interactive question 13: Comprehensive question
You are Richard Carpenter, a newly-qualified ICAEW Chartered Accountant, working in the finance
department at Chippy plc, a sportswear company with a number of subsidiaries in the UK and overseas.
On 1 October 20X2, Chippy acquired 100% of the ordinary shares of Marusa Inc, a sportswear
company based in Ruritania. The national currency of Ruritania is the krown (Kr).
You receive the following email from Ying Cha, the finance director of Chippy:
To: Richard Carpenter
From: Ying Cha
Date: 4 November 20X3
Subject: Marusa financial statements for the year ended 30 September 20X3
Richard,
Marusa's finance director, Sian Parsons, has provided a draft statement of financial position which has
been prepared using Ruritanian GAAP (Exhibit 1). This needs to be restated using IFRS before we
consolidate Marusa's results. Marusa achieved break-even for the year and the company has no current
tax liability.
Sian has also prepared some notes (Exhibit 2) that detail key transactions for the year ended
30 September 20X3.
There is no deferred tax under Ruritanian GAAP, but I am particularly concerned about the deferred tax
implications of some of the key transactions under IFRS.
I would like you to do the following:
 For each of the key transactions (Exhibit 2):
– Explain any adjustments which need to be made to ensure that Marusa's financial statements
comply with IFRS
– Prepare the journal entries needed to adjust Marusa's financial statements to IFRS
 Prepare a revised statement of financial position for Marusa at 30 September 20X3 in accordance
with IFRS, showing all workings clearly.
Please prepare your figures to the nearest Kr'000.
Exhibit 1 – Marusa - Draft statement of financial position at 30 September 20X3
Kr'000
Non-current assets
Property, plant & equipment 61,600
Intangible assets 8,500
Financial investments 7,700
77,800
101,500
Equity
Share capital Kr1 shares 10,000
Revaluation surplus 16,800
69,400
Loans 10,000
Provisions 15,000
101,500

Exhibit 2 – Notes prepared by Sian Parsons: Key transactions in the year ended 30 September
20X3
1 Purchase of machinery
On 1 January 20X3 Marusa bought some specialist machinery from the USA for $30 million.
Payment for the machinery was made on 31 March 20X3.
In accordance with local Ruritanian GAAP, I recognised the cost of the machinery on 1 January
20X3 at Kr10 million, using the opening rate of exchange at 1 October 20X2.
I have charged a full year's depreciation of Kr1.0 million in cost of sales, as Marusa depreciates the
machinery over a ten-year life and it has no residual value. I have therefore included the machinery
in the statement of financial position at Kr9 million.
An amount of Kr2.5 million has been debited to retained earnings. This is in respect of the C
difference between the sum paid to the supplier of Kr12.5 million on 31 March 20X3 and the cost H
recorded in non-current assets of Kr10 million. A
P
The Kr/US$ exchange rates on relevant dates were: T
E
1 Kr = R
1 October 20X2 $3.00
1 January 20X3 $2.50
22
31 March 20X3 $2.40
30 September 20X3 $2.00
In Ruritania the tax treatment of property, plant and equipment and exchange differences is the
same as the IFRS treatment.
2 Impairment
Marusa bought a warehouse on 1 October 20W3 for Kr36 million. The warehouse is being
depreciated over 20 years with no residual value. On 1 October 20X2, due to a rise in property
prices, the warehouse was revalued to Kr42 million and a revaluation surplus of Kr16.8 million was
recognised. No transfers are made between the revaluation surplus and retained earnings under
Ruritanian GAAP in respect of depreciation.
There has been a slump in the local property market recently, so an impairment review was
undertaken at 30 September 20X3, and the warehouse was assessed as being worth Kr12 million.
I have therefore charged Kr18 million to profit or loss to reflect the difference between the carrying
amount of the warehouse of Kr30 million before 30 September 20X3 and the new value of
Kr12 million.
3 Investment
On 1 April 20X3, Marusa bought one million shares in a local listed company for Kr7.70 per share.
This represents a 3% shareholding. The intention is to hold the shares until 31 December 20X3,
and then sell them at a profit. I have recognised the shares at cost in the statement of financial
position in accordance with Ruritanian GAAP. The market value of the shares at 30 September
20X3 was Kr12.50 per share.
Under Ruritanian tax rules, income tax is charged at 20% on the accounting profit recognised on
the sale of the investment.
4 Provision
On 1 October 20X2, Marusa signed an agreement with the Ruritanian government for exclusive
rights for the next 20 years to the organic cotton grown on government-owned land. The cost of
buying these rights was Kr8.5 million, which has been recognised in intangible assets in Marusa's
statement of financial position. Under the terms of the rights agreement, Marusa has to repair any
environmental damage at the end of the 20-year period.
There is a 40% probability of the eventual cost of environmental repairs being Kr15 million and a
60% probability of the cost being Kr10 million. To be prudent I have created a provision for
Kr15 million, and debited this to operating costs. Marusa has a pre-tax discount rate of 8%. The
environmental costs will be allowed for tax purposes when paid. The income tax rate is expected to
remain at 20%.
Income taxes 1207

Requirement
Respond to Ying Cha's instructions.
10 Audit focus
Section overview
 The provision for and related statement of profit or loss entries for deferred taxation are based on
assumptions that rely on management judgements.
 Procedures should be adopted to ensure any assumptions are reasonable and the requirements of
IAS 12 have been met.
10.1 Auditing tax

10.1.1 Audit risks
Until recently, tax accounting has been of secondary concern in the corporate group reporting process.
The tax figures in the financial statements are, however, often material by their nature, and the
increased public interest around tax avoidance now places greater pressure on companies and groups to
get tax reporting right.
The following factors increase the audit risk in respect of current and deferred tax, particularly in a
group reporting context:
 Lack of tax accounting knowledge: even in larger groups with in-house tax specialist resource, the
board is often more interested in the cash cost of tax than in tax accounting.
 Lack of foreign tax knowledge: the tax figures of foreign operations are particularly at risk of
misstatement, and auditing them may require specialist knowledge.
 Complex or unusual transactions: the tax implications of such transactions may be overlooked by
management, but they can be complex and material.
 Lack of appropriate tax reporting processes: the basic processes (such as Excel spreadsheets) used
by many entities are unable to respond to complex tax reporting requirements. The use of manual
input increases the risk of errors, and may render workings difficult to audit.
10.1.2 Use of tax specialists

On the audit of larger or more complex entities, tax audit specialists are likely to be actively involved from
the start of the audit as members of the audit team, using their tax accounting expertise to carry out the
review of tax figures in the statement of financial position and statement of profit or loss. In such cases, the
tax audit team will report their findings, including any identified misstatements and any areas of significant
uncertainty, to the audit team. The tax team's workings papers must be included within the audit working
papers file.
Point to note:
In accordance with the FRC's revised Ethical Standard the provision of tax services by an audit firm for PIEs
is prohibited.
10.1.3 Current tax: audit procedures

Auditors (or the tax specialists involved in the audit) should carry out audit procedures including the
following:
 Obtain copies of the prior period tax computation.
 Inquire whether any tax enquiries have been raised by the tax authorities in the period.

 Inquire into the status of any unresolved tax enquiries, and obtain supporting correspondence
with the tax authorities.
 Obtain copies of the current period tax computation, and evaluate whether:
– the opening balances agree to the closing balances in the prior period tax computation;
– the figures in the tax computation agree to figures in the financial statements;
– estimates contained within the tax computation are based on reasonable assumptions; and
– all tax rates and allowances are based on applicable tax legislation.
 Review details of tax payments made/refunds received in the period, and agree payments to the
cash and bank account.
10.1.4 Deferred tax: audit procedures

C
The following procedures will be relevant: H
A
 Consider whether it is appropriate for the company to recognise deferred tax (eg, is the company P
expected to make future taxable profits against which the deferred tax would unwind?). T
E
 Obtain a copy of the deferred tax workings. R
 Check the arithmetical accuracy of the deferred tax working.

 Agree the figures used to calculate temporary differences to those on the tax computation and 22
 Consider the assumptions made in the light of the auditor's knowledge of the business and any
other evidence gathered during the course of the audit to ensure reasonableness.
 Agree the opening position on the deferred tax account to the prior year financial statements.
 Review the basis of the provision to ensure:
– it is in line with accounting practice under IAS 12 Income Taxes; and
– any changes in accounting policy have been disclosed.
 Verify that the rate of corporation tax at which the deferred tax asset/liability unwinds is
appropriate and in line with current tax legislation.
10.1.5 Transfer pricing

Besides auditing current and deferred tax, transfer pricing is an important area over which sufficient
appropriate audit evidence must be sought. When the entity's transfer pricing policies are challenged by
the tax authorities, the effect on the company's current tax position over several years is likely to be
material.
Please refer to Chapter 20 for a more detailed discussion of transfer pricing.
Case Study: Petrofac plc

Petrofac plc is a global oil and gas services company, listed on FTSE 250. In the group financial
statements for the year ended 31 December 2014, tax accounting was identified as an area of particular
audit risk by the group auditor, Ernst & Young. The following excerpts from the auditor's report for the
period describe the risk, and the audit team's responses to the risk.
Accounting for taxation assets, liabilities, income and expenses
Area of risk
The wide geographical spread of the Group's operations, the complexity of application of local tax rules
in many different jurisdictions and transfer pricing risks affecting the allocation of income and costs
charged between jurisdictions and businesses increase the risk of misstatement of tax balances. The
assessment of tax exposures by Management requires judgement given the structure of individual
contracts and the increasing activity of tax authorities in the jurisdictions in which Petrofac operates.
Furthermore, the recognition of deferred tax assets and liabilities needs to be reviewed regularly to
ensure that any changes in local tax laws and profitability of associated contracts are appropriately
considered. Refer to note 7 of the financial statements for disclosures in respect of taxation for the year.
Income taxes 1209

Audit approach
We used tax specialists in our London team in the planning stages to determine which jurisdictions
should be in scope, as well as in the audit of tax balances. We also involved local tax specialists in the
relevant jurisdictions where we deemed it necessary. We considered and challenged the tax exposures
estimated by management and the risk analysis associated with these exposures along with claims or
assessments made by tax authorities to date. We also audited the calculation and disclosure of current
and deferred tax (refer to Note 7) to ensure compliance with local tax rules and the Group's accounting
policies including the impact of complex items such as share based payments and the review of
management's assessment of the likelihood of the realisation of deferred tax balances.

Summary
IAS 12
Income Taxes
Current Deferred
C
tax tax
H
A
P
Taxable temporary Deductible T
Asset Liability
differences temporary differences E
R
WHERE
Excess Deferred tax Deffered tax
paid liability recognised asset 22
OR
Tax loss Recognised only
c/back Exceptions Deferred tax liabilities where probable
recovers tax • Initial recognition of relating to business that taxable
of previous goodwill combinations shall be profit will be
period • Initial recognition of recognised unless available
an asset or liability • Parent, investor or
in a transaction venturer is able to
which control reversal of
– Is not a business temporary
combination difference
– At the time of • Probable that
the transaction temporary
affects neither difference will not
accounting reverse in the
profit nor foreseeable future
taxable profit or
loss
Exceptions Deferred tax asset

Transactions that arise relating to business
from initial recognition combinations shall be
of a transaction that recognised if probable
• Is not a business that
combination and • Temporary
• At the time of the differences will
transaction affects reverse in the
neither accounting foreseeable future
profit nor taxable • Taxable profit will
profit or loss be available to be
utilised
Income taxes 1211

Self-test
IAS 12 Income Taxes
1 Torcularis
The Torcularis Company has interest receivable which has a carrying amount of £75,000 in its
statement of financial position at 31 December 20X6. The related interest revenue will be taxed on
a cash basis in 20X7.
Torcularis has trade receivables that have a carrying amount of £80,000 in its statement of financial
position at 31 December 20X6. The related revenue has been included in its statement of profit or
loss and other comprehensive income for the year to 31 December 20X6.
Requirement
According to IAS 12 Income Taxes, what is the total tax base of interest receivable and trade
receivables for Torcularis at 31 December 20X6?
2 What will the following situations give rise to as regards deferred tax, according to IAS 12 Income
Taxes?
(a) Development costs have been capitalised and will be amortised through profit or loss, but
were deducted in determining taxable profit in the period in which they were incurred.
(b) Accumulated depreciation for a machine in the financial statements is greater than the
cumulative capital allowances up to the reporting date for tax purposes.
(c) A penalty payable is in the statement of financial position. Penalties are not allowable for tax
purposes.
3 Budapest
On 31 December 20X6, The Budapest Company acquired a 60% stake in The Lisbon Company.
Among Lisbon's identifiable assets at that date was inventory with a carrying amount of £8,000
and a fair value of £12,000. The tax base of the inventory was the same as the carrying amount.
The consideration given by Budapest resulted in the recognition of goodwill acquired in the
business combination.
Income tax is payable by Budapest at 25% and by Lisbon at 20%.
Requirement
Indicate whether the following statements are true or false, in respect of Budapest's consolidated
statement of financial position at 31 December 20X6, in accordance with IAS 12 Income Taxes.
(a) No deferred tax liability is recognised in respect of the goodwill.
(b) A deferred tax liability of £800 is recognised in respect of the inventory.
4 Dipyrone
The Dipyrone Company owns 100% of the Reidfurd Company. During the year ended
31 December 20X7:
(1) Dipyrone sold goods to Reidfurd for £600,000, earning a profit margin of 25%. Reidfurd held
30% of these goods in inventory at the year end.
(2) Reidfurd sold goods to Dipyrone for £800,000, earning a profit margin of 20%. Dipyrone held
25% of these goods in inventory at the year end.
The tax base of the inventory in each company is the same as its carrying amount. The tax rate
applicable to Dipyrone is 26% and that applicable to Reidfurd is 33%.
Requirement
What is the deferred tax asset at 31 December 20X7 in Dipyrone's consolidated statement of
financial position under IAS 12 Income Taxes and IFRS 10 Consolidated Financial Statements?

5 Rhenium
The Rhenium Company issued £6 million of 8% loan stock at par on 1 April 20X7. Interest is
payable in two instalments on 30 September and 31 March each year.
The company pays income tax at 20% in the year ended 31 December 20X7, but expects to pay at
25% for 20X8 as it will be earning sufficient profits to pay tax at the higher rate.
For tax purposes interest paid and received is dealt with on a cash basis.
Requirement
What is the deferred tax balance at 31 December 20X7, according to IAS 12 Income Taxes?
6 Cacholate
The Cacholate Company acquired a property on 1 January 20X6 for £1.5 million. The useful life of C
the property is 20 years, which is also the period over which tax depreciation is charged. H
A
On 31 December 20X7, the property was revalued to £2.16 million. The tax base remained P
unaltered. T
E
Income tax is payable at 20%. R
Requirement
What is the deferred tax charge for the year ended 31 December 20X7, and where is it charged, 22
under IAS 12 Income Taxes?
7 Spruce
Spruce Company made a taxable loss of £4.7 million in the year ended 31 December 20X7. This
was due to a one-off reorganisation charge in 20X7; before that, Spruce made substantial taxable
profits each year.
Assume that tax legislation allows companies to carry back tax losses for one financial year, and
then carry them forward indefinitely.
Spruce's taxable profits are as follows.
Year ended £'000
31 December 20X6 500
31 December 20X8 (estimate) 1,000
31 December 20X9 (estimate) 1,200
31 December 20Y0 and onwards Uncertain
Spruce pays income tax at 25%.
Requirement
What is the deferred tax balance in respect of tax losses in Spruce's statement of financial position
at 31 December 20X7, according to IAS 12 Income Taxes?
8 Bananaquit
At 31 December 20X6, The Bananaquit Company has a taxable temporary difference of
£1.5 million in relation to certain non-current assets.
At 31 December 20X7, the carrying amount of those non-current assets is £2.4 million and the tax
base of the assets is £1.0 million.
Tax is payable at 30%.
Requirement
Indicate whether the following statements are true or false, in accordance with IAS 12 Income
Taxes.
(a) The deferred tax charge through profit or loss for the year is £30,000.
(b) The statement of financial position deferred tax asset at 31 December 20X7 is £420,000.
Income taxes 1213

9 Antpitta
The Antpitta Company owns 70% of The Chiffchaff Company. During 20X7 Chiffchaff sold goods
to Antpitta at a mark-up above cost. Half of these goods are held in Antpitta's inventories at the
year end. The rate of income tax is 30%.
Requirement
Indicate whether the following statements are true or false according to IAS 12 Income Taxes and
IFRS 10 Consolidated Financial Statements, when preparing Antpitta's consolidated and Chiffchaff's
individual financial statements for the year ended 31 December 20X7.
(a) A deferred tax asset arises in the individual statement of financial position of Chiffchaff in
relation to intra-group transactions.
(b) A deferred tax asset arises in Antpitta's consolidated statement of financial position due to the
intra-group transactions.
10 Parea
In order to maximise its net assets per share, The Parea Company wishes to recognise the
minimum deferred tax liability allowed by IFRS. Parea only pays tax to the Government of
Gredonia, at the rate of 22%.
On 1 January 20X6 Parea acquired some plant and equipment for £30,000. In the financial
statements it is being written off over its useful life of four years on a straight-line basis, even
though tax depreciation is calculated at 27% on a reducing-balance basis.
On 1 January 20X3 Parea acquired a property for £40,000. Both in the financial statements and
under tax legislation it is being written off over 25 years on a straight-line basis. On
31 December 20X7 the property was revalued to £50,000 with no change to its useful life, but this
revaluation had no effect on the tax base or on tax depreciation.
Requirement
Determine the following amounts for the deferred tax liability of Parea in its consolidated financial
statements according to IAS 12 Income Taxes.
(a) The deferred tax liability at 31 December 20X6
(b) The deferred tax liability at 31 December 20X7
(c) The charge or credit for deferred tax in profit or loss for the year ended 31 December 20X7
11 XYZ
XYZ, a public limited company, has decided to adopt the provisions of IFRSs for the first time in its
financial statements for the year ending 30 November 20X1. The amounts of deferred tax provided
as set out in the notes of the group financial statements for the year ending 30 November 20X0
were as follows:
£m
Tax depreciation in excess of accounting depreciation 38
Other temporary differences 11
Liabilities for healthcare benefits (12)
Losses available for offset against future taxable profits (34)
3
The following notes are relevant to the calculation of the deferred tax liability as at
30 November 20X1:
1 XYZ acquired a 100% holding in a foreign company on 30 November 20X1. The subsidiary
does not plan to pay any dividends for the financial year to 30 November 20X1 or in the
foreseeable future. The carrying amount in XYZ's consolidated financial statements of its
investment in the subsidiary at 30 November 20X1 is made up as follows:
£m
Carrying amount of net assets acquired excluding deferred tax 76
Goodwill (before deferred tax and impairment losses) 14
Carrying amount/cost of investment 90

The tax base of the net assets of the subsidiary at acquisition was £60 million. No deduction is
available in the subsidiary's tax jurisdiction for the cost of the goodwill.
Immediately after acquisition on 30 November 20X1, XYZ had supplied the subsidiary with
inventories amounting to £30 million at a profit of 20% on selling price. The inventories had
not been sold by the year end and the tax rate applied to the subsidiary's profit is 25%. There
was no significant difference between the fair values and carrying amounts on the acquisition
of the subsidiary.
2 The carrying amount of the property, plant and equipment (excluding that of the subsidiary)
is £2,600 million and their tax base is £1,920 million. Tax arising on the revaluation of
properties of £140 million, if disposed of at their revalued amounts, is the same at
30 November 20X1 as at the beginning of the year. The revaluation of the properties is
included in the carrying amount above.
C
Other taxable temporary differences (excluding the subsidiary) amount to £90 million as at H
A
30 November 20X1.
P
3 The liability for healthcare benefits in the statement of financial position had risen to T
E
£100 million as at 30 November 20X1 and the tax base is zero. Healthcare benefits are
R
deductible for tax purposes when payments are made to retirees. No payments were made
during the year to 30 November 20X1.
4 XYZ Group incurred £300 million of tax losses in 20X0. Under the tax law of the country, tax 22
losses can be carried forward for three years only. The taxable profits for the years ending
30 November were anticipated to be as follows:
20X1 20X2 20X3
£m £m £m
110 100 130
The auditors are unsure about the availability of taxable profits in 20X3, as the amount is
based on the projected acquisition of a profitable company. It is anticipated that there will be
no future reversals of existing taxable temporary differences until after 30 November 20X3.
5 Income tax of £165 million on a property disposed of in 20X0 becomes payable on
30 November 20X4 under the deferral relief provisions of the tax laws of the country. There
had been no sales or revaluations of property during the year to 30 November 20X1.
6 Income tax is assumed to be 30% for the foreseeable future in XYZ's jurisdiction and the
company wishes to discount any deferred tax liabilities at a rate of 4% if allowed by IAS 12.
7 There are no other temporary differences other than those set out above. The directors of XYZ
have calculated the opening balance of deferred tax using IAS 12 to be £280 million.
Requirement
Calculate the liability for deferred tax required by the XYZ Group at 30 November 20X1 and the
deferred tax expense in profit or loss for the year ending 30 November 20X1 using IAS 12,
commenting on the effect that the application of IAS 12 will have on the financial statements of
the XYZ Group.
Income taxes 1215

Technical reference
Tax base of an asset/liability IAS 12.7, IAS 12.8
Current tax
 Unpaid current tax recognised as a liability IAS 12.12
 Benefit relating to tax losses that can be carried back to recover previous IAS 12.13
period current tax recognised as asset
Taxable temporary differences

 Deferred tax liability shall be recognised on all taxable temporary IAS 12.15
differences except those arising from:
– Initial recognition of goodwill

– Initial recognition of an asset or liability in a transaction which:
 Is not a business combination, and
 At the time of the transaction affects neither accounting profit
nor taxable profit (tax loss)
Deductible temporary differences

 Deferred tax asset shall be recognised for all deductible temporary IAS 12.24
differences to the extent that taxable profit will be available to be used,
unless asset arises from initial recognition of asset or liability in a
transaction that:
– Is not a business combination, and
– At the time of the transaction affects neither accounting profit nor
taxable profit or loss
Unused tax losses and unused tax credits
 Deferred tax asset may be recognised in respect of unused tax losses and IAS 12.34
unused tax credits to the extent that future taxable profits will be available
Deferred tax assets and liabilities arising from investments in subsidiaries, IAS 12.39, IAS 12.44
branches and associates and investments in joint ventures
Tax rates and manner of recovery

 Measurement of deferred tax at tax rates expected to apply when asset IAS 12.47
realised or liability settled to reflect tax consequences of manner of IAS 12.51
recovery
Discounting
 Deferred tax assets and liabilities shall not be discounted IAS 12.53
Annual review
 Carrying amount of deferred tax asset to be reviewed at each reporting IAS 12.56
date


(a) The tax base of the accrued expenses is nil.
(b) The tax base of the interest received in advance is nil.
(c) The tax base of the prepaid expenses is nil.
(d) The tax base of the loan is £1 million.

H
The tax base of the asset is £70,000 (£100,000 – £30,000). A
(a) Recovery through continued use P
T
Temporary difference of £150,000 – £70,000 = £80,000 is all taxed at 30% resulting in a deferred E
R
tax liability of £24,000.
(If the entity expects to recover the carrying amount by using the asset it must generate taxable
income of £150,000, but will only be able to deduct depreciation of £70,000.) 22
(b) Recovery through sale

If the entity expects to recover the carrying amount by selling the asset immediately for proceeds
of £150,000, the temporary difference is still £80,000. Of this, only the £50,000 excess of proceeds
over cost is taxable. Therefore the deferred tax liability will be computed as follows.
Taxable temporary Deferred
difference Tax rate tax liability
£ £
Cumulative tax depreciation 30,000 30% 9,000
Proceeds in excess of cost 50,000 Nil –
Total temporary difference 80,000 9,000

(a) Recovery through continued use
If the entity expects to recover the carrying amount by using the asset, the situation is as in
Recovery 1 above in the same circumstances.
(b) Recovery through sale
If the entity expects to recover the carrying amount by selling the asset immediately for proceeds
of £150,000, the entity will be able to deduct the indexed cost of £110,000. The net profit of
£40,000 will be taxed at 40%. In addition, the cumulative tax depreciation of £30,000 will be
included in taxable income and taxed at 30%. On this basis, the tax base is £80,000 (£110,000 –
£30,000), there is a taxable temporary difference of £70,000 and there is a deferred tax liability of
£25,000 (£40,000  40% plus £30,000  30%).

Jonquil Co will recover the carrying amount of the equipment by using it to manufacture goods for
resale. Therefore, the entity's current tax computation is as follows.
Year
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Taxable income* 10,000 10,000 10,000 10,000 10,000
Depreciation for tax purposes 12,500 12,500 12,500 12,500 0
Taxable profit (tax loss) (2,500) (2,500) (2,500) (2,500) 10,000
Current tax expense (income) at 40% (1,000) (1,000) (1,000) (1,000) 4,000
Income taxes 1217

* ie, nil profit plus (£50,000  5) depreciation add-back.
The entity recognises a current tax asset at the end of years 20X1 to 20X4 because it recovers the
benefit of the tax loss against the taxable profit of year 20X0.
The temporary differences associated with the equipment and the resulting deferred tax asset and
liability and deferred tax expense and income are as follows.
Year
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Carrying amount 40,000 30,000 20,000 10,000 0
Tax base 37,500 25,000 12,500 0 0
Taxable temporary difference 2,500 5,000 7,500 10,000 0
Opening deferred tax liability 0 1,000 2,000 3,000 4,000
Deferred tax expense (income): bal fig 1,000 1,000 1,000 1,000 (4,000)
Closing deferred tax liability @ 40% 1,000 2,000 3,000 4,000 0
The entity recognises the deferred tax liability in years 20X1 to 20X4 because the reversal of the taxable
temporary difference will create taxable income in subsequent years. The entity's income statement is as
follows.
Year
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Income 10,000 10,000 10,000 10,000 10,000
Depreciation (10,000) (10,000) (10,000) (10,000) (10,000)
Profit before tax 0 0 0 0 0
Current tax expense (income) (1,000) (1,000) (1,000) (1,000) 4,000
Deferred tax expense (income) 1,000 1,000 1,000 1,000 (4,000)
Total tax expense (income) 0 0 0 0 0
Net profit for the period 0 0 0 0 0

The company will recognise an expense for the consumption of employee services given in
consideration for share options granted, but will not receive a tax deduction until the share options are
actually exercised. Therefore a temporary difference arises and IAS 12 Income Taxes requires the
recognition of deferred tax.
A deferred tax asset (a deductible temporary difference) results from the difference between the tax
base of the services received (a tax deduction in future periods) and the carrying value of zero. IAS 12
requires the measurement of the deductible temporary difference to be based on the intrinsic value of
the options at the year end. This is the difference between the fair value of the share and the exercise
price of the option.
If the amount of the estimated future tax deduction exceeds the amount of the related cumulative
remuneration expense, the tax deduction relates not only to the remuneration expense, but also to
equity. If this is the case, the excess should be recognised directly in equity.
Year to 31 May 20X6
Deferred tax asset:
£
Fair value (40,000  £8.50  1/2) 170,000
Exercise price of option (40,000  £4.00  1/2 ) (80,000)
Intrinsic value (estimated tax deduction) 90,000
Tax at 30% 27,000
The cumulative remuneration expense is £60,000, which is less than the estimated tax deduction of
£90,000. Therefore:
 a deferred tax asset of £27,000 is recognised in the statement of financial position;
 there is deferred tax income of £18,000 (60,000  30%); and
 the excess of £9,000 (30,000  30%) goes to equity.

Year to 31 May 20X7
Deferred tax asset:
£
Fair value
(40,000  £8) 320,000
(120,000  £8  1/3) 320,000
640,000
Exercise price of options
(40,000  £4) (160,000)
(120,000  £5  1/3) (200,000)
Intrinsic value (estimated tax deduction) 280,000
Tax at 30% 84,000
Less previously recognised (27,000) C
57,000 H
A
P
The cumulative remuneration expense is £220,000, which is less than the estimated tax deduction of
T
£280,000. Therefore: E
R
 a deferred tax asset of £84,000 is recognised in the statement of financial position at 31 May 20X7;
 there is potential deferred tax income of £57,000 for the year ended 31 May 20X7;
 of this, £9,000 (60,000  30%) – (9,000) goes directly to equity; and 22
 the remainder (£48,000) is recognised in profit or loss for the year.

The entity recognises a deferred tax asset of £0.9 million (£3m  30%) and, in profit or loss, deferred tax
income of £0.9 million. Goodwill is not adjusted, as the recognition does not arise within the
measurement period (ie, within the 12 months following the acquisition).

(a) The fair value adjustment to the property reduces goodwill by £24 million (being 80% of the
£30m FV adjustment).
As a result of the fair value uplift, the non-controlling interest must be adjusted up by £6 million
(20% × £30m).
The journal to record the adjustments to property, goodwill and the NCI at the date of acquisition
is:
DEBIT Property £30m
CREDIT Goodwill £24m
CREDIT NCI £6m
The fair value uplift is subsequently depreciated such that by the reporting date its carrying value is
£15 million (10/20 yrs × £30m). The journal to record the consolidation adjustment for extra
depreciation is:
DEBIT Group retained earnings (80% × £15m) £12m
DEBIT NCI (20% × 15,000) £3m
CREDIT Property – accumulated depreciation £15m
(b) At acquisition, property held within Dorian's accounts is uplifted by £30 million as a consolidation
adjustment.
This results in a taxable temporary difference of £30 million, and so a deferred tax liability of
£4.8 million (16% × £30m) at acquisition.
This is recognised by:
DEBIT Goodwill £3.84m
DEBIT Non-controlling interest (20% × £4.8m) £0.96m
CREDIT Deferred tax liability £4.8m
Income taxes 1219

By the reporting date, £15 million of this temporary difference has reversed and therefore a further
journal is required to reduce the deferred tax liability by £2.4 million (16% × £15m):
DEBIT Deferred tax liability £2.4m
CREDIT Retained earnings (80% × £2.4m ) £1.92m
CREDIT NCI (20% × £2.4m) £0.48m

An intangible asset acquired in a business combination is recognised where it meets the definition of an
asset and is identifiable ie, it is either separable or arises from contractual or legal rights. This is the case
regardless of whether the acquiree recognises the asset on its individual statement of financial position.
The Jenner Group amortises domain names over a 10-year (120 month) period. Rannon was acquired
50 months before the reporting date, therefore the carrying amount of the domain name as at
31 March 20X4 is 70/120  £40,800,000 = £23,800,000.
A deferred tax liability arises in respect of the fair value adjustment since this results in the carrying
amount of the domain name exceeding its tax base of nil. The deferred tax liability is 17% 
£23,800,000 = £4,046,000.
Amortisation since acquisition of 50/120 x £40,800,000 = £17,000,000 on the domain name and the
£2,890,000 (£17,000,000  17%) movement in the associated deferred tax liability must also be
accounted for and allocated between group retained earnings and the non-controlling interest:
(a)
DEBIT Intangible assets £40,800,000
CREDIT Goodwill £40,800,000
To recognise fair value adjustment on acquisition.
DEBIT Retained earnings (60%  17%  £4,161,600

£40,800,000)
DEBIT Non-controlling interest (40%  17%  £2,774,400
£40,800,000)
CREDIT Deferred tax liability £6,936,000
To recognise deferred tax liability on fair value adjustment at acquisition.
(b)
DEBIT Retained earnings (60%  £17,000,000) £10,200,000
DEBIT Non-controlling interest (40%  £6,800,000
£17,000,000)
CREDIT Intangible assets £17,000,000
To recognise amortisation on the domain name since acquisition.

(c)
DEBIT Deferred tax liability £2,890,000
CREDIT Retained earnings (60%  £2,890,000) £1,734,000
CREDIT Non-controlling interest (40%  £2,890,000) £1,156,000
To recognise the movement in deferred tax on the fair value adjustment since acquisition.

(a) An unrelieved tax loss gives rise to a deferred tax asset; however, only where there are expected to
be sufficient future taxable profits to use the loss.
There is no indication of Rhydding's future profitability, although the extent of the current year
losses suggests that future profits may not be available. If this is the case then no deferred tax asset
should be recognised.

If, however, the current year loss is due to a one-off factor, or there are other reasons why a return
to profitability is expected, then the deferred tax asset may be recognised at 20% × £6.5m =
£1.3 million.
(b) The intra-group sale gives rise to an unrealised year-end profit of £12m × 20/120 × ½ = £1m.
Consolidated profit and inventory are adjusted for this amount.
This profit has, however, already been taxed in the accounts of Burley. A deductible temporary
difference therefore arises which will reverse when the goods are sold outside the group and the
profit is realised. The resulting deferred tax asset is £1m × 30% = £300,000.
This may be recognised to the extent that it is recoverable.

(a) (i) Fair value adjustments are treated in a similar way to temporary differences on revaluations in H
A
the entity's own accounts. A deferred tax liability is recognised under IAS 12 even though the P
directors have no intention of selling the property, as it will generate taxable income in excess T
of depreciation allowed for tax purposes. The deferred tax of £1m  25% = £0.25m is debited E
to goodwill, reducing the fair value adjustments (and net assets at acquisition) and increasing R
goodwill.
(ii) Provisions for unrealised profits are temporary differences which create deferred tax assets and 22
the deferred tax is provided at the receiving company's rate of tax. A deferred tax asset would
2
arise of (3.6  ) @ 30% = £360,000.
6
(b) (i) The unrealised gains are temporary differences which will reverse when the investments are
sold therefore a deferred tax liability needs to be created of (£8m  25%) = £2m.
(ii) The allowance is a temporary difference which will reverse when the currently unidentified
loans go bad and the entity will then be entitled to tax relief. A deferred tax asset of (£2m at
25%) = £500,000 should be created.
(c) No deferred tax liability is required for the additional tax payable of £2 million, as Angelo controls
the dividend policy of Escalus and does not intend to remit the earnings to its own tax regime in
the foreseeable future.
(d) Angelo's unrelieved trading losses can only be recognised as a deferred tax asset to the extent they
are considered to be recoverable. In assessing the recoverability there needs to be evidence that
there will be suitable taxable profits from which the losses can be deducted in the future. To the
extent Angelo itself has a deferred tax liability for future taxable trading profits (eg, accelerated tax
depreciation) then an asset could be recognised.

Investments in foreign branches (or subsidiaries, associates or joint arrangements) are affected by
changes in foreign exchange rates. In this case, the branch's taxable profits are determined in dinars,
and changes in the dinar/pound exchange rate may give rise to temporary differences. These differences
can arise where the carrying amounts of the non-monetary assets are translated at historical rates and
the tax base of those assets are translated at the closing rate. The closing rate may be used to translate
the tax base because the resulting figure is an accurate measure of the amount that will be
deductible in future periods. The deferred tax is charged or credited to profit or loss.
The deferred tax arising will be calculated using the tax rate in the foreign branch's jurisdiction, that
is 20%.
Property Dinars ('000) Exchange rate Pounds
£'000
Carrying amount:
Cost 6,000 1,200
Depreciation for the year (500) (100)
Carrying amount 5,500 5 1,100
Income taxes 1221

Property Dinars ('000) Exchange rate Pounds
£'000
Tax base:
Cost 6,000
Tax depreciation (750)
Carrying amount 5,250 6 875
Temporary difference 225
Deferred tax at 20% 45
The deferred tax charge in profit or loss will therefore increase by £45,000.
If the tax base had been translated at the historical rate, the tax base would have been £(5.25m ÷ 5) =
£1.05 million. This gives a temporary difference of £1.1m – £1.05m = £50,000, and therefore a deferred
tax liability of £50,000 × 20% = £10,000. This is considerably lower than when the closing rate is used.

According to IAS 12 Income Taxes the tax expense in the statement of profit or loss and other
comprehensive income includes the tax charge for the year, any under or overprovision of income tax
from the previous year and any increase or decrease in the deferred tax provision:
£
Current tax expense X
Under/overprovisions relating to prior periods X/(X)
Increases/decreases in the deferred tax balance X/(X)
X
While the correction of an over or under provision relates to a prior period, this is not a prior period
adjustment as defined in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors and as
assumed by Tacks. Rather, it is a change in accounting estimate.
Changes in accounting estimates result from new information or new developments and, accordingly,
are not corrections of errors. A prior period error, which would require a prior period adjustment is an
omission or misstatement arising from failure to use reliable information that was available or could
have been obtained at the time of the authorisation of the financial statements. This is not the case
here. Tacks had accounted for all known issues at the previous year end (30 November 20X1), and
could not have foreseen that the tax adjustment would be required. No penalties were applied by the
taxation authorities, indicating that there were no fundamental errors in the information provided to
them. Correction of an over- or under-provision for taxation is routine, since taxation liabilities are
difficult to estimate.
The effect of a change in accounting estimate must be applied by the company prospectively by
including it in profit or loss in the period of change, with separate disclosure of the adjustment in the

Journal entries and explanations:
Machinery purchase
The plant is categorised as a non-monetary asset per IAS 21. As such it should be measured at the rate
of exchange at the acquisition date of 1 January 20X3. Therefore the plant should originally have been
included at cost of Kr12 million (US$30m/2.5) and a liability for that sum recognised too.
Depreciation should be charged over the useful life of the asset, which commences on 1 January, and so
only nine months depreciation is required to 30 September 20X3. This gives a depreciation charge of
Kr900,000 and a carrying amount of Kr11.1 million.
An exchange difference arises between 1 January and 31 March, when payment is made. This should be
charged to the income statement instead of directly to equity.
The correct exchange difference is therefore a loss of Kr 500,000 (Kr12.5m – Kr12m).

The relevant correcting journals are:
DR CR
Kr million Kr million
DEBIT PPE
Cost Kr12m – Kr10m 2
CREDIT Creditor 2
Being correct recording of cost of the machinery
DEBIT Creditor 2.5

CREDIT Retained earnings 2.5
Being journal to reverse original exchange difference (Kr12.5m – Kr10m)
DEBIT Profit or loss 0.5

C
CREDIT Creditor 0.5 H
Being correct exchange loss taken to profit or loss A
P
DEBIT PPE 0.1 T
CREDIT Profit or loss 0.1 E
Being correction to depreciation charge (Kr 1m – Kr 0.9m) R
There are no deferred tax implications as the tax base and the carrying amount are the same.
Impairment 22
Per IAS 36 the impairment of Kr18 million should initially be offset against the revaluation surplus of
Kr16.8 million, and the excess of Kr1.2 million charged in the income statement.
The journal is:
CREDIT Profit or loss Kr16.8m
DEBIT Revaluation surplus Kr16.8m
Again there should be no deferred tax implications as the tax base and the carrying amount are the
same.
Investment
The investment is classified as held for trading per IFRS because there is an intention to sell the shares at
the end of the year. Therefore they should be measured at fair value and the gain/loss taken to the
income statement.
At 30 September the increase in fair value is Kr4.8 million, and this is credited to the income statement.
DEBIT Investments Kr 4.8m
CREDIT Profit or loss Kr 4.8m
A deferred tax liability of Kr 960,000 (20%  Kr 4.8m) should be created because the recognition of the
increase in fair value represents a taxable temporary difference.
DEBIT Profit or loss deferred tax Kr 960,000
CREDIT Deferred tax provision Kr 960,000
Provision
The provision should initially be based on a figure of Kr10 million per IAS 37, as this is the most likely
outcome for the clean-up costs.
However the provision should then be discounted using the pre-tax discount rate of 8% over the
20 year period from 1 October 20X2. The initial provision should therefore be Kr 2.145 million.
As the provision relates to the rights, the cost should be added to intangible assets.
The intangible asset should then be amortised in the income statement over the 20 years to when the
rights expire.
Income taxes 1223

The provision should be unwound over the period to when the clean-up costs are due.
Dr Cr
DEBIT Intangible asset 2.145
DEBIT Provision 12.855
CREDIT Profit or loss 15
DEBIT Profit or loss (Kr10.645m/20) 0.532

CREDIT Intangible asset 0.532
DEBIT Profit or loss (finance costs) (Kr2.145m  8%) 0.172

CREDIT Provision 0.172
Because the clean-up costs are tax deductible, a deferred tax asset should be created for the provision at
30 September 20X3.
The provision is Kr2.317 million (Kr2.145m + 0.172m) and so the deferred tax asset is Kr 0.463 million.
Dr Cr
DEBIT Deferred tax asset 0.463
CREDIT Profit or loss 0.463
Adjusted statement of financial position
Statement of financial position at 30 September 20X3

Draft Plant Impair Invest Prov'n Total
Kr'000 Kr'000 Kr'000 Kr'000 Kr'000 Kr'000
Non-current assets
Property, plant & equipment 61,600 2,100 63,700
Intangible assets 8,500 1,613 10,113
Financial investments 7,700 4,800 12,500
Deferred tax 0 463 463
77,800 86,776
Current assets 23,700 23,700
Total assets 101,500 110,476
Issued Kr 1 shares 10,000 10,000
Retained earnings 42,600 2,100 16,800 3,840 14,759 80,099
Revaluation surplus 16,800 (16,800) 0
69,400 90,099
Loans 10,000 10,000
Provisions 15,000 (12,683) 2,317
Deferred tax 0 960 960
Current liabilities 7,100 7,100
Total equity & liabilities 101,500 110,476
Note: The deferred tax asset can be offset against the deferred tax liability if both are due to the same
tax authority.

IAS 12 Income Taxes

1 Torcularis
£nil and £80,000
IAS 12.7 Examples 2 and 3 show that:
 For interest receivables the tax base is nil.
 The tax base for trade receivables is equal to their carrying amount. C
H
2 (a) Deferred tax liability
A
(b) Deferred tax asset P
(c) No deferred tax implications T
E
'Development costs' lead to a deferred tax liability. R
'A penalty payable' has no deferred tax implications.
3 Budapest 22
(a) True
(b) True
Under IAS 12.19 the excess of an asset's fair value over its tax base at the time of a business
combination results in a deferred tax liability. As it arises in Lisbon, the tax rate used is 20% and the
liability is £800 ((£12,000 – £8,000)  20%).
The recognition of a deferred tax liability in relation to the initial recognition of goodwill is
specifically prohibited by IAS 12.15(a).
4 Dipyrone
£25,250
Under IFRS 10, intra-group profits recognised in inventory are eliminated in full and IAS 12 applied
to any temporary differences that result. This profit elimination results in the tax base being higher
than the carrying amount, so deductible temporary differences arise. Deferred tax assets are
measured by reference to the tax rate applying to the entity who currently owns the inventory.
So the deferred tax asset in respect of Dipyrone's eliminated profit is £14,850 (£600,000  25% 
30%  33% tax rate) and in respect of Reidfurd's eliminated profit is £10,400 (£800,000  20% 
25%  26% tax rate), giving a total of £25,250.
5 Rhenium
£30,000 asset
The year-end accrual is £120,000 (£6m  8%  3/12). Because the £120,000 year-end carrying
amount of the accrued interest exceeds its nil tax base, under IAS 12.5 there is a deductible
temporary difference, of £120,000. Under IAS 12.24 a deferred tax asset must be recognised.
The deferred tax asset is the deductible temporary difference multiplied by the tax rate expected to
exist when the tax asset is realised (IAS 12.47). This gives a deferred tax asset of (£120,000  25%)
= £30,000.
6 Cacholate
£162,000
Because the £2.16 million year-end carrying amount of the asset exceeds its £1.35 million
(£1,500,000  18/20) tax base, under IAS 12.5 there is a taxable temporary difference, of
£810,000. Under IAS 12.15 a deferred tax liability must be recognised, of £162,000 (£810,000 
20%). As there was no such liability last year (the carrying amount and the tax base were the
same), the charge in the current year is for the amount of the liability.
Income taxes 1225

Because the revaluation surplus is recognised as other comprehensive income and accumulated in
equity (IAS 12.62), the deferred tax charge is recognised as tax on other comprehensive income
and also accumulated in equity, under IAS 12.61.
7 Spruce
£550,000
A deferred tax asset shall be recognised for the carry forward of unused tax losses to the extent that
future taxable profits will be available for offset (IAS 12.34). The loss incurred in the current year is
a one-off, and the company has a history of making profits and expects to do so over the next two
years. So it is likely that there will be future profits to offset.
£500,000 of the loss will be relieved by carry back, leaving £4,200,000 for carry forward. But the
carry forward is limited to the likely future profits, so £2.2 million.
At the 25% tax rate, the deferred tax asset is £550,000.
8 Bananaquit
(a) False
(b) False
The deferred tax figure in profit or loss is the difference between the opening and closing deferred
tax liabilities. At the start of the year the liability was £450,000 (£1.5m  30%). The amount of the
change is £30,000, but it is a deferred tax credit, not charge to profit or loss.
At the end of the year the £2.4 million carrying amount of the assets exceeds their £1.0 million tax
base, so under IAS 12.5 there is a taxable temporary difference, of £1.4 million. Under IAS 12.15 a
deferred tax liability (not asset) of £420,000 (£1.4m  30%) must be recognised.
9 Antpitta
(a) False
(b) True
There is an unrealised profit relating to inventories still held within the group, which must be
eliminated on consolidation (IFRS 10). But the tax base of the inventories is unchanged, so it is
higher than the carrying amount in the consolidated statement of financial position and there is a
deductible temporary difference (IAS 12.5).
10 Parea
(a) £132
(b) £3,743
(c) £349 credit
At 31 December 20X6 the carrying amount of the plant is £30,000  (1 – 25%) = £22,500, while
the tax base is £30,000  (1 – 27%) = £21,900. The taxable temporary difference is £600 and the
deferred tax liability is 22% thereof, £132.
At 31 December 20X7 the carrying amount of the plant is £30,000  (1 – (25% × 2)) = £15,000,
while the tax base is £30,000  (1 – 27%) = £15,987, leading to a deductible temporary difference
2
of £987. A deferred tax asset should be recognised in relation to this.

Before its revaluation, the property's carrying amount is £40,000 – (5 years at 4%) = £32,000 and
the tax base is the same. The revaluation to £50,000 creates a taxable temporary difference of
£18,000.
As Parea pays all its tax to a single authority, it must offset deferred tax assets and liabilities
(IAS 12.74). At 31 December 20X7 there is a deferred tax liability of £(–987 + 18,000) = £17,013 
22% = £3,743.
The change in deferred tax liability over the year is £3,743 – £132 = £3,611. Of this, £18,000 
22% = £3,960 relates to the property revaluation and is recognised in other comprehensive
income. This leaves £3,611 – £3,960 = £(349) to be credited to profit or loss (IAS 12.58).

11 XYZ
Calculation of deferred tax liability

Carrying Tax Temporary XYZL/
amount base differences Rate (XYZA)
£m £m £m % £m
Goodwill (note 1) 14 – –
Subsidiary (note 1) 76 60 16 25 4
Inventories (note 2) 24 30 (6) 25 (1.5)
Property, plant and equipment (note 3) 2,600 1,920 680 30 204
Other temporary differences 90 30 27
Liability for healthcare benefits (100) 0 (100) 30 (30)
Unrelieved tax losses (note 4) (100) 30 (30) C
Property sold – tax due 30.11.20X4 H
A
(165/30%) 550 30 165
P
1,130 338.5 * T
Deferred tax liability b/d (given) 280 E
Deferred tax attributable to subsidiary to goodwill (from above) 4 R
 Deferred tax expense for the year charged to P/L (balance) 54.5
Deferred tax liability c/d (from above) 338.5 *
22
* Deferred tax asset (1.5 + 30 + 30) (61.5)

Deferred tax liability (balance) 400
338.5
Notes
1 As no deduction is available for the cost of goodwill in the subsidiary's tax jurisdiction, then
the tax base of goodwill is zero. Paragraph 15(a) of IAS 12 states that XYZ Group should not
recognise a deferred tax liability of the temporary difference associated with the goodwill.
Goodwill will be increased by the amount of the deferred tax liability of the subsidiary ie,
£4 million.
2 Unrealised group profit eliminated on consolidation is provided for at the receiving company's
rate of tax (ie, at 25%).
3 The tax that would arise if the properties were disposed of at their revalued amounts which
was provided at the beginning of the year will be included in the temporary difference arising
on the property, plant and equipment at 30 November 20X1.
4 XYZ Group has unrelieved tax losses of £300 million. This will be available for offset against
current year's profits (£110m) and against profits for the year ending 30 November 20X2
(£100m). Because of the uncertainty about the availability of taxable profits in 20X3, no
deferred tax asset can be recognised for any losses which may be offset against this amount.
Therefore, a deferred tax asset may be recognised for the losses to be offset against taxable
profits in 20X2. That is £100 million  30% ie, £30 million.
Comment
The deferred tax liability of XYZ Group will rise in total by £335.5 million (£338.5m – £3m), thus
reducing net assets, distributable profits and post-tax earnings. The profit for the year will be
reduced by £54.5 million which would probably be substantially more under IAS 12 than the old
method of accounting for deferred tax. A prior period adjustment will occur of £280m – £3m as
IAS are being applied for the first time (IFRS 1) ie, £277 million. The borrowing position of the
company may be affected and the directors may decide to cut dividend payments. However, the
amount of any unprovided deferred tax may have been disclosed under the previous GAAP
standard used. IAS 12 brings this liability into the statement of financial position but if the bulk of
the liability had already been disclosed the impact on the share price should be minimal.
Income taxes 1227

CHAPTER 23
Financial statement analysis 1
Introduction
Topic List
1 Users and user focus
2 Accounting ratios and relationships
3 Statements of cash flows and their interpretation
4 Economic events
5 Business issues
6 Accounting choices
7 Ethical issues
8 Industry analysis
9 Non-financial performance measures
10 Limitations of ratios and financial statement analysis
1229
Introduction
 Analyse and evaluate the performance, position, liquidity, efficiency and solvency of an
entity through the use of ratios and similar forms of analysis including using quantitative
and qualitative data
 Compare the performance and position of different entities allowing for inconsistencies in
the recognition and measurement criteria in the financial statement information provided
 Make adjustments to reported earnings in order to determine underlying earnings and
compare the performance of an entity over time
 Compare and appraise the significance of accruals basis and cash flow reporting
Specific syllabus references for this chapter are: 9(d), 9(g), 9(h), 9(k)

1 Users and user focus
Section overview
 Different groups of users of financial statements will have different information needs.
 The focus of an investigation of a business will be different for each user group.
1.1 Information needs

You have covered external users and their information needs in your Professional Level studies and they
were touched on again in Chapters 1 and 2 of this Study Manual. The following table summarises the
main groups of users of financial statements and the information they need.
Users Need information to:
Present and potential investors Make investment decisions, therefore need information on the
following:
 Risk and return on investment
 Ability of entity to pay dividends
Employees  Assess their employer's stability and profitability
 Assess their employer's ability to provide remuneration,
employment opportunities and retirement and other
C
benefits
H
Lenders Assess whether loans will be repaid, and related interest will A
P
be paid, when due T
E
Suppliers and other trade creditors Assess the likelihood of being paid when due
R
Customers  Assess whether the entity will continue in existence –
important where customers have a long-term involvement
with, or are dependent on, the entity, for example where 23
there are product warranties or where specialist parts may
be needed
 Assess whether business practices are ethical
Governments and their agencies  Assess allocation of resources and, therefore, activities of
entities
 Help with regulating activities
 Assess taxation
 Provide a basis for national statistics
The public Assess trends and recent developments in the entity's
prosperity and its activities – important where the entity
makes a substantial contribution to a local economy, for
example by providing employment and using local suppliers
An entity's management also needs to understand and interpret financial information, both as a basis for
making management decisions and also to help in understanding how external users might react to the
information in the financial statements.
1.2 User focus

The primary focus of users of the financial statements differs according to their interests. Examples are as
follows:
(a) Customers and suppliers are most interested in current liquidity, but also focus on overall pre-tax
profitability and net worth of the business in their evaluation of likely future liquidity.
Financial statement analysis 1 1231

(b) Lenders focus on liquidity, longer-term solvency and ability to service and repay debts.
(c) Shareholders' main concern is with risk and return. They therefore focus mainly on gearing and
dividend cover to measure the risk, and on post-tax returns and the overall net worth of the
business to measure return. However, they are also interested in solvency, as they will be the first to
lose out in the event that the company runs into financial difficulties. Finally, shareholders are
interested in liquidity, as this affects the security of their dividends.
1.3 User focus: Corporate Reporting

We will consider all types of users in our studies of financial analysis. However, in the context of
Corporate Reporting, the main standpoints are those of:
 investor (or potential investor)
 credit analyst
1.3.1 Investor
An investor uses financial analysis to determine whether an entity is stable, solvent, liquid, or profitable
enough to be invested in. When looking at a specific company, the financial analyst will often focus on
the statement of profit or loss and other comprehensive income, the statement of financial position and
the statement of cash flows.
In addition, certain accounting ratios are more relevant to investors than to other users. These are
discussed in section 2.7.
One key area of financial analysis involves extrapolating the company's past performance into an
estimate of the company's future performance.
1.3.2 Credit analyst

A credit analyst may have a similar perspective to a lender, although he/she may be advising a lender
rather than doing the lending. As the name suggests, credit analysts are experts in evaluating the
creditworthiness of individuals and businesses. They determine the likelihood that a borrower will be
able to meet financial obligations and pay back a loan, often by reviewing the borrower's financial
history and determining whether market conditions will be conducive to repayment.
Credit analysts are likely to use ratios, including cash flow ratios (see section 3.2) when reviewing the
financial history of a potential borrower. They focus on determining whether the borrower will have
sufficient cash flows by comparing ratios to industry standards, other borrowers and historical trends.
1.4 Financial position and performance

Different users usually require different information. However, there is overlap, as all potential users are
interested in the financial performance and financial position of the company as a whole.
The next section examines how accounting ratios can be used to help assess financial performance and
position. The additional perspective provided by analysis of the statement of cash flows is covered later
in this chapter.
2 Accounting ratios and relationships
Section overview
 Ratios are commonly classified into different groups according to the focus of the investigation.
 Ratios can help in assessing performance, short-term liquidity, long-term solvency, efficiency and
investor returns.
2.1 Introduction to ratios

Accounting ratios help to summarise and present financial information in a more understandable form.
They help with assessing the performance of a business by identifying significant relationships between

different figures. The term 'accounting ratios' is used loosely, to cover the outcome of different types of
calculation; some ratios measure one amount as a ratio of another (such as 2:1) whereas others measure
it as a percentage of the other (such as 200%).
Ratios are of no use in isolation. To be useful, a basis for comparison is needed, such as the following:
 Previous years
 Other companies
 Industry averages
 Budgeted or forecast vs actual
Ratios do not provide answers but help to focus attention on important areas, therefore minimising the
chance of failing to identify a significant trend or weakness.
Ratios divide into the following main areas:
 Performance
 Short-term liquidity
 Long-term solvency
 Efficiency (asset and working capital)
 Investors' (or stock market) ratios
2.1.1 Which figures to use?

Many accounting ratios are calculated using one figure from the statement of profit or loss and other
comprehensive income (which covers a period of time, usually a year) and one from the statement of
financial position (which is a snapshot at a point in time, usually the year end). The result may be
C
distorted if the statement of financial position (snapshot) amounts are not typical of the amounts H
throughout the period covered by the statement of profit or loss and other comprehensive income. A
P
Consider a toy retailer with a 31 December year end: over half its annual sales may well be made in the T
three months leading up to Christmas, while its inventory levels at 31 December will probably be at E
their lowest point throughout the year, and certainly much lower than at their highest point which R
might be some time in October in the run up to Christmas. To calculate a relationship between cost of
sales for 12 months and the 31 December level of inventories and then use it as a measure of
management's efficiency in managing inventory levels (as does the inventory turnover ratio in section 23
2.5.2 below) runs the risk of a major distortion. The calculation should really be done using the
statement of profit or loss and other comprehensive income amount and the average inventory holding
throughout the year, calculating the average every month or more frequently.
But monthly statement of financial position amounts are not made available to financial statement users.
Sometimes half-yearly (or quarterly) statements of financial position are published, in which case they
may well result in useful averages. But averaging the amounts at the current year end and the previous
year end may well be no better than just using current year-end amounts, since the result may only be
to average two unrepresentative amounts.
2.2 Performance
2.2.1 Significance
Performance ratios measure the rate of return earned on capital employed, and analyse this into profit
margins and use of assets. These ratios are frequently used as the basis for assessing management
effectiveness in utilising the resources under their control.
2.2.2 Key ratios

Return on capital employed (ROCE)
This measures the overall efficiency of a company in employing the resources available to it; that is, its
capital employed.

Return  Source : SPLOCI 
 100  
Capital employed  Source: SFP 
where: Return = profit before interest and tax (PBIT) + associates' post-tax earnings
Capital employed = equity + net debt, where net debt = interest-bearing debt (non-current
and current) minus cash and cash equivalents
Remember:
 Equity includes irredeemable preference shares and the non-controlling interests.
 Net debt includes redeemable preference shares.
Many different versions of this ratio are used but all are based on the same idea: identify the long-term
resources available to a company's management and then measure the financial return earned on those
resources.
In the version used in this Study Manual, the total resources available to a company are the amounts
owed to shareholders who receive dividends, plus the amounts owed to those who provide finance only
on the condition that they receive interest in return. So interest-bearing debt, both long term and short
term (for example bank overdrafts), are included but trade payables (which are an interest-free source of
finance) are not. But to cope with companies which move from one month to another between positive
and overdrawn bank balances, holdings of cash and cash equivalents (but not any other 'cash' current
assets which management does not describe as cash equivalents) are netted off, to arrive at 'net debt'.
The return is the amount earned before deducting any payments to those who provide the capital
employed. So it is the profits before both dividends and interest payable. Because interest is tax-
deductible, the profit figure is also before taxation. The PBIT (profit before interest and tax) tag is well
established within the UK, so this term is used in ratio calculations although in the statement of profit or
loss and other comprehensive income layout used in this Study Manual the description given to this
figure is 'profit/(loss) from operations'.
To allow valid comparisons to be made with other companies, the return must also include the earnings
from investments in associates, because some groups carry out large parts of their activities through
associates, rather than the parent or subsidiaries.
Strictly speaking, it is the associates' pre-tax earnings which should be included, but under IAS 28 only
the post-tax amount is shown. In practice, some users adjust this figure using an estimated tax rate for
the associates to establish a pre-tax return.
Like profit, capital employed is affected by the accounting policies chosen by a company. For example, a
company that revalues its PPE will have higher capital employed than one which does not. The
depreciation expense will be higher and profits will be reduced as a result of the policy. The accounting
adjustments will reduce ROCE.
Return on shareholders' funds (ROSF)
This measures how effectively a company is employing funds that parent company shareholders have
provided.
Profit attributable to owners of parent  Source : SPLOCI 

 
Equity minus non-controlling interest  Source: SFP 
It is the return on the funds provided by the parent company's shareholders that is being analysed here,
so it is their equity which goes on the bottom of the fraction. This is the equity used in the ROCE
calculation minus the non-controlling interest.
The return is the profit for the year attributable to those shareholders.
Analysis usually focuses on ROCE, as opposed to ROSF, because the issue is management's ability to
generate return from overall resources rather than how those resources are financed.

Worked example: Calculating ROCE and ROSF
Consider two companies without subsidiaries in the same industry with different capital structures:
Company 1 Company 2
£m £m
Equity (A) 80 20
Loans at 10% 20 80
Capital employed (B) 100 100
PBIT (C) 20 20
Loan interest at 10% (2) (8)
Tax at 30% (5) (4)
Profit after tax (for owners) (D) 13 8
Solution
Company 1 Company 2
% %
ROCE (C) as % of (B) 20 20
ROSF (D) as % of (A) 16 40
ROCE is the same, so the companies are equally good in generating profits. But with different capital
structures, ROSF is very different.
C
If it wished, Company 1 could achieve the same capital structure (and therefore the same ROSF) by H
borrowing £60 million and using it to repay shareholders. A
P
It is often easier to change capital structures than to change a company's ability to generate profits. T
Hence the focus on ROCE. E
R
Note that Company 2 has much higher gearing and lower interest cover (these ratios are covered later
in this chapter).
23
Interactive question 1: ROCE and ROSF

Name five considerations that you should consider when drawing conclusions from ROCE and ROSF
calculations.
(1)
(2)
(3)
(4)
(5)
Gross profit percentage/margin

This measures the margin earned by a company on revenue, before taking account of overhead costs.
Gross profits  Source: SPLOCI 

 100  
Revenue  Source: SPLOCI 

Interactive question 2: Gross profit percentage
List four possible reasons for changes in the year on year gross profit percentage.
(1)
(2)
(3)
(4)
Operating cost percentage

This measures the relationship of overheads (fixed and variable, which usually comprise distribution
costs and administrative expenses) to revenue.
Operating costs/overheads  Source: SPLOCI 

 100  
Ideally this should be broken into variable overheads (expected to change with revenue) and fixed
overheads. However, such information is not usually published in financial statements.
Interactive question 3: Operating cost percentage

List two considerations that could account for changes in the operating cost percentage.
(1)
(2)
Operating profit margin/net margin

This shows the profit margin after all operating expenses.
PBIT Profit from operations  Source: SPLOCI 

 100 or  100  
Revenue Revenue  Source: SPLOCI 
2.2.3 Commentary
ROCE measures the return achieved by management from assets that they control, before payments to
providers of financing for those assets (lenders and shareholders).
For companies without associates, ROCE can be further subdivided into net profit margin and asset
turnover (use of assets).
Net profit margin  Net asset turnover = ROCE
PBIT Revenue PBIT
 =
Revenue Capital employed Capital employed
 Source : SPLOCI   Source : SPLOCI   Source : SPLOCI 

     
 Source : SPLOCI   Source: SFP   Source: SFP 
This subdivision is useful when comparing a company's performance from one period to another. While
ROCE might be identical for the two periods, there might be compensating changes in the two
components; that is, an improvement in margin might be offset by a deterioration in asset utilisation.
The subdivision might be equally useful when comparing the performance of two companies in the
same period.

Although associates' earnings are omitted, it will probably be worth making this subdivision even for
groups with earnings from associates, unless those earnings are very substantial indeed.
Net profit margin is often seen as a measure of quality of profits. A high profit margin indicates a high
profit on each unit sold. This ratio can be used as a measure of the risk in the business, since a high
margin business may remain profitable after a fall in margin while a low margin business may not.
Worked example: Net profit margin

Two companies with a revenue of £200 have net profit margins of 30% and 4%. If each company
discounts their sale prices by 5%, compute revised net profit margins.
5% price
Company 1 Base discount Revised
£ £ £
Revenue 200 (10) 190
Costs (140) (140)
Profit 60 (10) 50
Net profit margin 30% 26%
5% price
Company 2 Base discount Revised
£ £ £
Revenue 200 (10) 190
Costs (192) (192)
Profit 8 (10) (2)
C
Net profit margin 4% –1%
H
A
P
T
By contrast, net asset turnover (considered further under efficiency ratios in section 2.5.2 below) is often E
seen as a quantitative measure, indicating how intensively the management is using the assets. R
A trade-off often exists between margin and net asset turnover. Low margin businesses, for example
food retailers, usually have high asset turnover. Conversely, capital-intensive manufacturing industries 23
usually have relatively low asset turnover but higher margins, for example electrical equipment
manufacturers.
Gross profit is useful for comparing the profitability of different companies in the same sector but less
useful across different types of business, as the split of costs between cost of sales and other expense
headings varies widely according to the nature of the business. Even within companies competing
within the same industry distortions can be caused if companies allocate individual costs to different
cost headings.
Particular care must be taken when calculating, and then considering the implications of, these ratios if
the company concerned is presenting both continuing and discontinued operations. In the statement of
profit or loss and other comprehensive income layout used in this Study Manual, the amounts for
revenue, gross profit, operating costs and profit from operations all relate to continuing operations only.
Although amounts relating to the discontinued operations' revenue, total costs and profit from
operations are made available in the notes, it is probably not worth adding them back into the
continuing operations' amounts, for the simple reason that the results of continuing operations form the
most appropriate base on which to project future performance.
2.3 Short-term liquidity

2.3.1 Significance
Short-term liquidity ratios are used to assess a company's ability to meet payments when due. In
practice, information contained in the statement of cash flows is often more useful when analysing
liquidity.

2.3.2 Key ratios
Current ratio
This measures the adequacy of current assets to cover current liabilities.
Current assets  Source: SFP 

(usually expressed as X:1)  
Current liabilities  Source: SFP 
Quick (acid test or liquidity) ratio
Inventories, often rather slow moving, are eliminated from current assets, giving a better measure of
short-term liquidity. This is appropriate for those types of business that take significant time to convert
inventories into cash, such as an aircraft manufacturer.
Current assets – inventories  Source: SFP 

(usually expressed as X:1)  
Current liabilities  Source: SFP 
Interactive question 4: Current and quick ratios

Suggest a conclusion that may be drawn from high and low current and quick ratios.
What factors should be considered when investigating changes in short-term liquidity ratios?


2.3.3 Commentary
The current ratio is of limited use as some current assets, for example inventories, may not be readily
convertible into cash, other than at a large discount. Hence, this ratio may not indicate whether or not
the company can pay its debts as they fall due.
As the quick ratio omits inventories, this is a better indicator of liquidity but is subject to distortions. For
example, retailers have few trade receivables and use cash from sales quickly, but finance their
inventories from trade payables. Hence, their quick ratios are usually low, but this is in itself no cause for
concern.
A high current or quick ratio may be due to a company having excessive amounts of cash or short-term
investments. Though these resources are highly liquid, the trade-off for this liquidity is usually a low
return. Hence, companies with excessive cash balances may benefit from using them to repay longer-
term debt or invest in non-current assets to improve their overall returns.
Therefore, both the current and quick ratios should be treated with caution and should be read in
conjunction with other information, such as efficiency ratios and cash flow information.
In the statement of financial position layout used in this Study Manual, any non-current assets held for
sale will be presented immediately below the subtotal for current assets. In classifying them as held for
sale, the company is intending to realise them for cash, so it will usually be appropriate to combine this
amount with current assets when calculating both the current and quick ratios.
2.4 Long-term solvency

2.4.1 Significance
Gearing ratios examine the financing structure of a business. They indicate to shareholders and lenders
the degree of risk attached to the company and the sensitivity of earnings and dividends to changes in
profitability level.

2.4.2 Key ratios
Gearing ratio
Gearing measures the relationship between a company's borrowings and its risk capital.
Net debt (per ROCE)  Source: SFP 

 100  
Equity (per ROCE)  Source: SFP 
Alternatively, the ratio may be computed as follows:
Net debt
 100
Net debt + equity
Worked example: Gearing

The following are the summarised statements of financial position for two companies. Calculate the
gearing ratios and comment on each.
Company 1 Company 2
£m £m
Non-current assets 7 18
Inventory 3 3
Trade receivables 4 3
Cash 1 2
15 26
Equity 10 10 C
H
Trade payables 3 4 A
Borrowings 2 12 P
15 26 T
E
Solution R
Company 1 Company 2
Net debt  (2 – 1)   (12 – 2)  23
Gearing = 10%   100%  
Equity  10   10 
Both companies have the same equity amount. Company 1 is lower risk, as its borrowings are lower
relative to equity. This is because interest on borrowings and capital repayments of debt must be paid,
with potentially serious repercussions if they are not. Dividend payments on equity instruments are an
optional cash outflow for a business.
Company 2 has a high level of financial risk. If the borrowings were secured on the non-current assets,
then the assets available to shareholders in the event of a winding up are limited.
Interactive question 5: Gearing

When drawing conclusions from gearing ratios suggest two matters that should be considered.
(1)
(2)
Interest cover
Profit before interest payable (ie, PBIT + investment income)  Source: SPLOCI 
 
Interest payable  Source: SPLOCI 
In calculating this ratio, it is standard practice to add back into interest any interest capitalised during
the period.

2.4.3 Commentary
Many different measures of gearing are used in practice, so it is especially important that the ratios used
are defined.
Note that under IAS 32 Financial Instruments: Presentation redeemable preference shares should be
included in liabilities (non-current or current, depending on when they fall due for redemption), while
the dividends on these shares should be included in the finance cost/interest payable.
It is also the case that IAS 32 requires compound financial instruments, such as convertible loans, to be
split into their components for accounting purposes. This process allocates some of such loans to equity.
Notes
1 Interest on debt capital generally must be paid irrespective of whether profits are earned – this may
cause a liquidity crisis if a company is unable to meet its debt capital obligations.
2 Loan capital is usually secured on assets, most commonly non-current assets – these should be
suitable for the purpose (not fast-depreciating or subject to rapid changes in demand and price).
High gearing usually indicates increased risk for shareholders as, if profits fall, debts will still need to be
financed, leaving much smaller profits available to shareholders. Highly geared businesses are therefore
more exposed to insolvency in an economic downturn. However, returns to shareholders will grow
proportionately more in highly geared businesses where profits are growing.
The gearing ratio is significantly affected by accounting policies adopted, particularly the revaluation of
PPE. An upward revaluation will increase equity and capital employed. Consequently it will reduce
gearing.
Worked example: Impact of gearing on earnings

A company has an annual profit before interest of £200. Its interest on non-current debt is fixed at £100
per annum.
Consider the effects on net profits if the profits before interest were to decrease or increase by £100 per
annum.
(1) (2) (3)
£ £ £
Profit before interest 200 100 300
Interest on non-current debt (100) (100) (100)
Profit available to shareholders (earnings) 100 – 200
Compared to situation (1):
Change in profits before interest –50% +50%
Change in earnings –100% +100%
Low gearing provides scope to increase borrowings when potentially profitable projects are available.
Low-geared companies will usually be able to borrow more easily and cheaply than already highly
geared companies.
However, gearing can be too low. Equity finance is often more expensive in the long run than debt
finance, because equity is usually seen as being more risky. Therefore an ungeared company may
benefit from adjusting its financing to include some (usually cheaper) debt, thus reducing its overall cost
of capital.
Gearing is also significant to lenders, as they are likely to charge higher interest, and be less willing to
lend, to companies which are already highly geared, due to the increased default risk.
Interest payments are allowable for tax purposes, whereas dividends are not. This is another attraction of
debt.
Interest cover indicates the ability of a company to pay interest out of profits generated. Relatively low
interest cover indicates that a company may have difficulty financing the running costs of its debts if its
profits fall, and also indicates to shareholders that their dividends are at risk, as interest must be paid
first, even if profits fall.

2.5 Efficiency
2.5.1 Significance
Asset turnover and the working capital ratios are important indicators of management's effectiveness in
running the business efficiently, as for a given level of activity it is most profitable to minimise the level
of overall capital employed and the working capital employed in the business.
2.5.2 Key ratios

Net asset turnover
This measures the efficiency of revenue generation in relation to the overall resources of the business. As
the amount of net assets equals the amount of capital employed and as capital employed is used in the
ROCE calculation, it is easiest to calculate net asset turnover as:
Revenue  Source: SPLOCI 

 
Note that net asset turnover can be further subdivided by separating out the non-current asset element
to give non-current asset turnover:
Revenue  Source: SPLOCI 

 
Non-current assets  Source: SFP 
This relates the revenue to the non-current assets employed in producing that revenue.
Asset turnover is sometimes known as 'sweating the assets'. It is a reference to management's ability to C
maximise the output from each £ of capital that the company uses within the business. H
A
Inventory turnover P
T
The inventory turnover ratio measures the efficiency of managing inventory levels relative to demand. A E
business needs inventory to meet the needs of customers, but inventories are not generating revenues R
until they are physically sold, and tie up capital during this period. Like all management decisions, a
delicate path has to be followed between keeping too much and too little inventory.
23
Cost of sales  Source: SPLOCI 
 
Inventories  Source: SFP 
(= number of times inventories are turned over each year – usually the higher the better)
or
Inventories
 365
Cost of sales
(= number of days on average that an item is in inventories before it is sold – usually the lower the
better)
Ideally the three components of inventories should be considered separately:
 Raw material to volume of purchases
 WIP to cost of production
 Finished goods to cost of sales
Interactive question 6: Inventory turnover

State two implications of high and low inventory turnover rates.
(1)
(2)
Remember: the inventory turnover rate can be affected by seasonality. The year-end inventory position
may not reflect the average level of inventory.

Trade receivables collection period
This measures in days the period of credit taken by the company's customers.
Trade receivables  Source: SFP 

 365  
To obtain a full picture of receivables collection, it is best to exclude from the revenue figure any cash
sales, since they do not generate receivables. This may be difficult, because published financial
statements do not distinguish between cash and credit sales. Strictly speaking, VAT should be removed
from receivables (revenue excludes VAT), but such adjustments are rarely made in practice.
Interactive question 7: Trade receivables collection period

Suggest three matters that a change in the ratio could indicate.
(1)
(2)
(3)
Remember: the year-end receivables may not be representative of the average over the year.
Trade payables payment period

This measures the number of days' credit taken by the company from suppliers.
Trade payables  Source : SFP 

 365  
Credit purchases  Source: SPLOCI 
This should be broadly similar to the trade receivables collection period, where a business makes most
sales and most purchases on credit. If no figures are available for credit purchases, use cost of sales.
Interactive question 8: Trade payables payment period

Suggest two matters that a high and increasing trade payables payment period may indicate.
(1)
(2)
Remember: the year-end payables may not be representative of the average over the year.
Working capital cycle/cash operating cycle

These last three ratios are often brought together in the working capital cycle (alternatively the cash
operating cycle), calculated as inventory days plus trade receivables collection period minus trade
payables payment period.
Any increase in the total working capital cycle may indicate inefficient management of the components
of working capital.
2.5.3 Commentary
Net asset turnover enables useful comparisons to be made between businesses in terms of the extent to
which they work their assets hard in the generation of revenue.
Inventory turnover, trade receivables collection period and trade payables payment period give an
indication of whether a business is able to generate cash as fast as it uses it. They also provide useful

comparisons between businesses, for example on effectiveness in collecting debts and controlling
inventory levels.
Efficiency ratios are often an indicator of looming liquidity problems or loss of management control. For
example, an increase in the trade receivables collection period may indicate loss of credit control.
Declining inventory turnover may suggest poor buying decisions or misjudgement of the market. An
increasing trade payables payment period suggests that the company may be having difficulty paying
its suppliers; if they withdraw credit, a collapse may be precipitated by the lack of new supplies.
If an expanding business has a positive working capital cycle, it will need to fund this extra capital
requirement, from retained earnings, an equity issue or increased borrowings. If a business has a
negative working capital cycle, its suppliers are effectively providing funding on an interest-free basis.
As with all ratios, care is needed in interpreting efficiency ratios. For example, an increasing trade
payables payment period may indicate that the company is making better use of its available credit
facilities by taking trade credit where available. Therefore, efficiency ratios should be considered
together with solvency and cash flow information.
2.6 Non-current asset analysis

Analysts of financial statements use the information provided to understand future performance. For
capital-intensive companies it is essential that they understand the capital expenditure policies and
efficiency of non-current assets.
2.6.1 Capital expenditure to depreciation

Capital expenditure (additions) C
H
Depreciation A
P
This ratio highlights whether a company is expanding its non-current assets. A ratio below one would T
indicate that it is not even maintaining its operating capacity. A ratio in excess of one would indicate E
that the company is expanding operating capacity. But PPE price changes should be taken into account: R
if they are rising, a ratio of more than one may still indicate a reduction in capacity, unless significant
operating efficiencies are being generated from the new assets.
23
This ratio should include all additions, including those acquired under finance leases. The ratio is of
limited benefit where the entity leases operating facilities and classifies those leases as operating leases.
It is often helpful to review this ratio over a number of years to identify trends. In the short-term, capital
expenditure can be discretionary.
2.6.2 Ageing of non-current assets

Accumulated depreciation
Gross carrying amount of non-current assets
This ratio identifies the proportion of the useful life of PPE that has expired. It should be calculated for
each class of PPE. It helps identify:
 assets that are nearing the end of their useful life that may be operating less efficiently or may
require significant maintenance; and
 the need to invest in new PPE in the near term.
Obviously both of these ratios are influenced by the depreciation policies adopted by management.

Worked example: Capital expenditure
The following is an extract from the financial statements of Raport Ltd for the year ended 31 December
20X4.
Note 1 Plant and
equipment
£'000
Cost
At 1 January 20X4 2,757
Additions 137
Disposals (94)
At 1 January 20X4 1,922
Depreciation 302
Disposals (60)
Carrying amount 1 January 20X4 835
Carrying amount 31 December 20X4 636
Note 2 20X4 20X3

£'000 £'000
Profit from operations is stated after charging
Depreciation 302 289
Loss on disposal of plant and equipment 25 32
Requirement
Provide an analysis of the plant and equipment of Raport Ltd.
Solution
 137 
 Capital expenditure represents 45%   100%  of the depreciation expense for the year. This
 302 
suggests that management is not maintaining capacity.
 2,164 
 Accumulated depreciation represents 77%   100%  of the cost of the assets.
 2,800 
 1,922 
This has increased from 70%   100%  in the previous year.
 2,757 
This confirms that plant and equipment is ageing without replacement. On average the plant and
equipment is entering the last quarter of its useful life. This could indicate that the plant is
becoming less efficient.
 The accounting policies should be reviewed, because the losses on disposal could indicate that
depreciation rates are too low and that useful lives have been overestimated. This would confirm
that the plant and equipment is aged and raise further concerns about its renewal and efficiency.
2.7 Investors' ratios

2.7.1 Significance
Different investors' ratios (also known as stock market ratios) help different investors:
 Price/earnings ratio will be important to those investors looking for capital growth.
 Dividend yield, dividend cover and dividends per share will be important to those investors seeking
income.

Because all economic decisions relate to the future, not the past, investors should ideally use forecast
information. In practice only historical figures are usually available from financial statements, but
investment analysts devote substantial amounts of time to making estimates of future earnings and
dividends which they publish to their clients.
Investors' ratios are only meaningful for quoted companies as they usually relate, directly or indirectly, to
the share price.
2.7.2 Key ratios

Dividend yield
Dividend per share
 100
Current market price per share
The market price per share is a forward-looking value, since a buyer of a share buys into the future, not
past, performance of the company. So the most up to date amount for the dividend per share needs to
be used; using information in financial statements, the total dividend will be the interim for the year
recognised in the statement of changes in equity plus the final for the year disclosed in the notes to the
accounts.
Dividend yield may be more influenced by dividend policy than by financial performance. A high yield
based on recent dividends and the current share price may come about because the share price has
fallen in anticipation of a future dividend cut. Rapidly growing companies may exhibit low yields based
on historical dividends, especially if the current share price reflects anticipated future growth, because
such companies often retain cash in the business, through low dividends, to finance that growth.
C
Dividend cover H
A
Earnings per share P
Dividend per share T
E
A quoted company is required by IAS 33 Earnings per Share to disclose an amount for its earnings per R
share (EPS). You have met this in Chapter 11.
The dividend cover ratio shows the extent to which a current dividend is covered by current earnings. It
23
is an indication of how secure dividends are, because a dividend cover of less than one indicates that the
company is relying to some extent on its retained profits, a policy that is not sustainable in the long
term.
Price/earnings (P/E) ratio
Earnings per share
The P/E ratio is used to indicate whether shares appear expensive or cheap in terms of how many years
of current earnings investors are prepared to pay for. The P/E ratio is often used to compare companies
within a sector, and is published widely in the financial press for this purpose.
A high P/E ratio calculated on historical earnings usually indicates that investors expect significant future
earnings growth and hence are prepared to pay a large multiple of historical earnings. (Remember that
the share price takes into account market expectations of future profits, whereas EPS is based on past
levels of profit.) Low P/E ratios often indicate that investors consider growth prospects to be poor.
Net asset value
Net assets (equity attributable to owners of parent company)
Number of ordinary shares in issue
This calculation results in an approximation to the amount shareholders would receive if the company
were put into liquidation and all the assets were realised for, and all the liabilities were paid off at, their
statement of financial position amounts. In theory it is the amount below which the share price should
never fall because, if it did, someone would acquire all the shares, liquidate the company and take a
profit through distributions totalling the net asset value.
But the statement of financial position does not measure non-current assets at realisable value (many
would sell for less than their carrying amount but some, such as freehold and leasehold properties,

might realise more) and additional liabilities, such as staff redundancy payments and liquidation fees,
would need to be recognised. But there might be cash inflows on liquidation relating to items such as
intangible assets, which can be sold but were not recognised in the statement of financial position
because they did not meet the recognition requirements.
So net asset value is only an approximation to true liquidation values, but it is still widely regarded as a
solid underpinning to the share price.
2.8 Other indicators

Ratios are a key tool of analysis but other sources of information and comparisons are also available.
2.8.1 Absolute comparisons

Absolute comparisons can provide information without computing ratios, for example comparing
statement of financial position or statement of profit or loss and other comprehensive income amounts
between this year and last and identifying changes.
Such comparisons may help to explain changes in ratios; if, for example, the statement of financial
position shows that new shares have been issued to repay borrowings or finance new investment, this
may explain a change in gearing and ROCE.
2.8.2 Background information

Background information supplied about the nature of the business may help to explain changes or
trends, for example you may be told that the business has made an acquisition, disposal or entered a
new market. The type of business itself has a major impact on the information presented in the financial
statements.
2.8.3 Cash flow information

The statement of cash flows provides information as to how a business has generated and used cash so
that users can obtain a fuller picture of liquidity and changes in financial position. Interpretation of cash
flow information is covered in the next section.
Interactive question 9: Calculations

Now try this comprehensive example to practise the calculation of various ratios that could be required
in the examination.
JG Ltd Group
Summarised consolidated statement of financial position at 31 December 20X1
£ £
Current assets
Inventories 600
Investments 40
1,600
4,200
Equity
Ordinary share capital (£1) 1,000
Attributable to owners of JG Ltd 1,650
Equity 1,800

£ £
Borrowings 1,400
Redeemable preference shares 200
1,600
Current liabilities
Trade payables 750
Bank overdraft 50
800
4,200
Summarised consolidated statement of profit or loss and other comprehensive income

for the year ended 31 December 20X1
£ £
Revenue 6,000
Gross profit 2,000
Operating expenses (1,660)
Profit from operations 340
Interest on borrowings (74)
Preference share dividend (10)
(84)
Income from investments 5
C
Tax (106)
H
Profit after tax 155 A
Attributable to: P
T
Owners of JG Ltd 140
E
Non-controlling interest 15 R
155
Requirement 23
Calculate the ratios applicable to JG Ltd.
Solution
(a) Return on capital employed (ROCE)

Profit before interest and tax
 100 =
Capital employed
(b) Return on shareholders' funds (ROSF)

Profit attributable to owners of parent company
=
Equity – non-controlling interest
(c) Gross profit %

GP
 100 =
Revenue
(d) Net profit margin
Profit before interest and tax
 100 =
Revenue
(e) Net asset turnover
Revenue
=
Capital employed

(f) Proof of ROCE = Net profit margin × Net asset turnover
ROCE = ×
(g) Non-current asset turnover
Revenue
=
Non- current assets
(h) Current ratio

Current assets
=
Current liabilities
(i) Quick ratio
Current assets less inventories
=
Current liabilities
(j) Inventory turnover
Cost of sales
=
Inventories
(k) Inventory days
Inventories
 365 =
Cost of sales
(l) Trade receivables collection period
Trade receivables
 365 =
Revenue
(m) Trade payables payment period
Trade payables
 365 =
Cost of sales
(n) Gearing
Net debt
 100 =
Equity
(o) Interest cover

PBIT + Investment income
=
Interest payable
3 Statements of cash flows and their interpretation
Section overview
 The analysis of the statement of cash flows is essential to an understanding of business
performance and liquidity of individual companies and groups.
 Cash flow ratios provide crucial information as a part of financial statement analysis.
The ratios examined so far relate to information presented in the statement of financial position and
statement of profit or loss and other comprehensive income. The statement of cash flows provides
valuable additional information, which facilitates more in-depth analysis of the financial statements.

The importance of the statement of cash flows lies in the fact that businesses fail through lack of cash,
not lack of profits:
(a) A profitable but expanding business is likely to find that its inventories and trade receivables rise
more quickly than its trade payables (which provide interest-free finance). Without adequate
financing for its working capital, such a business may find itself unable to pay its debts as they fall
due.
(b) An unprofitable but contracting business may still generate cash. If, for example, a statement of
profit or loss and other comprehensive income is weighed down with depreciation charges on non-
current assets but the business is not investing in any new non-current assets, capital expenditure
will be less than book depreciation.
IAS 7 Statement of Cash Flows therefore requires the provision of information about changes in the cash
and cash equivalents of an entity, as a basis for the assessment of the entity's ability to generate cash
inflows in the future and its needs to use such cash flows. Cash flow information, when taken with the
rest of the financial statements, helps the assessment of:
 changes in net assets
 financial structure
 ability to affect timing and amount of cash flows
Cash flow information also facilitates comparisons between entities, because it is unaffected by different
accounting policies – to this extent it is often regarded as more objective than accrual-based
information.
3.1 Types of cash flow C

H
3.1.1 Operating activities A
P
Operating cash flows may be compared with profit from operations. The extent to which profits are T
matched by strong cash flows is an indication of the quality of profit from operations in that, while E
profit from operations represents the earnings surplus available for dividend distribution, operating cash R
flows represents the cash surplus generated from trading, which the company can then use for other
purposes.
23
However, caution is required where there are significant non-current assets, because depreciation is
included in operating profit, but not operating cash flow. Depreciation could therefore be excluded
from operating profit for comparison with cash flows, as the cash flows for non-current asset
replacement are presented under investing, not operating, activities.
If operating cash flows are significantly lower than profit from operations, this may indicate that the
company is in danger of running out of cash and encountering liquidity problems. In such cases,
particular attention needs to be paid to the liquidity and efficiency ratios.
Significant operating cash outflows are unsustainable in the long run. If operating cash flow is negative,
this needs to be investigated. Possible reasons include the following:
(a) Building up inventory levels due to expansion of the business, which tends to increase cash paid to
suppliers but does not produce profit from operations because costs are included in inventories
(b) Declining revenue or reduced margins
Rapid expansion of a business is often associated with operating cash outflows. In the short term, this
need not be a problem provided that sufficient finance is available.
Payments to service debt finance are non-discretionary, in that the terms of loan agreements usually
require finance to be serviced, even if the business is not profitable.
If operating cash flows are insufficient to cover the interest cash flows, the company is likely to be in
serious financial trouble, unless there is an identifiable non-recurring cause for the shortfall or new
equity finance is forthcoming, for example to reduce interest-bearing debts.
Taxation cash flows are also non-discretionary. They tend to lag behind tax charges recognised in the
statement of profit or loss and other comprehensive income. In growing businesses, tax cash outflows
will often be smaller than tax charges.
Note: Cash payments to manufacture or acquire, and cash receipts on the sale of, assets held for rental
to others are cash flows from operating (not investing) activities.

3.1.2 Investing activities
This heading in the statement of cash flows includes cash flows relating to property, plant and
equipment. In the short term, these cash flows are discretionary, in that the business will normally
survive even if property, plant and equipment expenditure is delayed for some months, or even years.
Significant cash outflows indicate property, plant and equipment additions, which should lead to the
maintenance or enhancement of operating cash flows in the long term. However, such investment must
be financed, either from operating cash flows or from new financing.
Net outflows on property, plant and equipment replacement can also be compared with the
depreciation expense in the statement of profit or loss and other comprehensive income. A significant
shortfall of capital spend compared to depreciation may indicate that the company is not replacing its
property, plant and equipment as they wear out, or might suggest that depreciation rates are wrongly
estimated.
3.1.3 Financing activities

Financing cash flows show how the company is raising finance (by debt or shares) and what finance it is
repaying.
The reasons underlying financing cash flows need to be analysed. For example, inflows may be to
finance additions to property, plant and equipment to expand the business or renew assets. New share
finance may be used to repay debt, thus reducing future interest costs. Alternatively, new financing may
be necessary to keep the company afloat if it is suffering significant operating and interest cash outflows.
This last situation is unsustainable in the long term, as the company will eventually become insolvent.
3.1.4 Equity dividends paid

Equity dividends paid are, in theory, a discretionary cash flow. However, companies are often under
significant investor pressure to maintain dividends even where their profits and cash flows are falling.
Equity dividends paid should be compared to the cash flows available to pay them. If a company is
paying out a significant amount of the available cash as dividends, it may not be retaining sufficient
funds to finance future investment or the repayment of debt.
It is common policy among private equity companies, which own a number of well-known companies,
both in the UK and overseas, to not pay dividends and focus instead on debt minimisation.
3.2 Cash flow ratios

Traditional ratios are based on information in the statement of profit or loss and other comprehensive
income and statement of financial position. Some of these can be adapted to produce equivalent ratios
based on cash flow.
3.2.1 Cash return on capital employed

Cash return (see below)  Source: SCF 
 100  
Cash return is computed as:
Cash generated from operations X
Interest received (from investing activities) X
Dividends received (from investing activities) X
X
Capital employed is the same as that used in ROCE.

The cash return is an approximate cash flow equivalent to profit before interest payable. As capital
expenditure is excluded from the cash return, care is needed in comparing cash ROCE to traditional
ROCE which takes account of depreciation of non-current assets.

3.2.2 Cash from operations/profit from operations
Cash generated from operations  Source: SCF 
 100  
Profit from operations  Source: SPLOCI 
This measures the quality of the profit from operations. Many profitable companies have to allocate a
large proportion of the cash they generate from operations to finance the investment in additional
working capital. To that extent, the profit from operations can be regarded as of poor quality, since it is
not realised in a form which can be used either to finance the acquisition of non-current assets or to pay
back borrowings and/or pay dividends.
So the higher the resulting percentage, the higher the quality of the profits from operations.
3.2.3 Cash interest cover

Cash return (as in 3.2.1)  Source: SCF 
 
Interest paid  Source: SPLOCI 
This is the equivalent of interest cover calculated based on the statement of profit or loss and other
comprehensive income. Capital expenditure is normally excluded on the basis that management has
some discretion over its timing and amount. Caution is therefore needed in comparing cash interest
cover with traditional interest cover, as profit from operations is reduced by depreciation. Cash interest
cover will therefore tend to be slightly higher.
3.2.4 Investors' ratios

C
Cash flow per share H
A
Cash flow for ordinary shareholders ( = cash return (as in 3.2.1) – interest paid – tax paid)  Source: SCF  P
  T
Number of ordinary shares  Source: SFP  E
R
This is the cash flow equivalent of earnings per share. It is common practice to exclude capital
expenditure from this measure, because of the discretion over the timing of such expenditure. Therefore
caution needs to be exercised in comparing cash flow per share with traditional EPS, as earnings do take
23
account of depreciation.
Cash dividend cover
Cash flow for ordinary shareholders (as above)
Equity dividends paid
This is the cash flow equivalent of dividend cover based on earnings. Similar comments apply regarding
exclusion of capital expenditure as are noted under cash flow per share.

Interactive question 10: Calculation of cash flow ratios
The following is a statement of cash flows for a company.
Year ended
31 March 20X6
£'000 £'000
Cash generated from operations (Note) 12,970
Interest paid (360)
Tax paid (4,510)
Net cash from operating activities 8,100
Purchase of property, plant and equipment (80)
Dividends received 20
Proceeds on sale of property, plant and equipment 810
Net cash from investing activities 750
Dividends paid (4,500)
Borrowings (1,000)
Net cash used in financing activities (5,500)
Change in cash and cash equivalents 3,350
Cash and cash equivalents brought forward 2,300
Cash and cash equivalents carried forward 5,650
Note:
£'000
Reconciliation of profit before tax to cash generated from operations
Finance cost 340
Amortisation 560
Depreciation 2,640
Loss on disposal of property, plant and equipment 160
Decrease in inventories 570
Decrease in receivables 340
(Decrease) in trade payables (50)
The profit from operations for 20X6 is £8,750,000 and the capital employed at 31 March 20X6 was
£28,900,000. There were 15 million ordinary shares in issue throughout the year.
Requirement
Calculate the cash flow ratios listed below for 20X6.
Solution
(a) Cash return
Cash generated from operations =
Interest received =
Dividends received =
(b) Cash return on capital employed

Cash return (from above)
 100 =
Capital employed
(c) Cash from operations/profit from operations
Cash generated from operations
 100 =
Profit from operations

(d) Cash interest cover
Cash return
=
Interest paid
(e) Cash flow per share
Cash flow for ordinary shareholders
=
Number of ordinary shares
(f) Cash dividend cover
Cash flow for ordinary shareholders
=
Equity dividends paid
4 Economic events
Section overview
Economic factors can have a pervasive effect on company performance and should be considered when
analysing financial statements.
C
The economic environment that an entity operates in will have a direct effect on its financial H
performance and financial position. The economic environment can influence management's strategy A
P
but in any event will influence the business performance. T
Examples of economic factors that should be considered when analysing financial statements could E
R
include:
(a) State of the economy
23
If the economy that a company operates in is depressed then it will have an adverse effect on the
ratios of a business. When considering economic events it is important to consider the different
geographical markets that a company operates in. These may provide different rates of growth,
operating margins, future prospects and risks. An obvious current example is the contrast in the
economies of Greece and Germany. Other examples could include emerging markets versus those
in recession. Some businesses are more closely linked to economic activity than others, especially if
they involve discretionary spending, such as holidays, eating out in restaurants and so on.
(b) Interest rates and foreign exchange rates
Increases in interest rates may have adverse effects on consumer demand particularly if the
company is involved in supplying products that are discretionary purchases or in industries, such as
home improvements, that are sensitive to such movements. Highly geared companies are most at
risk if interest rates increase or if there is an economic downturn; their debt still needs to be
serviced, whereas ungeared companies are less exposed. Changes in foreign exchange rates will
have a direct effect on import and export prices with direct effects on competitiveness.
(c) Government policies
Fiscal policy can have a direct effect on performance. For example, the use of trade quotas and
import taxes can affect the markets in which a company operates. The availability of government
export assistance or a change in levels of public spending can affect the outlook for a company.
(d) Rates of inflation
Inflation can have an effect on the comparability of financial statements year on year. It can be
difficult to isolate changes due to inflationary aspects from genuine changes in performance.
In analysing the effect of these matters on financial statements, the disclosures required by IFRS 8
Operating Segments are widely regarded as necessary to meet the needs of users.

5 Business issues
Section overview
The nature of the industry in which the company operates and management's actions have a direct
relationship with business performance, position and cash flow.
The information in financial statements is shaped to a large extent by the nature of the business and
management's actions in running it. These factors influence trends in the business and cause ratios to
change over time or differ between companies.
Examples of business factors influencing ratios are set out below.
(a) Type of business
This affects the nature of the assets employed and the returns earned. For example, a retailer may
have higher asset turnover but lower margins than a manufacturer and a services business may
have very little property, plant and equipment (so low capital employed and high ROCE) while a
manufacturer may have lots of property, plant and equipment (so high capital employed and low
ROCE).
(b) Quality of management
Better managed businesses are likely to be more profitable (and have improved working capital
management) than businesses where management is weak. Where management is seen as high
quality then this can have a favourable effect.
(c) Market conditions
If a market sector is depressed, this is likely to affect companies adversely and make most or all of
their ratios appear worse. Diverse conglomerates may operate in a number of different business
sectors, each of which is affected by different market risks and opportunities.
(d) Management actions
These will be reflected in changes in ratios. For example, price discounting to increase market share
is likely to reduce margins but increase asset turnover; withdrawing from unprofitable market
sectors is likely to reduce revenue but increase profit margins.
(e) Changes in the business
If the business diversifies into wholly new areas, this is likely to change the resource structure and
thus impact on key ratios. An acquisition near the year end will mean that capital employed will
include all the assets acquired but profits from the acquisition will only be included in the
statement of profit or loss and other comprehensive income for a small part of the year, thus
tending to depress ROCE. But this can be adjusted for, because IFRS 3 Business Combinations
requires acquirers to disclose by way of note, total revenue and profit as if all business
combinations had taken place on the first day of the accounting period.
Worked example: Acquisition during year

A group's revenue for the current period was £10 million (previous year £8 million) and its period end
trade receivables were £1.6 million (previous year £900,000). During the year a new subsidiary was
acquired which carried trade receivables of £300,000 at the acquisition date.
At first sight there appears to be a very disproportionate increase in trade receivables, up by almost 78%
((1,600/900) – 1) when revenue is up by 25%. But if the previous year receivables are increased by the
acquired receivables of £300,000, the increase in receivables is 33% ((1,600/1,200) – 1), more
comparable with the revenue increase.

Notes
1 The acquisition renders the period-end trade receivables collection period non-comparable with
that for the previous period.
2 The consolidated statement of cash flows will present the trade receivables component in the
working capital adjustments as the amount after the acquired receivables have been added on to
the group's opening balance.
3 IFRS 3 requires disclosure in respect of each acquisition of the amounts recognised at the
acquisition date for each class of assets and liabilities and the acquiree's revenue and profit or loss
recognised in consolidated profit or loss for the year. In addition, there should be disclosure of the
consolidated revenue and profit or loss as if the acquisition date for all acquisitions had been the
first day of the accounting period. This allows users to understand the impact of the acquired entity
on the financial performance and financial position as evidenced in the consolidated financial
statements.
Worked example: Impact of type of business

Set out below are example ratios for two quoted companies:
Heavy Advertising
manufacturing and media
 PBIT 
Return on capital employed   13.9% 36.6%
 Capital employed 
C
 PBIT 
Net margin   13.2% 3.1% H
 Revenue  A
P
 Revenue 
Net asset turnover   1.05 times 11.8 times T
 Capital employed  E
R
 Current assets 
Current ratio   1.35:1 0.84:1
 Current liabilities 
 Current assets – inventories  23
Quick ratio   0.96:1 0.78:1
 Current liabilities 
 Net debt 
Gearing   38.4% 104.1%
 Equity 
 PBIT + investment income 
Interest cover   4.1 times 5.9 times
 Interest payable 
 Cost of sales 
Inventory turnover   4.5 times 58.8 times
 Inventories 
Trade receivables collection  Trade receivables 
  365  63 days 30 days
period  Revenue 
This illustration shows that very different types of business can have markedly different ratios. A heavy
manufacturing company has substantial property, plant and equipment and work in progress and earns
a relatively high margin. An advertising and media company generates a very high ROCE, mainly
because its asset base, as reflected in the financial statements, is small. Most of the 'assets' of such a
business are represented by its staff, the value of whom is not recognised in the statement of financial
position.
In analysing the effect of business matters on financial statements, the segment disclosures required by
IFRS 8 Operating Segments provide important information that allows the user to make informed
judgements about the entity's products and services.

One of the complications in analysing financial statements arises from the way IFRSs are structured:
 IAS 1 Presentation of Financial Statements sets down the requirements for the format of financial
statements, containing provisions as to their presentation, structure and content; but
 the recognition, measurement and disclosure of specific transactions and events are all dealt with
in other IFRSs.
So preparers of financial statements must consider the possible application of several different IFRSs
when deciding how to present certain business transactions and business events and users must be
aware that details about particular transactions or events may appear in several different parts of the
Interactive question 11: The effect of business issues on financial reporting

A listed company operating in the electronics manufacturing sector has decided that due to cost
pressures it will downsize its UK-based operations. A number of manufacturing facilities will close and
the activities will be outsourced to South-East Asian countries.
Requirement
Identify six IASs/IFRSs that may need to be considered and briefly give examples of why.
Solution
(1)
(2)
(3)
(4)
(5)
(6)
6 Accounting choices
Section overview
 IFRSs include scope for choices in accounting treatment.
 Management make estimates on judgemental matters such as inventory obsolescence that can
have a significant effect on the view given.
6.1 Accounting policy choices

The scope for making choices in accounting treatment has been narrowed significantly in recent years
due to the development of more prescriptive accounting standards.
Nevertheless, significant choices still exist in a number of areas, for example:
(a) Asset revaluation
Revaluation of property, plant and equipment is particularly significant because it affects the total
amounts recognised as depreciation expense in profit or loss over the life of an asset. Revaluation
also has a significant impact on gearing and ROCE. If assets are revalued upwards, this increases
equity and total net assets but does not alter debt. Therefore, the gearing ratio will fall. Asset
revaluations also increase capital employed without a pound (£) for pound (£) effect on profits, so
the ROCE will fall. Because depreciation is based on the revalued amount, it will rise, further
depressing ROCE.

(b) Cost or fair value model for measurement of investment property
Where the cost model is used, the asset should be depreciated over its useful life. This produces a
systematic expense in profit or loss. The use of the fair value model potentially introduces volatility
into profit or loss and capital employed. Key ratios such as ROCE will be more difficult to predict if
the fair value model is adopted.
(c) Classification of financial assets
Financial assets can be classified in up to four different ways. The classification affects their
measurement in the statement of financial performance and the presentation of the gains or losses.
This will have a direct effect on profit and capital employed.
The disclosure of accounting policies within the financial statements allows users to understand those
policies and adjust financial statements to a different basis, if desired.
Interactive question 12: Asset revaluation

On 1 January 20X1, Tiger Ltd bought for £120,000 an item of plant with an estimated useful life of
20 years and no residual value. Tiger Ltd depreciates its property, plant and equipment on a straight-line
basis. Tiger Ltd's year end is 31 December.
On 31 December 20X3, the asset was carried in the statement of financial position as follows:
£'000
Non-current asset at cost 120
Accumulated depreciation (3  (120,000 ÷ 20)) (18)
102 C
H
Situation A A
P
The asset continues to be depreciated as previously at £6,000 per annum, down to a carrying amount at T
31 December 20X6 of £84,000. E
R
On 1 January 20X7, the asset is sold for £127,000, resulting in a profit of £43,000.
Situation B
23
On 1 January 20X4, the asset is revalued to £136,000, resulting in a gain of £34,000. The total useful life
remains unchanged. Depreciation will therefore be £8,000 per annum; that is, £136,000 divided by the
remaining life of 17 years.
On 1 January 20X7, the asset is sold for £127,000, resulting in a reported profit on disposal of £15,000.
Requirement
Ignoring the provisions of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, summarise
the impact on reported results and net assets of each of the above situations for the years 20X4 to 20X7
inclusive.

6.2 Judgements and estimates
Even though accounting standards set out detailed requirements in many areas of accounting,
management still needs to exercise judgement and make significant estimates in preparing the financial
statements.
Examples of judgements and estimates required of management include:
Financial statement area Judgement or estimation required
Property, plant and equipment  Depreciation methods

 Residual values
 Useful lives
 Revaluations/impairments
Intangible assets  Allocation of consideration in a business combination
 Future cash flows for impairment tests
 Amortisation periods
Inventories  Inclusion of overheads and the normal level of activity
 Inventory valuation methods
Lease transactions  Classification as an operating or finance lease
 Method of allocating finance charges
Provisions  Probability of outflow of economic benefits
 Measurement of liabilities
Construction contracts  Estimates of future costs
 Estimation of stage of completion
Trade receivables  Collectability and impairment
Segment analysis  Allocation of common costs to segments
 Setting of transfer prices between segments
The increasing use of cash flow analysis by users of financial statements is often attributed to the issues
surrounding the inappropriate exercise of judgement in the application of accounting policies.
In certain areas business analysts adjust financial statements to aid comparability to facilitate better
comparison. These adjustments are often termed 'coping mechanisms'.
For example, some analysts convert operating leases into finance leases in the statement of financial
position using the 'Rule of 8'. This involves multiplying the operating lease expense in the statement of
profit or loss and other comprehensive income by a factor (8 being the most commonly used), and
adding this to debt in the statement of financial position.
This is because there is often a fine dividing line between finance and operating leases. Some leases are
sold by lessors on the basis that they will qualify as operating leases, and thus keep gearing low. The
Rule of 8 adjustment nullifies such an approach and increases comparability between companies using
these different types of lease.
7 Ethical issues
Section overview
Ethical issues can arise in the preparation of financial statements. Management may be motivated to
improve the presentation of financial information.
The preparation of financial statements requires a great deal of professional judgement, honesty and
integrity. Therefore, Chartered Accountants should employ a degree of healthy scepticism when
reviewing financial statements and any analysis provided by management.

The financial statements and the associated ratio analysis could be affected by pressure on the preparers
of those financial statements to improve the financial performance, financial position or both. Managers
of organisations may try to improve the appearance of the financial information to:
 increase their level of bonus pay or other reward benefits;
 deliver specific targets such as EPS growth to meet investors' expectations;
 reduce the risk of corporate insolvency, such as by avoiding a breach of loan covenants;
 avoid regulatory interference, for example where high profit margins are obtained;
 improve the appearance of all or part of the business before an initial public offering or disposal, so
that an enhanced valuation is obtained; and
 understate revenues and overstate expenses to reduce tax liabilities.
Users of financial statements must be wary of the use of devices which improve short-term financial
position and financial performance. Such inappropriate practices can be broadly summarised into three
areas:
(a) Window dressing of the year-end financial position
Examples may include the following:
(i) Agreeing with customers that receivables are paid on shorter terms around year end, so that
the trade receivables collection period is reduced and operating cash flows are enhanced
(ii) Modifying the supplier payment cycle by delaying payments normally made in the last month of
the current year until the first month of the following year; this will improve the cash position C
H
(iii) Offering incentives to distributors to buy just before year end rather than just after A
P
(b) Exercise of judgement in applying accounting standards
T
Examples may include the following: E
R
(i) Unreasonable cash flow estimates used in justifying the carrying amount of assets subject to
impairment tests
23
(ii) Reducing the percentage of outstanding receivables for which full provision is made
(iii) Reducing the obsolescence provisions in respect of slow-moving inventories
(iv) Extending useful lives of property, plant and equipment to reduce the depreciation charge
(c) Inappropriate transaction recording
Examples may include the following:
(i) Additional revenue can be pushed through in the last weeks of the accounting period, only for
returns to be accepted and credit notes issued in the next accounting period
(ii) Intentionally failing to correct a number of accounting errors which individually are immaterial
but are material when taken together
(iii) Deferring revenue expenses, such as repairs and maintenance, into future periods
Actions such as these will not make any difference to financial performance over time, because all they
do is to shift profit to an earlier period at the expense of the immediately following period. Financial
position can be improved by measures such as these only in the short term. But there may well be short-
term benefits to management if these improvements keep the business within its banking covenants or
if performance bonuses are to be paid to management if certain profit levels are achieved.

Interactive question 13: Changing payment dates
A company prepares a budget for the months of December 20X5 and January 20X6 and the position at
31 December 20X5 which includes the following:
£'000
Supplier payments in each of December 20X5 and January 20X6 300
Current assets at 31 December 20X5
Cash 400
1,100
Inventories 500
1,600
Current liabilities at 31 December 20X5 1,000
Requirement
Calculate the current and quick ratios under the following options:
Option 1 Per the budget
Option 2 Per the budget, except that the supplier payments budgeted for December 20X5 are
made in January 20X6
Option 3 Per the budget, except that the supplier payments budgeted for January 20X6 are made in
December 20X5
Solution
Current ratio Quick ratio
Option 1
Option 2
Option 3
Finance managers who are part of the team preparing the financial statements for publication must be
careful to withstand any pressures from their non-finance colleagues to indulge in reporting practices
which dress up short-term performance and position. Financial managers must be conscious of their
obligations under the ethical guidelines of the professional bodies of which they are members and in
extreme cases may find it useful to seek confidential guidance from district society ethical counsellors
and the ICAEW ethics helpline which is maintained for members. For members of ICAEW, guidance can
be found in the Code of Ethics.
Interactive question 14: Ethical pressures

You are the financial controller of Haddock plc. A new Managing Director (MD) with a strong
domineering character has recently been appointed by Haddock plc. She has decided to launch an
aggressive acquisition strategy and a target company has been identified. You have drafted a report for
Haddock plc's management team that identifies several material fair value adjustments which would
increase the carrying amount of the acquired assets if the acquisition occurs. The MD has demanded
that you revise your report on the fair value adjustments so that the carrying amounts of the acquired
assets are materially reduced rather than increased.
Requirement
Identify the motivations of the MD and discuss the actions that you should consider.
Solution
Motivations





Actions to consider




8 Industry analysis
Section overview
Industry-specific performance measures can be extremely useful when analysing financial statements.
8.1 Introduction
Some industries are assessed using specific performance measures that take into consideration their
specific natures. This is often the case with industries that are relatively young and growing rapidly, for
which the traditional finance-based performance criteria do not show the full operational performance.
Many professional analysts use non-financial performance measures when valuing companies for merger
and acquisition (M&A) purposes. The M&A industry uses sophisticated tools that combine a variety of
figures, both financial and non-financial in nature, when advising clients on the appropriate price to pay C
H
for a company.
A
P
T
8.2 Specific industries E
R
Mobile phone operators often quote their growth in subscriber numbers and the average spend per
customer per year. This is because such companies have high fixed costs, such as the cost of the
communications licence and the maintenance of the mobile mast network; this high operational
23
gearing magnifies the profit effect of increases in customers.
Satellite television companies similarly are keen to quote increases in their customer base.
Worked example: BSkyB

BSkyB added more than 70,000 TV customers in the three months to the end of March 2014 – its
highest rate in five years. BSkyB said that a focus on marketing its TV products, which include cheaper
internet service Now TV, had paid off, with 74,000 new subscribers in the period taking the total TV
base to 10.6 million.
BSkyB often quotes the 'churn' rate, which is the percentage of customers who cancel their
subscriptions. It is closely monitored by industry analysts, to see whether the growth in subscribers is
being offset by existing customers leaving.
Service companies with a finite number of places to offer, such as airlines and hotels, will quote their
seat/bed occupancy rates. This is viewed by industry analysts as a measure of the individual success of
the company and is compared to both industry averages and competitors.
Retailers are often assessed on sales per square metre of floor space. Such information can be used by
external users to compare the performance of retailers operating within the same industry, and also
internally by management to identify poorly performing stores operated by the organisation.
Retailers will also quote 'like for like' sales. This is the growth in sales revenues, after stripping out the
impact of new stores that have opened during the year. The reason for this is that they can demonstrate
to users that they are increasing revenues both organically from existing outlets as well as by expanding
their operations. Analysts may also look at like for like sales to arrive at a less optimistic picture, as in the
example below.
(Source: https://www.theguardian.com/media/2014/may/01/bskyb-tv-broadband-now-tv)

Worked example: J Sainsbury plc
From The Motley Fool website:
March 2014 saw Sainsbury's underlying sales rise by 2.8%, although like for like sales only gained 0.2%.
(Source: www.fool.co.uk/investing/2014/09/22/the-best-reason-to-buy-j-sainsbury-plc/)
Worked example: Professional service companies

Some of the specific performance measures used in professional service companies include the
following:
 Fees per partner (or director)
 Chargeability percentage of staff – this could be calculated as the total hours billed to clients
divided by the total number of available hours
 Employee turnover – this could be calculated as the number of voluntary resignations and
terminations, divided by the total number of employees at the beginning of the period
 Average fee recovery per hour – this could be calculated as the total fee income divided by the
number of hours incurred
 Days of unbilled inventory
9 Non-financial performance measures
Section overview
Non-financial performance measures can often be as important as financial performance measures in
analysing financial statements.
9.1 Profit-seeking entities

Company performance can be measured in terms of volume growth as well as financial growth. Some
companies will therefore present non-financial information in the form of growth in the level of sales in
terms of units. An oil company might quote barrels of oil produced, a games console company the units
sold at launch. This is especially important if the price for the product is erratic, such as oil or raw
materials.
Market share is also an important benchmark of success within an industry. This can be used as a benchmark
of the success of an individual product line, or used as the basis to increase other types of revenues.
Worked example: Market shares

A web traffic analysis firm reported that in April 2012 Microsoft had a 50% share of the web browser
market (April 2011: 55%). In the same month Mozilla Firefox had a 19% share (down in the year from
22%), followed by Google's Chrome at 17% (up from 12%) and Apple's Safari at 9% (up from 7%).
(Source: https://www.forbes.com/sites/limyunghui/2012/04/06/internet-explorer-fightback-qa-with-ie-
lead-of-microsoft-asia-jonathan-wong/#71a778187263)
Other interested parties can also make use of the financial statements. For example, there may be
information relating to the number of employees working at an entity. Such information can be used to
assess employment prospects, as a company that is increasing its number of staff probably has greater
appeal to prospective employees. Staff efficiency can also be calculated by calculating the average
revenue per employee.

However, as with all performance measures, care must be taken to make sure the information means
what it says. For example, a company might outsource a significant number of its functions, such as HR,
IT, payroll after-sales service and so on. Thus it would appear to have a relatively low employee base
compared to a competitor who operated such functions in-house. Comparability would be distorted.
9.2 Not for profit entities

Not all entities are profit-seeking. Schools, hospitals, charities and so on may all have objectives that are
not financially based. However, they may be assessed by interested parties and present information
alongside their financial statements.
Institution Performance measure
Hospital Speed at attending to patients, success rates for certain types of operation, length of
waiting lists
School Exam pass rates, attendance records of pupils, average class sizes
Charity Percentage of income spent on administrative expenses, speed of distribution of
income
10 Limitations of ratios and financial statement analysis
Section overview C
Below is a summary of the limitations of ratios and financial statement analysis. H
A
P
Financial statement analysis is based on the information in financial statements so ratio analysis is subject T
to the same limitations as the financial statements themselves. E
R
(a) Ratios are not definitive measures. They provide clues to the financial statement analysis but
qualitative information is invariably required to prepare an informed analysis.
23
(b) Ratios calculated on the basis of published, and therefore incomplete, data are of limited use. This
limitation is particularly acute for those ratios which link statement of financial position and income
statement figures. A period-end statement of financial position may well not be at all representative
of the average financial position of the business throughout the period covered by the income
statement.
(c) Ratios use historical data, which may not be predictive, as it ignores future actions by management
and changes in the business environment.
(d) Ratios may be distorted by differences in accounting policies between entities and over time.
(e) Ratios are based on figures from the financial statements. If there is financial information that is not
captured within the financial statements (such as changes to the company reputation), then this
will be ignored.
(f) Comparisons between different types of business are difficult because of differing resource
structures and market characteristics. However, it may be possible to make indirect comparisons
between businesses in different sectors, by comparing each to its own sector averages.
(g) Window dressing and creative practices can have an adverse effect on the conclusions drawn from
the interpretation of financial information.
(h) Price changes can have a significant effect on time-based analysis across a number of years.

Summary
Accounting ratios
Performance Liquidity Investor Solvency Cash flow Efficiency
Current Dividend Cash return

ROCE Gearing Net asset
ratio yield on capital
turnover
employed
Quick Dividend Interest
ROSF Cash from
ratio cover cover Inventory
ops/profit
turnover
from ops
GP% P/E ratio
Cash Receivables
interest collection
Operating cover period
NAV
cost %
Payables
Cash flow
payment
Operating per share
period
margin
Cash Non-current
dividend asset
cover analysis
Financial Statement Analysis
Non-financial
Economic Business Accounting Ethical Industry
performance
issues issues issues issues issues
measures

Self-test
1 Wild Swan
The following extracts have been taken from the financial statements of Wild Swan Ltd, a
manufacturing company.
Statements of financial position as at 31 December
20X3 20X2
£'000 £'000 £'000 £'000
Assets
Non-current assets
Current assets
Trade and other receivables 2,261 1,657
3,819 2,662
Total assets 8,284 5,481

Ordinary share capital 522 354
Preference share capital (irredeemable – 8%) 150 150
C
Revaluation surplus 1,857 –
H
Retained earnings 2,084 2,094 A
Equity 4,613 2,598 P
T
Non-current liabilities E
Borrowings 105 – R
Current liabilities
Trade and other payables 1,941 1,638 23
Taxation 183 62
Bank overdraft 1,442 1,183
3,566 2,883
Total equity and liabilities 8,284 5,481
Statements of profit or loss and other comprehensive income for year ended 31 December
20X3 20X2
£'000 £'000
Revenue 24,267 21,958
Cost of sales (20,935) (19,262)
Gross profit 3,332 2,696
Net operating expenses (2,604) (2,027)
Profit from operations 728 669
Net finance cost payable (67) (56)
Taxation (203) (163)
Other comprehensive income for the year
Revaluation of property, plant and equipment 1,857 –
Total comprehensive income for the year 2,315 450

Statements of changes in equity for the year ended 31 December (total columns)
20X3 20X2
£'000 £'000
Balance brought forward 2,598 2,400
Total comprehensive income for the year 2,315 450
Issue of ordinary shares 168 –
Final dividends on ordinary shares (300) (180)
Interim dividends on ordinary shares (156) (60)
Dividends on irredeemable preference shares (12) (12)
Balance carried forward 4,613 2,598
Statement of cash flows for the year ended 31 December 20X3

£'000 £'000
Interest paid (67)
Tax paid (82)
Net cash from operating activities 1,059
Purchases of non-current assets (1,410)
Proceeds on sale of property, plant and equipment 670
Dividends paid (468)
Proceeds from borrowings 105
Issue of shares 168
Net cash used in financing activities (195)
Net change in cash and cash equivalents 124
Cash and cash equivalents brought forward (3 – 1,183) (1,180)
Cash and cash equivalents carried forward (386 – 1,442) (1,056)

£'000
Depreciation charge 965
Profit on disposal of property, plant and equipment (14)
Finance cost 67
Increase in inventories (170)
Increase in trade and other receivables (604)
Increase in trade and other payables 303
Key ratios
20X3 20X2
Gross profit percentage 13.7% 12.3%
Net margin 3.0% 3.0%
Net asset turnover 4.2 times 5.8 times
Trade receivables collection period 34 days 28 days
Interest cover 10.9 11.9
Current ratio 1.1 0.9
Quick ratio 0.7 0.6
Cash flow ratios (20X3 only)

Cash return on capital 22.1%
Cash interest cover 18 times

Requirements
(a) Calculate return on capital employed and gearing (net debt/equity) for both years.
(b) Comment on the financial performance and position and on the statement of cash flows of
Wild Swan Ltd in the light of the above information.
2 Reapson
Statement of changes in equity extract for the year ended 31 December 20X4
Revaluation Retained
Attributable to the owners of Reapson plc surplus earnings
£m £m
Balance brought forward – 800.00
Total comprehensive income for the year 350.00 222.90
Transfer between reserves (17.50) 17.50
Dividends on ordinary shares – (81.75)
Balance carried forward 332.50 958.65
As well as revaluing property, plant and equipment during the year (incurring significant additional
depreciation charges) Reapson plc incurred £40 million of costs relating to the closure of a division.
Reapson plc has £272.5 million of 50p ordinary shares in issue. The market price per share is 586p.
Requirement
Explain the following statistics from a financial journal referring to Reapson plc and relate them to C
the above information. H
A
(a) Dividend per share = 15p P
T
(b) Earnings per share Profit before ordinary dividends 222.9 E
= = = 40.9p R
No of ordinary shares in issue 545
(c) Dividend cover EPS 40.9

= = = 2.7 23
Dividend per share 15
(d) Dividend yield Dividend per share 15

= = = 2.6%
Current market price per share 586
(e) Price/earnings ratio Current market price per share 586

= = = 14.3
EPS 40.9
3 Verona
Verona plc is a parent company. The Verona plc group includes two manufacturers of kitchen
appliances. One of these companies, Nice Ltd, serves the North of England and Scotland. The
other company, Sienna Ltd, serves the Midlands, Wales and Southern England. Each of the two
companies manufactures an identical range of products.
Verona plc has a quarterly reporting system. Each group member is required to submit an
abbreviated set of financial statements to head office. This must be accompanied by a set of ratios
specified by the board of Verona plc. All manufacturing companies, including Nice Ltd and
Sienna Ltd, are required to calculate the following ratios for each quarter:
 Return on capital employed
 Trade receivables collection period
 Trade payables payment period
 Inventory turnover (based on average inventories)
The financial statements for the three months (that is, 89 days) ended 30 April 20X3, submitted to
the parent company, were as shown below.

Statements of profit or loss and other comprehensive income
for the quarter ended 30 April 20X3
Nice Ltd Sienna Ltd
£'000 £'000 £'000 £'000
Revenue 3,000 4,400
Opening inventories 455 684
Purchases 1,500 2,100
1,955 2,784
Closing inventories (539) (849)
Cost of materials 1,416 1,935

Wages and salaries 700 960
Depreciation 128 83
Cost of sales (2,244) (2,978)
Gross profit 756 1,422
Marketing 450 570
Administration 147 238
Loan interest 10 –
Overdraft interest – 5
(607) (813)
Profit for the period 149 609
Statements of financial position at 30 April 20X3

Nice Ltd Sienna Ltd
£'000 £'000 £'000 £'000
Assets
Non-current assets
Property 2,000 1,300
Plant and equipment 1,700 1,100
3,700 2,400
Current assets
Inventories 539 849
Cash and cash equivalents 71 –
2,032 2,580
Total assets 5,732 4,980

Equity
Ordinary share capital 1,745 479
Revaluation surplus 700 –
Equity 4,494 3,788
Borrowings 800 –
5,294 3,788
Current liabilities
Trade and other payables 438 1,062
Overdraft – 130
438 1,192
The managing director of Nice Ltd feels that it is unfair to compare the two companies on the basis
of the figures shown above, even though they have been calculated in accordance with the group's
standardised accounting policies. The reasons he puts forward are as follows.
 Verona plc is in the process of revaluing all land and buildings belonging to group members.
Nice Ltd's properties were revalued up by £700,000 on 1 February 20X3 and this revaluation
was incorporated into the company's financial statements. The valuers have not yet visited
Sienna Ltd and that company's property is carried at cost less depreciation.

The Verona group depreciates property on a quarterly basis, calculated at a rate of 4% per
annum.
 Nice Ltd's new production line costing £600,000 became available for use during the final
week of the period under review. The cost of purchase was borrowed from a bank and is
included in the figures for non-current borrowings.
The managing director of Nice Ltd believes the effect of the purchase of this machine should
be removed, as it happened so close to the period end.
The Verona group depreciates machinery at a rate of 25% of cost per annum.
 Nice Ltd supplied the Verona group's hotel division with goods to the value of £300,000 in
October 20X2. This amount is still outstanding and has been included in Nice Ltd's trade
receivables figure. Nice Ltd has been told that this balance will not be paid until the hotel
division has sufficient liquid funds.
 Nice Ltd purchased £400,000 of its materials, at normal trade prices, from a fellow member of
the Verona group. This supplier had liquidity problems and the group's corporate treasurer
ordered Nice Ltd to pay for the goods as soon as they were delivered.
Requirements
(a) Calculate the ratios required by the Verona group for both Nice Ltd and Sienna Ltd for the
quarter, using the figures in the financial statements submitted to the holding company.
(b) Explain briefly which company's ratio appears the stronger in each case.
(c) Explain how the information in the notes above has affected Nice Ltd's return on capital C
employed, trade receivables collection period and trade payables payment period. H
A
(d) Explain how the calculation of the ratios should be adjusted to provide a fairer basis for P
comparing Nice Ltd with Sienna Ltd. T
E
4 Brass Ltd R
You are the financial accountant of Brass Ltd, a company which operates a brewery and also owns
and operates a chain of hotels and public houses. Your managing director has obtained a copy of
the latest financial statements of Alliance Breweries Ltd, a competitor, and has gained the 23
impression that, although the two companies are of a similar overall size, Alliance's performance is
rather better than that of Brass Ltd.
He is also concerned about his company's ability to repay a £20 million loan. The statements of
profit or loss and other comprehensive income and statements of financial position of the two
companies for the year to 31 December 20X2 and extracts from the notes are set out below.
Statements of profit or loss and other comprehensive income
Brass Ltd Alliance Breweries Ltd
£'000 £'000 £'000 £'000
Revenue 157,930 143,100
Cost of sales (57,400) (56,500)
Gross profit 100,530 86,600
Distribution costs 27,565 21,502
Administrative expenses (Note 1) 53,720 29,975
(81,285) (51,477)
Profit from operations 19,245 35,123
Finance cost (2,000) –
Profit before tax 17,245 35,123
Tax (5,690) (11,590)
Profit for the year 11,555 23,533

Statements of financial position
Brass Ltd Alliance Breweries Ltd
£'000 £'000 £'000 £'000
Assets
Non-current assets
Property, plant and equipment (Note 3) 71,253 69,570
Intangibles (Note 2) – 3,930
71,253 73,500
Current assets
Cash and cash equivalents 5,102 –
40,255 26,840
Total assets 111,508 100,340

Equity
Ordinary share capital 30,000 50,000
Revaluation surplus 15,253 –
62,028 82,080
Non-current liabilities (10% loan) 20,000 –
Current liabilities (Note 4) 29,480 18,260
Notes
1 Administrative expenses
Alliance
Breweries
Brass Ltd Ltd
£'000 £'000
Directors' remuneration 2,753 1,204
Advertising and promotion 10,361 2,662
2 Intangible assets – Alliance Breweries Ltd

Intangible assets include brand names and trademarks purchased from Odlingtons Breweries
Ltd in 20X0, which are being amortised over their useful lives.
3 Brass Ltd – Property, plant and equipment
Freehold
land and Motor Plant and
buildings vehicles machinery Total
£'000 £'000 £'000 £'000
Cost or valuation 1 January 20X2 113,712 655 3,397 117,764
Additions 3,150 125 523 3,798
Cost or valuation 31 December 20X2 116,862 780 3,920 121,562
Provision for depreciation 1 January (43,239) (272) (2,548) (46,059)
20X2
Charge for year (3,506) (156) (588) (4,250)
Provision for depreciation (46,745) (428) (3,136) (50,309)
31 December 20X2
Carrying amount 31 December 20X2 70,117 352 784 71,253
The company's freehold land and buildings were revalued during 20X0 by the directors.

Alliance Breweries Ltd – Property, plant and equipment
Freehold
hotels and
Freehold public Motor Plant and
brewery houses vehicles machinery Total
£'000 £'000 £'000 £'000 £'000
Cost 1 January 20X2 5,278 80,251 874 5,612 92,015
Additions – 8,920 79 489 9,488
Cost 31 December 20X2 5,278 89,171 953 6,101 101,503
Provision for depreciation
1 January 20X2 (2,771) (23,291) (477) (3,838) (30,377)
Charge for year (96) (490) (238) (732) (1,556)
Provision for depreciation
31 December 20X2 (2,867) (23,781) (715) (4,570) (31,933)
Carrying amount
31 December 20X2 2,411 65,390 238 1,531 69,570
4 Current liabilities
Alliance
Breweries
Brass Ltd Ltd
£'000 £'000
Trade payables 23,919 7,875
Taxation 5,561 10,235
Bank overdraft – 150
29,480 18,260 C
H
5 Non-current liabilities A
P
The 10% loan is redeemable in June 20X4. T
E
6 Accounting policies
R
Both companies have similar accounting policies apart from depreciation where the policies
are as follows:
23
Brass Ltd – Depreciation
Depreciation is provided by the company to recognise in profit or loss the cost of property,
plant and equipment on a straight-line basis over the anticipated life of the assets as follows.
%
Freehold buildings 4
Motor vehicles 20
Plant and equipment 10–33
Freehold land is not depreciated.
Leasehold property is amortised over the term of the lease.
Alliance Breweries Ltd – Depreciation
Property, plant and equipment are depreciated over their useful lives as follows.
%
Motor vehicles 25
Plant and equipment 10–25
Freehold land Nil
Freehold buildings 1
The following ratios have been calculated for Brass Ltd for the year ended 31 December 20X2.
Profit before interest and tax 19,245
(1) ROCE = % = 25%
Capital employed 62,028 + 20,000 – 5,102
Revenue 157,930
(2) Asset turnover = = 2.05
Capital employed 62,028 + 20,000 – 5,102

(3) Net profit margin = % = 12.2%
Revenue 157,930
Gross profit 100,530

(4) Gross profit percentage = % = 63.7%
Revenue 157,930

(5) Current ratio = = 1.37
Current assets – inventories 33,135

(6) Quick ratio = = 1.12
Trade receivables 28,033

(7) Trade receivables collection period = × 365 = 65 days
Revenue 157,930
Cost of sales 57,400
(8) Inventory turnover = = 8.1
Inventory 7,120
Requirements
(a) Prepare a report to the managing director comparing the profitability and liquidity of Brass
Ltd with Alliance Breweries Ltd, using the ratios given for Brass Ltd and appropriate
accounting ratios for Alliance Breweries Ltd and suggest possible reasons for the differences
between the results of the two companies.
(b) State briefly what adjustments would be necessary to the financial statements of the
companies for a more relevant comparison of their relative performance.
5 Caithness plc
Caithness plc, a parent company, requires sets of management information, including key ratios,
from all its subsidiaries. The most recent sets of information for two of its subsidiaries, Sutherland
Ltd and Argyll Ltd, two manufacturing companies, show the following.
Sutherland Argyll
Ltd Ltd
Return on capital employed (ROCE) 5% 13%
Gross profit percentage 30% 35%
Net margin 13% 10%
Current ratio 2.5:1 3:1
Quick ratio 1.8:1 2.7:1
Trade receivables collection period 60 days 45 days
Trade payables payment period 40 days 50 days
Inventory turnover 60 days 20 days
Gearing (debt/equity) 55% 100%
Interest cover 4 times 2 times
Cash return on capital employed (cash ROCE) 7% 8%
(1) Each company is treated as a mainly autonomous unit, although they share an accounting
function and Caithness plc does determine the dividend policy of the two subsidiaries.
Companies in the group must use the same accounting policies.
(2) It is group policy to record all assets at cost less accumulated depreciation and impairment
losses. However, Sutherland Ltd has revalued its freehold property and included the results in
the recent management information above.
(3) Argyll Ltd has recently leased a specialised item of plant and machinery. In the management
information above the lease rentals have been recognised as an expense in profit or loss, but
the managing director has said that this is a finance lease and the group directors are aware
that the year-end published financial statements will need to reflect this.
(4) Sutherland Ltd and Argyll Ltd trade with other companies in the group. At the instigation of
Argyll Ltd, Sutherland Ltd has supplied one of the other companies in the group with goods
with a selling price of £200,000. These are no longer in group inventories but Sutherland Ltd
has been told that the goods will not be paid for until the liquidity problems of the other
company are resolved.

Requirements
(a) Comment on the relative financial performance and position of Sutherland Ltd and Argyll Ltd
from the above information.
(b) Identify what further information you would find useful to help with your commentary in (a),
providing reasons.
(c) It transpires that the managing director of Argyll Ltd, who was previously head of the
accounting function for both companies, was aware, at the time of preparing the above
information, that Caithness plc is considering selling its stake in one of these companies and
that Caithness plc intends to use the information to help it in making its decision.
Comment on the information above in the light of this and set out any additional information
which would help you to form a view on the situation.
6 Trendsetters Ltd
Trendsetters Ltd is a long-established chain of provincial fashion boutiques, offering mid-price
clothing to a target customer base of late teens/early twenties. However, over the past eighteen
months, the company appears to have lost its knack of spotting which trends from the catwalk
shows will succeed on the high street. As a result, the company has had to close a number of its
stores just before its year end of 31 December 20X2.
You have been provided with the following information for the years ended 31 December 20X1
and 20X2.
Statement of cash flows for the year ended 31 December
20X2 20X1 C
£'000 £'000 H
Cash flows from operating activities A
Cash generated from operations 869 882 P
T
Interest paid (165) (102)
E
Tax paid (13) (49) R
Net cash from operating activities 691 731
Dividends received – 55 23
Proceeds from sales of investments 32 –
Proceeds from sale of property, plant and equipment 1,609 12
Net cash from investing activities 1,641 67
Dividends paid – (110)
Borrowings taken out 500 100
Net cash from/(used in) financing activities 500 (10)
Net change in cash and cash equivalents 2,832 788
Cash and cash equivalents brought forward 910 122
Cash and cash equivalents carried forward 3,742 910

20X2 20X1
£'000 £'000
Profit before tax 2,293 162
Investment income – (55)
Finance cost 165 102
Depreciation charge 262 369
Loss on disposal of investments 101 –
Profit on disposal of property, plant and equipment (1,502) (2)
Increase in inventories (709) (201)
Increase/decrease in trade and other receivables (468) 256
Increase in trade and other payables 727 251
Cash generated from operations 869 882

Extracts from the statement of profit or loss and other comprehensive income and statement of
financial position for the same period were as follows.
20X2 20X1
£'000 £'000
Revenue 2,201 3,102
Equity
Ordinary share capital 100 100
7,152 4,872
Long-term liabilities
Borrowings 1,500 1,000
Current liabilities
Trade and other payables 1,056 329
9,708 6,201
Requirements
(a) Comment on the above information, calculating three cash flow ratios to help you in your
analysis.
(b) You have now learnt that the financial controller of Trendsetters Ltd has been put under
severe pressure by his operational directors to improve the figures for the current year.
Discuss how this pressure might have influenced both the above information and other areas
of the financial statements, and suggest what actions the financial controller should consider
in responding to these pressures.


When drawing conclusions from ROCE/ROSF consider:
(1) Target return on capital (company or shareholder)
(2) Real interest rates
(3) Age of plant
(4) Leased/owned assets
(5) Upward revaluations of non-current assets, which increase capital employed, increase depreciation
charges and reduce ROCE/ROSF

Variations between years may be attributable to:
(1) Change in sales prices
(2) Change in sales mix
(3) Change in purchase/production costs C
(4) Inventory obsolescence H
A
P
E
May change because of: R
(1) Change in the amount of sales – investigate whether due to price or volume changes
(2) Non-recurring costs
23

Low and high ratios could suggest the following:
 Liquidity problems (low ratio)
 Poor use of shareholder/company funds (high ratio)
Two possible factors to investigate would be as follows:
 Constituent components of ratio: inventory obsolescence (in case of current ratio), recoverability of
receivables (in case of both ratios)
 Manipulation – if company has positive cash balances and a ratio greater than 1:1, payment of
current liabilities such as trade payables just before the year end will improve ratio

When drawing conclusions from gearing ratios, consider the following:
(1) Upward revaluations of non-current assets increase shareholders' funds and decrease gearing.
(2) Whether carrying amounts of non-current assets are likely to be volatile.

(1) High inventory turnover rate – may be efficient but the risk of running out of inventory is increased
(2) Low inventory turnover rate – inefficient use of resources and potential obsolescence problems

A change in the ratio may indicate:
(1) Bad debt/collection problems
(2) Change in nature of customer base (new customer is big but is a slow payer)
(3) Change in settlement terms

(1) High figure may indicate liquidity problems
(2) Potential appointment of receiver by aggrieved suppliers

(a) Return on capital employed (ROCE)
 100 =  100 = 10%
Capital employed 1,800 + 1,600 + 50 − 60
(b) Return on shareholders' funds (ROSF)
Profit attributable to owners of parent company 140
=  100 = 8.5%
Equity – non-controlling interest 1,800 − 150
(c) Gross profit %
GP 2,000
 100 =  100 = 33.33%
Revenue 6,000
(d) Net profit margin
 100 =  100 = 5.7%
Revenue 6,000
(e) Net asset turnover
Revenue 6,000
= = 1.8 times
Capital employed 1,800 + 1,600 + 50 − 60
(f) Proof of ROCE
ROCE = Net profit margin  Net asset turnover
10% = 5.7%  1.8 times
(g) Non-current asset turnover
Revenue 6,000
= = 2.3 times
Non- current assets 2,600
(h) Current ratio
= = 2 times
(i) Quick ratio
Current assets less inventories 1,600 − 600
= = 1.25 times
(j) Inventory turnover
Cost of sales 4,000
= = 6.66 times
Inventories 600
(k) Inventory days
Inventories 600
 365 =  365 = 55 days
Cost of sales 4,000

(l) Trade receivables collection period
 365 =  365 = 55 days
Revenue 6,000
(m) Trade payables payment period
Trade payables 750
 365 =  365 = 68 days
Cost of sales 4,000
(n) Gearing
Net debt 1,600 + 50 − 60
 100 =  100 = 88.3%
Equity 1,800
(o) Interest cover
PBIT + Investment income 340 + 5
= = 4.1 times
Interest payable 84
(a) Cash return £'000

12,970
Cash generated from operations
–
Interest received
20
Dividends received C
12,990 H
A
P
(b) Cash return on capital employed T
E
Cash return (from above) 12,990
 100 =  100 = 44.9% R
Capital employed 28,900
(c) Cash from operations/profit from operations

23
 100 =  100 = 148%
Profit from operations 8,750
(d) Cash interest cover

Cash return 12,990
= = 36 times
Interest paid 360
(e) Cash flow per share

Cash flow for ordinary shareholders (12,990 − 360 − 4,510)
= = 54p per share
Number of ordinary shares 15,000
(f) Cash dividend cover

Cash flow for ordinary shareholders (12,990 − 360 − 4,510)
= = 1.8 times
Equity dividends paid 4,500

Decisions to dispose of a group company or to close down a business activity within the group result in
restructurings. The decision to restructure a major part of the business will require consideration of the
following IASs/IFRSs:
(1) IAS 7's requirements as to disclosure within investing activities of the cash flows resulting from
disposals

(2) IAS 10's requirements as to events occurring after the end of the reporting period, whether they
are adjusting events (that is, confirmation of the carrying amounts of assets/liabilities) or non-
adjusting events (for example, the disclosure of a decision to restructure)
(3) IFRS 8's requirements as to segment reporting – a disposal could well affect the segments which are
reportable
(4) IFRS 5's requirements – a decision to restructure a major part of the business is likely to lead to
disclosures of both discontinued operations in the statement of profit or loss and other
comprehensive income and non-current assets held for sale in the statement of financial position
(5) IAS 36's requirements as to impairment of assets – impairment will almost certainly result from a
restructuring decision
(6) IAS 37's requirements as to provisions – liabilities which previously were only contingent may well
now require recognition and provisions for restructuring costs may need to be recognised
Other standards such as IAS 2 Inventories may also be relevant. Any surplus or excess inventory may
require disposal at below cost. In addition, the presentation of these events may need the consideration
of IAS 1 Presentation of Financial Statements.

Situation A – Asset is not revalued
20X4 20X5 20X6 20X7
£'000 £'000 £'000 £'000
Statement of profit or loss and other
Includes depreciation of (6) (6) (6) –
Profit on disposal of property, plant and
equipment – – – 43
Total impact on reported profit for 20X4 to 20X7 = £25,000 = proceeds of £127,000 less carrying
amount of £102,000 at 1 January 20X4
20X4 20X5 20X6 20X7
£'000 £'000 £'000 £'000
Carrying amount of asset at year end 96 90 84 –
(included in capital employed)
Situation B – Asset is revalued

20X4 20X5 20X6 20X7
£'000 £'000 £'000 £'000
Statement of profit or loss and other
Includes depreciation of (8) (8) (8) –
Profit on disposal of property, plant and
equipment – – – 15
Total impact on reported profit for 20X4 to 20X7 = £(9,000)

20X4 20X5 20X6 20X7
£'000 £'000 £'000 £'000
Gain on revaluation of property, plant and
equipment 34 – – –
Gain is not reported as part of profit
Therefore not included in earnings for any year

20X4 20X5 20X6 20X7
£'000 £'000 £'000 £'000
Carrying amount of asset at year end 128 120 112 –
(included in capital employed)
Summary
Situation A Situation B
No revaluation Revaluation
£'000 £'000
Aggregate impact on earnings (20X4 to 20X7) 25 (9)

Current ratio Quick ratio
Option 1 (1,600 ÷ 1,000) and (1,100 ÷ 1,000) 1.60: 1 1.10: 1
Option 2 ((1,600 + 300) ÷ (1,000 + 300)) and 1.46: 1 1.08: 1
((1,100 + 300) ÷ (1,000 + 300))
Option 3 ((1,600 – 300) ÷ (1,000 – 300)) and 1.86: 1 1.14: 1
((1,100 – 300) ÷ (1,000 – 300))

Motivations
 The new Managing Director (MD) is motivated to try to maximise the post-acquisition earnings
from the target company. This will help to increase EPS and the acquisition may be perceived as
more successful. C
H
 If asset carrying amounts are reduced at the date of acquisition, then goodwill will be increased by
A
the same amount. Goodwill is not amortised and, assuming no impairment occurs in the P
immediate post-acquisition period, the effect on earnings from increasing goodwill will be nil. T
E
 By reducing the asset carrying amounts, the depreciation and amortisation expense related to non- R
current assets will be reduced in the post-acquisition period, as will inventory amounts charged to
cost of sales. If asset carrying amounts were increased, the opposite would occur and post-
acquisition earnings would be adversely affected. 23
 Accounting standards such as IFRS 3 and IFRS 13 are clear in the determination and treatment of
the fair values of the acquired assets, liabilities and contingent liabilities. However, judgement is still
required in determining fair values. It is essential that an unbiased approach be used in applying
the judgement necessary. IFRS 13 has eliminated some of the subjectivity (see Chapters 2 and 20).
Actions to consider
 The MD should be made aware of the issues involved, including the potential professional and
legal issues. The requirements of the relevant accounting standards should be explained to her.
 It may be appropriate to discuss and explain the situation to other members of the board of
directors and to seek their opinions. They may be able to add support.
 If the MD continues to try to dominate and exert influence on the contents of the report, then it
would be appropriate to consult the ICAEW ethical handbook, the local district society support
member and/or the confidential ethics helpline.
 The approach of the MD may raise concerns about her ethical approach to business in areas other
than financial reporting. It is important to remain alert to other potential areas of inappropriate
practice. Ultimately the domineering approach of the MD may lead to the conclusion that
alternative employment should be sought.

1 Wild Swan
(a) Calculation of ratios 20X3 20X2
Profit before 728 669

= 12.6% = 17.7%
interest and tax 4,613 + 105 + 1,442 – 386 2,598  1,183  3
ROCE =
Capital employed
Net debt 105  1,442 – 386 1,183 − 3

Gearing =  25.2% = 45.4%
Equity 4,613 2,598
(b) Commentary on financial performance and position

Profitability
The overall profitability of the company has remained stable, with a constant net margin and
a slightly increased gross margin offset by increased overhead costs. Revenue growth of
10.5% ((24,267/21,958) – 1) has been achieved without an adverse effect on the net margin.
The drop in ROCE from 17.7% to 12.6% is due to the asset revaluation in 20X3. If the
revaluation surplus is removed, the comparison between the years is much more valid.
Asset turnover and ROCE may be artificially high due to the company's plant being old and
therefore heavily depreciated. This is suggested by the large depreciation charge on plant (as
a percentage of carrying amount). Alternatively, this together with the major investment in
replacing assets could indicate that plant has a relatively short life.
Liquidity and working capital management
For a manufacturer the trade receivables collection period appears satisfactory, though it has
increased by six days compared with 20X2. This may be due to the increased sales volume,
possibly encouraged by easier credit terms.
The current and quick ratios both appear low, though they have improved compared with
20X2. This appears to be due mainly to the large and increasing bank overdraft and to trade
payables, which have increased by 18% compared with revenue growth of 10.5%.
Seasonal factors may have distorted the liquidity position, for example because the business
has built up inventory to meet a sales peak shortly after the year end. This would tend to
increase trade payables and overdrafts. Interest expense amounts to only 6% of the average
overdraft, which suggests that the year-end balance is high relative to the year as a whole.
The decision to hold large amounts of cash, when the company has a bank overdraft equating
to 25% of net assets, appears to lack business logic, unless the amounts for some reason
cannot be set off against each other.
Long-term solvency
The company made a share issue for £168,000 in the year. It has very little non-current debt,
having issued only £105,000 in 20X3 and having none in issue in 20X2, but it does have
significant overdrafts. Although the gearing ratio of 25.2% appears acceptable, it has been
reduced by the asset revaluation.
Even if the debt was issued just before the year end (and therefore would not have had much
effect on the amount of interest charged), the group has high interest cover and could finance
more non-current debt. If the business does need debt financing on an ongoing basis (rather
than as a result of seasonal factors), it would probably be cheaper to obtain this via long-term
loans, rather than maintaining a large overdraft. This would also improve the company's
short-term liquidity position.

Cash flow analysis
Operating cash inflows of £1,208,000 compare favourably with operating profits of £728,000.
If non-current asset replacement cash flows are deducted, the resulting net operating cash
inflow falls to £468,000 (1,208 – 740). This is still more than adequate to finance £82,000
taxation, £67,000 interest and £12,000 preference dividends, leaving £307,000 available for
more discretionary use.
£468,000 was paid out in equity dividends, representing 147% of available cash flows before
financing (468 as a percentage of (1,059 – 740)). The excess was funded by the share
issue/borrowings. This level of dividends places an unnecessary strain on the company's cash
position and, if maintained, may lead to insufficient reinvestment to maintain operations.
The gearing of 25.2% is unlikely to threaten long-term solvency but the company would
nevertheless benefit from reducing its overdraft in favour of less costly forms of finance.
The cash flow ratios given help analyse the cash amount of:
 return on capital employed
 interest cover
These cash flow ratios eliminate non-cash items such as accruals from the traditional ratios.
The 22.1% cash return on capital employed (cash ROCE) for 20X3 is greater than the 12.6%
traditional ROCE. In other words, the net assets generate more cash than profit. This is
because the quality of profits is good (net cash inflow is greater than operating profit). Care
should be taken in comparing these two ratios. Traditional ROCE includes depreciation,
whereas cash ROCE excludes it, as it is non-cash. Depreciation is £965,000 which, if taken into C
account, more than counteracts this advantage. H
A
Cash interest cover of 18 in 20X3 again compares favourably with the traditional interest P
cover of 10.9. Cash interest cover would be expected to be slightly higher, as it is also based T
on net cash flow from operating activities. Interest paid and payable in 20X3 both amount to E
£67,000 so there are no opening/closing accruals to consider. R
Overall it would appear that Wild Swan Ltd has plenty of cash to cover its interest payments at
the current time. Interest payable will increase next year if the borrowings were made just 23
before the year end. Given the carrying amount of the non-current liabilities of £105,000 at
31 December 20X3 the interest payable next year should not dent either the interest cover or
cash interest cover sufficiently to cause concern.
2 Reapson
(a) Dividend – 15p per share
This should be the cash amount of total dividends paid per share (in pence) in the most
recent financial year. It ties in with the information provided, as it is the total dividend per the
statement of changes in equity divided by the number of shares in issue, that is:
£81.75m
= 15p per share
2 × 272.5m
This is the absolute amount of the per share dividend paid out by the company. To be of any
real meaning, it should be related to some other amount – see below.
(b) Earnings per share
This is the measure of the amount earned by the company on behalf of each ordinary share.
Its amount is not influenced by the dividend distribution policy of the company, being a
measure of earning capacity.
(c) Dividend cover
This gives an indication of the security of the dividend flow from the company, measured by
reference to its current year profits. (In practice a company can cover dividends out of
retained earnings.) If dividend cover is high, then the company is likely to be able to maintain
the level of dividend payments even if earnings fall.

Dividend cover is calculated as earnings per share divided by net dividends per share. The
impact of the exceptional closure costs (£40 million) and the increase in depreciation resulting
from the current year revaluation (£17.5 million reserve transfer) has been to reduce earnings
by £57.5 million. If these are added back, the earnings per share would become:
£222.9m + £57.5m
= 51.4p
545m
Revised dividend cover would therefore be:
51.4p
= 3.4 times
15p
(d) Dividend yield

This gives an indication of the income return that an investor might expect on his or her
shares. Because it is based on dividends, it too reflects distribution policy rather than earnings
and performance.
The investor could use this to compare with returns on alternative investments.
(e) Price/earnings ratio
This is a way of measuring how highly investors value the earnings a company produces. It is
therefore not affected by dividend policy.
Investors will pay more for shares now if they expect earnings to rise in the future, as these
earnings will be reflected in future dividends and/or capital appreciation.
Using the adjusted EPS figure calculated above the ratio would be:
Market price per share 586p
P/E ratio = = = 11.4 times
Earnings per share 51.4p
3 Verona
(a) Ratios using figures from the financial statements
Nice Ltd Sienna Ltd
Profit before interest and tax 149 + 10 609 + 5
× 100 × 100 = 3% × 100 = 16%
Capital employed 4,494 + 800 – 71 3,788 + 130

Trade receivables 1,422 1,731
× 89 × 89 = 42 days × 89 = 35 days
Revenue 3,000 4,400
Trade payables 438 1,062
× 89  89  26 days  89  45 days
Purchases 1,500 2,100
Inventory turnover
Cost of materials 1,416 1,935
= 2.8 times = 2.5 times
Average inventory (455 + 539)/2 (684 + 849)/2
(b) Comparison of the two companies

(i) ROCE
The managers of Nice Ltd are generating a far smaller return on the resources under their
control than are the managers of Sienna Ltd. Sienna Ltd has produced a greater
percentage return for each pound invested in the company than has Nice Ltd. This
suggests that Sienna Ltd is using its net assets more effectively than Nice Ltd.

(ii) Trade receivables collection period
Generally, the management of any company will try to obtain payment from credit
customers as soon as possible. Sienna Ltd again outperforms Nice Ltd by receiving cash
from customers seven days sooner on average.
(iii) Trade payables payment period
In this case companies usually prefer to put off paying creditors for as long as possible to
aid cash flow. Sienna Ltd has successfully managed to pay creditors an average of
nineteen days later than Nice Ltd.
(iv) Inventory turnover
As a further means of improving cash flow, companies try to turn over inventory as
quickly as possible, avoiding working capital being tied up in slow-moving lines. Here,
Nice Ltd is performing approximately 10% better than Sienna Ltd.
(c) Effect of information on Nice Ltd's ratios
ROCE
This will be affected by the revaluation and the purchase of new machinery.
The revaluation will have had a twofold effect on ROCE. It will increase capital employed by
£700,000 and reduce profit before interest and tax by additional depreciation of £7,000
(700,000 × 4% × 3/12).
Overall this will have reduced ROCE.
C
The purchase of the machinery will also have reduced ROCE due to capital employed H
increasing. The depreciation charge for just the last week of the period will not be sufficiently A
large as to distort comparisons. P
T
Trade receivables collection period E
R
The £300,000 receivable at some point in the future has artificially increased both trade
receivables and the related collection period.
Trade payables payment period 23
The £400,000 will have been included in purchases used in the calculation of the trade
payables payment period but as it was paid immediately it will not have been included in
trade payables. The payment period will appear lower than it otherwise would have been.
(d) Adjusted ratios
For ratio analysis to be meaningful, it is important to compare like with like. The managing
director of Nice Ltd has good reason to feel that the ratio analysis carried out on the two sets
of adjusted accounts results in misleading figures.
The group is intending to revalue the property of all group members. Until such time as
figures are available for all the companies, an adjustment should be made to exclude
revaluations from the ratios. Revaluation of property can result in a marked change in ROCE
(as well as other asset-based ratios). The additional depreciation charge should also be added
back to net profit.
The trade receivables collection period is normally used to analyse trade receivable payment
profiles. Debts due from group companies, especially the holding company, may be subject
to constraints outside the control of the receiving company, as in this case. As the holding
company can dictate when the debt is paid, the directors of Nice Ltd should not be held
answerable for this. Trade receivables should be reduced by £300,000.
The trade payables payment period should be calculated based on the ratio of trade payables
to credit purchases. As the payment was made as soon as the goods were delivered, this
amount should be treated as a cash purchase and excluded from the calculation.

4 Brass Ltd
(a) REPORT
To: Managing Director
From: Financial Accountant
Date: 9 June 20X3
Subject: Comparative analysis of results with Alliance Breweries Ltd
I set out below my comments on the profitability and liquidity of Brass Ltd compared with
those of our competitor, Alliance Breweries Ltd (Alliance). Equivalent accounting ratios to
those already calculated for Brass Ltd have been calculated for Alliance and are set out in the
Appendix.
Profitability
The fundamental profitability ratio ROCE for Brass Ltd is 25% and for Alliance 42.7%. It does
therefore at first sight appear that Alliance has a better overall performance. Further analysis
throws light on the reasons for this performance differential.
The ROCE can be subdivided into its two components: asset turnover and net profit margin.
The asset turnovers of Brass Ltd and Alliance are fairly similar (2.05 and 1.74 respectively). This
ratio indicates how well a business is utilising its assets. Brass Ltd appears to be making slightly
better use of its assets; that is, generating more revenue per pound of assets. This comparison
assumes that the assets of the two businesses are comparable and, in particular, that the
property, plant and equipment are comparable.
The major reason for the differing ROCE of the two companies would seem to be their
different net profit margins. The net profit margin of Brass Ltd is 12.2% while that of Alliance
is 24.5%. This is despite the fact that Brass Ltd has the better gross profit margin of 63.7%
compared with 60.5% for Alliance. Since both companies operate in the same business, the
gross profit percentage should be fairly similar and in fact the cost of sales figures are very
similar. Brass Ltd appears to be able to sell its beer at higher prices. Possible reasons for this
might include the following:
 A greater proportion of premium beer sales, such as real ale and more expensive lagers
 A greater proportion of higher added value goods, such as meals and accommodation
 A greater proportion of sales to the free trade at a higher margin (indicated by higher
receivables)
 A better reputation and more longstanding customer base
This favourable differential in the gross profit percentage is more than negated by Brass Ltd's
substantially higher overheads which cause our company to have a considerably inferior net
profit margin.
Reasons for the differences in administrative and distribution costs include the following:
 Low depreciation (1%) of freehold hotels and public houses by Alliance (see below)
 Higher expenditure on advertising and promotion to establish the brands of Brass Ltd
 Directors of the two businesses earning substantially different salaries
In conclusion, Brass Ltd should be the more profitable business because of its higher gross
margin. Overheads need to be carefully reviewed and reduced so that this is reflected in the
net profit.
In particular, we must carefully review our advertising and promotion expenditure in
comparison with Alliance. Currently Alliance spends considerably less than Brass Ltd because it
has invested a substantial amount in the acquisition of well-established brands.

Liquidity
Brass Ltd has a current ratio of 1.4 and a quick ratio of 1.1, whereas Alliance has a current
ratio of 1.5 and a quick ratio of 1.2. This would suggest that Alliance has slightly better
liquidity; however, the figures may not be strictly comparable due to the different trading
strategies.
Brass Ltd has inventory turnover of 8.1 compared with 13.8 for Alliance. This suggests that
either Brass Ltd is overstocked or possibly that we hold a greater number of inventory lines.
This greater range of products may to some extent account for our higher prices and gross
margin. In either case, a serious review of stockholding policy is necessary to remedy any
deficiency and to optimise the strategy.
The trade receivables collection period for Brass Ltd stands at 65 days, about a week slower
than Alliance at 58 days. This is probably due to our higher proportion of customers buying
on credit.
Brass Ltd has a £20 million loan in issue which is due for repayment in 18 months. As you are
aware, that is why we are accumulating our cash balance which currently stands at
£5,102,000. Hopefully, by the redemption date, we will have sufficient cash to redeem the
debt.
In summary, the liquidity positions of the two companies appear fairly similar except that
Brass Ltd has to be able to generate sufficient funds to repay its loan in 18 months. To
facilitate this the company needs to reduce its inventory levels so that the inventory turnover
ratio is closer to that of Alliance, and also to improve credit control to reduce the trade
receivables collection period. Improved cost control, as mentioned above under profitability,
C
should also have positive benefits. H
A
(b) Adjustments required to the financial statements of the two companies for a more relevant
P
comparison of their relative performance T
E
(i) Depreciation of freehold buildings
R
The freehold buildings of Alliance Breweries Ltd are being depreciated over 100 years as
opposed to our 25 years. This has a significant impact on the depreciation charge and
therefore on profit. We should review our depreciation policy for buildings. 23
(ii) Revaluation of land and buildings

Either eliminate the revaluation and associated depreciation from the Brass Ltd accounts, or
revalue the land and buildings of Alliance Breweries on a similar basis. Either adjustment
would have the effect of improving the ROCE of Brass Ltd relative to that of Alliance.
(iii) Intangibles
Write off the intangibles and associated amortisation from the accounts of Alliance. This
would have the effect of reducing the ROCE of Alliance.
The net effect of the three adjustments would be to improve the ROCE of Brass Ltd relative to that
of Alliance Breweries Ltd.

Appendix – Ratio analysis for Alliance Breweries Ltd
(1) ROCE = = 42.7%
Capital employed 82,080 + 150
Revenue 143,100
(2) Asset turnover = = 1.74
Capital employed 82,080 + 150
(3) Net profit margin = % = 24.5%
Revenue 143,100
Gross profit 86,600
(4) Gross profit percentage = % = 60.5%
Revenue 143,100
(5) Current ratio = = 1.47
Current assets – inventories 22,738
(6) Quick ratio = = 1.25
(7) Trade receivables collection Trade receivables 22,738
× 365 × 365 days = 58 days
period = Revenue 143,100
Cost of sales 56,500
(8) Inventory turnover = = 13.8
Inventory 4,102
5 Caithness plc
(a) Commentary on relative financial performance and position
Manufacturing companies tend to have a lower return on their capital employed (ROCE) than
non-manufacturing, due to their higher capital base.
However, Sutherland Ltd's ROCE is significantly lower than that of Argyll Ltd. The revaluation
of Sutherland Ltd's freehold property will be a factor if it resulted in an uplift of asset values.
This would:
 increase the depreciation charge and reduce the return; and
 increase capital employed.
However, Argyll Ltd's ROCE will probably decrease once the finance lease has been properly
accounted for; property, plant and equipment will probably increase capital employed by a
greater relative amount than the replacement of lease rentals by depreciation will increase
profit. (The finance cost element of a finance lease is presented within finance charges, below
the profit before interest and tax.)
Although the gross profit percentage of Sutherland Ltd is less than that of Argyll Ltd:
 the net margin is higher – indicating overhead costs are higher in Argyll Ltd; but
 Argyll Ltd's rental costs with regard to the finance lease are recognised at present in
profit or loss.
The current and quick ratios look healthy, as they are all well in excess of 1:1.
Sutherland Ltd appears to hold more inventories than Argyll Ltd. This is evident from:
 the higher number of days in inventories; and
 the fall from the current to the quick ratio for Sutherland Ltd is greater than for Argyll
Ltd.
Sutherland Ltd has more money invested in working capital than Argyll Ltd. This is evident
from:
 a higher trade receivables collection period (although this is artificially high, as another
group company accounts for £200,000);
 a lower trade payables payment period; and
 a higher inventory turnover period – though Argyll Ltd's inventory looks very low for a
manufacturing company.
Argyll Ltd has a higher gearing ratio than Sutherland Ltd and, probably as a consequence of
this, a lower interest cover. Both these ratios will worsen once the finance lease is correctly
accounted for.

Argyll Ltd could have raised some finance in the year, though this might be unlikely given that
Argyll Ltd has leased equipment recently.
Cash ROCE relates operating cash flow to the same capital as in ROCE. It would appear that
Sutherland Ltd is more efficient than Argyll Ltd at turning operating profits into cash, as cash
ROCE is higher than ROCE for Sutherland Ltd and lower for Argyll Ltd.
However, it is not clear what the effect of the finance lease capitalisation will be on Argyll Ltd's
cash ROCE. The cash generated from operations (the numerator in the calculation) will rise as
the lease payments are added back, but so will capital employed (the denominator). The
effect on cash ROCE depends on the relative changes in each.
Short-term liquidity may be more of an issue for Sutherland Ltd, given its higher working
capital ratios.
The effect of dividend policy also needs to be considered, as this could affect a number of
ratios.
(b) Further information needed with reasons
 The particular manufacturing sector in which the group operates – would help to provide
sector comparatives.
 Comparatives for the same period in the previous year – would help to provide a
benchmark for each company.
 Actual statements of comprehensive income and of financial position for each company –
to judge the effect of the revaluation, the finance lease and the £200,000 receivable.
Specific amounts would be needed for the revaluation and the finance lease. C
H
 Cash flow information to establish: A
P
– whether Sutherland Ltd may have short-term liquidity problems from high working T
capital ratios; and E
R
– whether Argyll Ltd has raised any finance in the year.
 Details of any dividend distribution.
23
Note: Marks awarded for any other valid comment.
(c) Commentary in the light of the managing director's knowledge
Certain facts regarding the managing director of Argyll Ltd now appear to be suspicious.
 He was previously the head of the (combined) accounts department and may still be in a
position to exert influence.
 Once Argyll Ltd's lease has been reclassified, its ROCE will decrease but its gross profit
percentage and net margin will increase. Although at the moment its ROCE and gross
profit percentage compare favourably with Sutherland Ltd, its net profit percentage does
not. It is the managing director who is pushing for this adjustment; in the light of what is
now known, the validity of this lease classification should be questioned.
 Sutherland Ltd appears to be taking longer to collect its debts than Argyll Ltd – this is in
part because of the inter-group sale arranged at the instigation of Argyll Ltd.
The following information would be useful to confirm the legitimacy of items listed under
Additional information (2) to (4).
 The reasons behind the revaluation
 The details of the lease to establish whether it really is finance or operating in nature
 Whether the inter-group sale really was to the benefit of Sutherland Ltd (for example sale
made at a profit) or a transaction engineered by Argyll Ltd's managing director
 Whether the managing director of Argyll Ltd has any other motive to improve Argyll
Ltd's figures (shareholding, bonus, and so on)

6 Trendsetters Ltd
(a) Cash flow ratios
20X2 20X1
Cash ROCE
Cash return 869 882 + 55
 100
Capital employed 7,152 + 1,500 − 3,742 4,872 + 1,000 − 910
869 937
= = 17.7% = = 18.9%
4,910 4,962
Cash from operations 869 882

 100
Profit from operations 2,293 + 165 162 + 102 − 55
= 35.4% = 422%
Cash interest cover
Cash return 869 882 + 55
= 5.3 times = 9.2 times
Interest paid 165 102
Commentary
 The slight fall in the cash ROCE from 18.9% to 17.7% shows that the company's
efficiency is falling. This is confirmed by a more dramatic fall in the net asset turnover
from 0.63 (3,102/(4,872 + 1,000 – 910)) to 0.45 (2,201/(7,152 + 1,500 – 3,742)).
 Although on the face of it the company has made a much higher profit before tax in
20X2 (£2,293,000) compared with 20X1 (£162,000), this 20X2 profit before tax
includes a one-off £1,502,000 profit on disposal of PPE.
 This is further illustrated by the decline in the ratio of cash from operations to profit from
operations, which has fallen from 422% to 35.4%. The quality of Trendsetters Ltd's
profits is clearly falling.
 Cash interest cover has fallen from 9.2 to 5.3. This is partly because the cash return has
fallen slightly (from £937,000 to £869,000) but mainly because of the increase in interest
paid from £102,000 in 20X1 to £165,000 in 20X2.
 Interest paid has increased by 62% over the year, yet borrowings have increased by only
50%. It may be that the company is now having to pay higher interest rates to
compensate lenders for increased risk, perhaps due to shorter-term or unsecured
borrowings.
 The disposal of stores, which has led to a profit of £1,502,000 (presumably because of
low carrying amounts and properties held for some years), may indicate the presence of
a well thought out restructuring plan which could save the company. However, this
seems unlikely as the company's interpretation of fashion trends is likely to be equally
well or badly received whatever the location of its stores.
 The sale of the stores therefore looks to be a short-term measure to boost the company's
cash resources. Whether this will help the company in 20X3 and beyond depends on
how the proceeds of sale are used. If the proceeds are used to acquire a more successful
chain of stores or more up to date expertise, the company's real profitability could
improve.

 Other factors indicate similar short-termism.
– Long-term investments have been sold, boosting cash in 20X2 by £32,000 but at
the expense of dividends received of £55,000. This sale also made a loss of
£101,000, indicating that the original investments were bought when stock markets
were higher.
– The statement of cash flows shows that trade and other payables have risen very
substantially during 20X2 (and by a lesser amount in 20X1). This indicates either an
inability to pay suppliers (the cash injection from the sale of stores was close to the
year end and opening cash only £122,000) or an unwillingness to do so. Pressing
suppliers for extended credit terms could lead to a loss of goodwill and ultimately a
refusal to supply.
 No dividends were paid in 20X2, indicating that the company's cash resources were low.
 Inventories have increased significantly over the year. This may indicate the holding of
obsolete inventories which should be written down.
 Overall, the company appears to be struggling to survive long term, despite the
substantial cash balances, and investors should be looking for a change in leadership of
the design department to take the company forward with a smaller number of stores.
(b) Pressure to improve the figures
There are several short-term devices which improve short-term performance and/or position,
many of which could have been used at Trendsetters Ltd.
 A company could 'window-dress' its cash position by taking out borrowings just before C
H
the year end, which it then repays early in the next accounting period. A
P
 The sale of assets (as here, with the disposal of stores) just before the year end will
T
improve the cash position in the short term but the impact of selling any profit- E
generating assets will not have a detrimental effect on profits until the following year. R
 Borrowings taken out close to the year end will not impact on interest payable and profit
until the following period.
23
 In areas where management have to make judgements, for example the level of
inventory, the recoverability of receivables or the level of impairments in respect of
tangible or intangible assets, it is always possible for an unscrupulous manager to justify
lower write-offs than are really needed.
 The timing of payments to suppliers can improve the trade payables payment period.
 Sales may be made in the last few weeks of the year, but no provision made for returns
(a provision which should be made in Trendsetters Ltd if it allows customers to return for
refunds, as many fashion stores do).
Actions
In response to such pressures, the financial controller should:
 consider his own professional position and the ethics of the situation;
 outline the issues to the operational directors and propose solutions that comply with
laws and standards; and
 contact the ethical helplines maintained by the professional bodies.

CHAPTER 24
Financial statement analysis 2
Introduction
Topic List
1 Recap from Chapter 23
2 Objectives and scope of financial analysis
3 Business strategy analysis
4 Accounting analysis
5 Accounting distortions
6 Improving the quality of financial information
7 Financial ratios interpretation
8 Forecasting performance
9 Data and analysis
10 Management commentary
11 Summary
12 Audit focus on fraud
Technical reference
1291
Introduction
 Comment on and critically appraise the nature and validity of items included in published
financial statements
 Comment and critically appraise the nature and validity of information disclosed in annual
reports, including integrated reporting and other voluntary disclosures
 Appraise the limitations of financial analysis
 Analyse and evaluate the performance, position, liquidity, efficiency and solvency of an
entity through the use of ratios and similar forms of analysis including using quantitative
and qualitative data
 Compare and appraise the significance of accruals basis and cash flow reporting
 Interpret the potentially complex economic environment in which an entity operates and
its strategy based upon financial and operational information contained within the annual
report (for example: financial and business reviews, reports on operations by
management, corporate governance disclosures, financial summaries and highlights)
 Appraise the significance of inconsistencies and omissions in reported information in
evaluating performance
 Compare the performance and position of different entities allowing for inconsistencies in
the recognition and measurement criteria in the financial statement information provided
 Make adjustments to reported earnings in order to determine underlying earnings and
compare the performance of an entity over time
 Analyse and evaluate business risks and assess their implications for corporate reporting
 Analyse and evaluate financial risks (for example financing, currency and interest rate risks)
and assess their implications for corporate reporting
 Determine analytical procedures, where appropriate, at the planning stage using technical
knowledge of corporate reporting, data analytics and skills of financial statement analysis
of details
 Review and evaluate, quantitatively and qualitatively, for example using analytical
procedures and data analytics, the results and conclusions obtained from audit procedures
Specific syllabus references for this chapter are: 9(a)–9(k), 11(f), 14(d), 15(c)

1 Recap from Chapter 23
Section overview
This section summarises the material on ratios from Chapter 23 and provides some interactive
questions to practise before moving on to the more advanced topics.
Main financial ratios

Financial ratios are the main tools of financial analysis and they will be used extensively at the Advanced
Level. The most important ratios are therefore reproduced here.
Profit before interest and tax (PBIT) + associates' post-tax earnings
× 100
Capital employed
Where capital employed = equity + net debt
Where net debt = current and non-current interest bearing debt minus cash and cash equivalents
Remember:
 Equity includes irredeemable preference shares and the equity element of the non-controlling
interest
 Net debt includes redeemable preference shares
Many different versions of this ratio are used in practice, but all are based on the same idea: identify the
long-term resources available to a company's management and then measure the financial return
earned on those resources. It is important that numerator and denominator are consistent, ie, the return
in the numerator is attributable to the resources included in the denominator.
Return on shareholders' funds (ROSF)
Net profit for the period
Share capital + Reserves
Gross profit percentage/margin

C
Gross profit
 100 H
Re venue A
P
Operating cost percentage T
E
Operating cos ts/overheads R
 100
Re venue
Operating profit margin
24
PBIT Profit from operations
 100 or  100
Re venue Revenue
Current ratio
Current assets
(usually expressed as X:1)
Current liabilities
Quick (acid test or liquidity) ratio
Receivables + Investments + Cash
(usually expressed as X:1)
Current liabilities
Gearing ratio
Net debt (per ROCE) Net debt
 100 or  100
Equity (per ROCE) Net debt  Equity

Interest cover
Profit before interest payable (ie, PBIT + investment income)
Interest payable
Net asset turnover

Revenue Revenue
or
Capital employed Non-current assets
Inventory turnover
Cost of sales Inventories
or  365
Inventories Cost of sales
Trade receivables
 365
Revenue
Trade payables
 365
Credit purchases
Working capital cycle

These last three ratios are often brought together in the working capital cycle, calculated as inventory
days plus trade receivables collection period minus trade payables payment period.
Cash cycle = Inventory days + Receivables days – Payables days
Capital expenditure to depreciation
Capital expenditure (additions)
Depreciation
Ageing of non-current assets

Gross carrying amount of non-current assets
Dividend yield
Dividend per share
× 100
Dividend cover
Earnings per share
Dividend per share
Price/earnings (P/E) ratio

Earnings per share
Earnings yield
Earnings per share
Earnings yield = × 100
Net asset value

Net assets (ordinary share capital and reserves)
Number of ordinary shares in issue

Interactive question 1: Financial ratio construction
You are given the following information on Apple Cart plc.
Statement of profit or loss for the year ended 31 December 20X6
£'000
Revenue 6,000
Gross profit 1,500
Operating expenses (680)
Operating profit 820
Finance costs (600)
Income tax (80)
Profit for the period 140
There was no other comprehensive income in the period.

Statement of financial position at 31 December 20X6
£'000 £'000
Assets
Non-current assets
Property, plant and equipment 5,900
Current assets
Property held for sale 120
Inventories 500
Trade and other receivables 570
1,470
Total assets 7,370
Issued capital (£1 shares) 3,640
Revaluation reserve 60
4,090
Interest-bearing borrowings / finance lease liabilities 1,175
Other long-term payables 1,270
C
2,445
H
Current liabilities A
Trade and other payables 640 P
Interest-bearing borrowings 195 T
835 E
Total equity and liabilities 7,370 R
Requirement
24
Calculate the return on capital employed (ROCE), the profit margin and the net asset turnover for Apple
Cart plc. Investigate the sensitivity of the results to different definitions of the return on capital
employed.

2 Objectives and scope of financial analysis
Section overview
Financial analysis is the process through which the stakeholders of a company, such as shareholders,
debt holders, government and employees, are able to assess the historical performance of the company
and form a view about its future prospects and value.
Financial analysis involves the following:

 The evaluation of a firm's business strategy, risks and profit potential
 The assessment of a firm's accounting policies and its conformity to its business strategy
 The evaluation of a firm's current and future performance and its long-term prospects
 The prediction of a firm's future performance
3 Business strategy analysis
Section overview
This section analyses the business strategy of a firm by looking at the industry in which the firm
operates, the competitive positioning of the company and the organisational structure and wealth
creation potential.
3.1 Business strategy analysis

A company can claim to create value if the rate of ROCE exceeds its weighted average cost of capital
(WACC). The WACC is the return that the capital contributors to a company, ie, its equity and bond
holders, require and is determined in the financial markets. Thus the WACC is largely exogenous to the
management of a firm. (This has been discussed in your Business Analysis Study Manual.)
The ROCE, on the other hand, is largely determined by the management of the company and is a
reflection of the decisions that management has made with regard to investment, production and
pricing policies, as well as the structure of the industry in which the company operates. A company that
operates in a highly competitive industry has less freedom to raise prices than a company that operates
in a less competitive industry. Similarly, investment in research and development will allow a firm to
produce more innovative products, to create patents and so on.
The various aspects of the operation of a firm that determine its return on capital will be investigated in
three stages. The first stage involves the investigation of the profit potential of the industry in which a
firm operates. The second stage will investigate the competitive positioning of a firm within a given
industry. The third stage investigates the sources of value of a particular firm.
3.2 Industry analysis

It is a fact of life that different industries have different rates of profitability. Industry analysis deals with the
analysis of the factors that determine the profit potential of a particular industry. Since profit is the
difference between revenues and costs, and since price setting in the output or input markets depends on
the competitive structure of each market, industry analysis explains the profitability of an industry by the
degree of competition in the industry. The degree of competition within an industry depends on:
 the degree of rivalry between the firms of an industry;
 the barriers to entrance into the industry;
 the substitutability of the industry's products;
 the price elasticity of the industry's products; and
 the structure of the input markets.

3.2.1 Degree of rivalry
In some industries such as retailing, firms compete aggressively by cutting prices, whereas in other
industries such as those involving services, there is less aggressive competition through prices, and the
competition takes the form of branding or some other distinctive product differentiation. An example of
a company that does not compete on price, but on product differentiation would be a company that
makes bespoke hand-crafted furniture. The factors that determine the degree of rivalry are as follows:
(a) The growth rate of the industry: If the demand for the products of an industry grows rapidly,
then revenues can grow through expanding production, without the need to cut prices. If on the
other hand the growth in demand for the products of the industry grows slowly, then firms may be
inclined to compete on price. Similarly, in a low growth situation, excess capacity in the industry
may force prices down.
(b) The number and relative size of the firms in the industry: The number of firms in an industry
determines the ability of firms to collude, as it is easier to co-ordinate price fixing when the number
of players is small. In addition, where there is a small number of equally sized companies, then the
companies can simply collude to divide up the market without any pressure on the prices. When
an industry consists of a large number of different sized companies, then price competition is more
likely. The UK airline industry is a good example of a fragmented market with high degree of price
competition.
(c) The degree of product differentiation in the industry: Industries which allow product
differentiation at low costs will also tend to compete on non-price terms, as differentiated products
are imperfect substitutes and therefore less sensitive to price changes.
(d) The existence of scale economies: Scale economies exist when average production costs fall as
the scale of operation of a company increases. Thus larger firms can reduce costs because of larger
cost efficiencies and in order to achieve this larger size they may have to cut prices to increase
production.
(e) The degree of operating leverage: The operating leverage of a firm measures the ratio of fixed
costs to variable costs at a given level of output. When the degree of operating leverage is high
companies may be inclined to reduce prices to expand the operations and thus use more the fixed
factors of production that give rise to fixed costs.
(f) Capital specificity: If there is excess capacity in an industry, an alternative to cutting prices is for a
company to leave the industry and move into a different industry. However, the ability to do this
may be limited by the specificity of the capital (human and physical) to an industry and the heavy
costs of converting the existing capital for a different use. C
H
A
3.2.2 Barriers to entrance P
T
Barriers to entrance make it difficult for new entrants to enter an industry and to increase competition. E
The main barriers to entrance are as follows: R
(a) The minimum size of operation: In many industries there is a minimum size of operation that only
a small number of firms can attain.
24
(b) Early entry advantage: In certain industries the first entrant generates an advantage that makes it
difficult for other entrants. An example is a company that has secured for a number of years the
supply of material.
(c) Distribution channels: In certain industries distribution channels are controlled by competitors
and it is therefore difficult for the products to reach the consumer.
(d) Regulation and legal constraints: There may be regulations that prevent the entry into a specific
industry of companies unless they meet certain requirements.
3.2.3 Product substitutability

For a number of industries there are substitute goods and the degree of substitutability affects the price-
setting behaviour of the entire industry. While there is some degree of substitutability between cars and
bicycles, it is unlikely that many car users will switch to cycling. Public transport on the other hand is a
closer substitute and it is much easier for motorists to switch to public transport.

3.2.4 Price elasticity
The price elasticity of the demand for the products of an industry is also an important factor in the
determination of the industry structure. The price elasticity measures the sensitivity of demand changes
in the price of a product. When demand is highly sensitive to price changes, then companies may not
be able to increase revenues by raising prices, since this will be offset by a fall in the demand.
The price sensitivity of a product also depends on the number of buyers of the product. Where the
number of buyers is small, a firm may be in a weak position. Firms that sell their products to the public
sector are in a particularly weak position, as there is no alternative market for their products.
3.2.5 The structure of the input markets

The structure of the input markets determines the price that firms pay for their inputs. In markets where
there is a larger number of suppliers it is easier for a firm to negotiate lower prices.
3.3 Competitive analysis

In the previous section we analysed the factors that affect the structure and consequently the
profitability of an industry. In this section we shall discuss the factors that determine the positioning of a
firm within a given industry.
There are basically two options that a firm has in deciding where to position itself relative to the industry
in order to create a competitive advantage. The first option is to produce at a lower cost than the other
firms in the industry. The second option is to produce products that are sufficiently differentiated so as
to be less sensitive to prices.
3.3.1 Low cost strategy

A low cost strategy can be achieved by a company through the following:
(a) Economies of scale: As we discussed above, economies of scale exist when the cost of production
per unit of output decreases as the level of production increases. Thus companies which reach a
certain size may be able to follow a low cost strategy.
(b) Economies of scope: Economies of scope exist when the average cost per product decreases as
the number of products produced by the company increases. This is due to the existence of fixed
factors of production which can be used more efficiently when used by a larger number of
products. The attainment of economies of scope is sometimes the main reason for the merger of
companies.
(c) Efficient organisation and production: The efficient organisation of a company which reduces
duplication of responsibilities, and reduces operational costs, as well as the adoption of more
efficient production methods may also lead to lower costs.
(d) Lower input costs: If a firm can achieve lower input costs because it has for instance
monopsonistic power, then the firm can achieve lower costs of production.
3.3.2 Product differentiation

The second strategy for the creation of competitive advantage is through product differentiation. As
we already discussed in the previous section, product differentiation reduces the competitive pressure
on a firm and thus it allows for greater profitability.
Product differentiation can take several forms, such as branding, product quality, product appearance,
delivery timing, terms of purchase or service, after-sales service and so on.
3.3.3 Assessing a competitive strategy

An understanding of a company's strategy will require, among other things, an appreciation of its key
success factors and risks. One aim of financial analysis is to evaluate how well the company is managing
these factors.
For example, in the pharmaceutical industry, a key factor for success might be the number of new drugs
brought to the market through the research and development (R&D) process. Expenditure on R&D

might be one factor to indicate the extent of the R&D process. While expenditure does not guarantee
successful products, any changes in expenditure might be indicative of longer-term commitment.
Further examples might be the level of bad debt write-offs on loans for banks and the level of warranty
provisions for any company where product quality is a key indicator.
A key factor in financial analysis is evaluating a company not just in isolation but by comparison with its
competitors. Where companies in the same industry adopt different accounting policies, analysts may
need to apply adjustments to the financial statements in order to compare like with like.
This does not, however, mean that all companies in the same industry should have the same accounting
policies, and the same measurement bases. Similarly, a company might make lower warranty provisions
or bad debt write-offs than other companies in the industry. This might be through imprudent
accounting, or because the company in question has better quality products and better credit
management. An analyst's judgement and wider knowledge of the company is needed rather than a
blanket adjustment to adopt the same accounting policies for all companies in the industry.
3.4 Corporate strategy and sources of value

The third step of business analysis deals with the investigation of the sources of value of the firm. We
have already discussed that value is created when the ROCE exceeds the WACC, and the factors that
affect an industry's ROCE which is in a sense a constraint but also an estimate of the ROCE for an
individual firm. We have also covered the two strategies which firms adopt in order to maximise their
ROCE. In this last session of competitive analysis, we look at how the structure of a firm and its
corporate strategy affects its ability to create value.
3.4.1 The structure of a firm

A firm will be able to create value only if it is efficiently organised. The exact organisation of a company
will depend on the transaction costs which are incurred in carrying out transactions which are related to
the operations of a firm. The theory that underpins this view of corporate organisation is the transaction
costs theory of the firm which postulates that firms are formed because transaction costs within an
organisation are lower than the costs of transacting through the markets. Depending on the nature of
the business, an organisation may reduce its transaction costs by engaging in multiproduct production
instead of producing a single product. This rationale underpins the diversification of, for example, the
banking industry into other areas such as insurance and securities trading.
3.4.2 Assessing value creation ability

How do we assess whether the organisational structure of a particular firm generates value? The C
H
fundamental test is whether transaction costs within a firm are higher than in the market. An example of A
a situation where value is created by resorting to the market is outsourcing. A second test is the P
existence of scope economies which can be exploited to reduce costs and create value. Economies of T
scope are generated by the more intensive use of a fixed factor of production. Such a fixed factor of E
R
production could be a brand name, a unique delivery channel etc. The third test is the existence in a
company of mechanisms that reduce agency costs. If a company passes all three tests then it is highly
likely that the company has the ability to generate value.
24
4 Accounting analysis
Section overview
This section analyses the sources of financial information that are needed for the financial analysis of a
company and the steps that need to be taken in order to identify potential problems and resolve them.
4.1 Scope of accounting analysis

The second stage of financial analysis is the evaluation of the accounting policies of the company and
their conformity with the business strategy of the firm. Accounting analysis involves the following steps:
 Evaluation of key accounting policies
 Evaluation of disclosure quality

 Identification of 'red flags'
 Elimination of accounting distortions
4.1.1 Evaluation of key accounting policies

An assessment needs to be made as to whether the accounting policies adopted attempt to inflate or
deflate earnings and asset values in a systematic way. If, where options for accounting policies exist, the
directors have always selected the option that inflates profits, then there may be concerns over the
quality of the reported earnings measure and whether it reflects (or distorts) underlying cash flows and
economic circumstances.
Companies also have to exercise judgement and make assumptions in the application of accounting
policy. Assumptions include, for example, figures for employee turnover, mortality rates and future
increases in salaries (if these will affect the eventual size of future benefits such as pension payments).
4.1.2 Evaluation of disclosure quality

Good quality disclosure makes it easier for valid financial analysis to take place. While GAAP sets a
minimum level of disclosure, there is nothing to prevent companies disclosing more than the minimum.
Indeed, many would expect a management keen on accessing capital markets to provide full disclosures
of key information, whether or not these were required by accounting standards.
Consideration might be given to the following:
 Whether any disclosure is made in addition to the minimum required by accounting regulations
 Whether the company has taken advantage of any exemptions from disclosure in accounting
standards, or produced the bare minimum disclosure
 Whether additional disclosure is quantitative and detailed; or alternatively qualitative and only
indicative
 Whether the information is disclosed in the notes to the financial statements and thus subject to a
statutory audit; or only in the accompanying information in the annual report and therefore only
subject to review
 The details in the supplementary statements, which are largely unregulated (such as in the
operating and financial review) and whether they provide an adequate explanation of current
performance
 Where alternative performance measures are used, clear explanations of the reconciling items to
the amounts in the financial statements
 Whether unusual items and policies are adequately explained and justified
 Clear explanations of any uncertainties and assumptions used in arriving at the amounts recognised
in the accounts
 The level of detail and relevance of segmental disclosure, where management has significant
discretion as to the method of analysis
 Whether non-accounting disclosures during the year have been consistent with the picture
presented in the financial statements
4.1.3 Identification of 'red flags'

The information contained in the financial statements will be used for the analysis of the historical
performance of a company or as the basis for the formation of expectations about the future
performance of the company and the estimate of its value. The validity of all three tasks will depend on
the reliability of the information derived from the financial statements. If the information is misleading
then it may lead to erroneous conclusions about the past and future performance of a company. Thus
the information contained in the financial statements should, as a first step, be assessed for its quality.
There are three basic aspects that need to be taken into account when interpreting financial ratios,
namely compliance of financial statements with the GAAP, the quality of audit and the presence of
creative accounting. Of the three, creative accounting is by far the main way of manipulating
information and for this reason we devote more attention to it.

Creative accounting is the active manipulation of accounting results for the purpose of creating an
altered impression of the underlying financial position or performance of an enterprise by using
accounting rules and guidance in a spirit other than that which was intended when the rules were
written.
The spectrum of creative accounting practices may include the following (commencing with the most
legitimate):
 Exercise of normal accounting policy choice within the rules permitted by regulation (eg, first in,
first out (FIFO) or average cost for inventory valuation)
 Exercise of a degree of estimation, judgement or prediction by a company within reasonable
bounds (eg, non-current asset lives)
 Judgement concerning the nature or classification of a cost (eg, expensing or capitalising
development costs)
 Systematic selection of legitimate policy choices and estimations to alter the perception of the
position or performance of the business in a uniform direction
 Systematic selection of policy choices and estimations that fall on the margin of permitted
regulation (or are not subject to regulation) in order to alter materially the perception of the
performance or position of the business, for example the timing of revenues and receivables
 Setting up of artificial transactions to create circumstances where material accounting
misrepresentation can take place
 Fraudulent activities
The following have been put forward as incentives for companies/managers engaging in creative
accounting:
(a) Income smoothing: Companies normally prefer to show a steady trend of growth in profits, rather
than volatility with significant rises and falls. Income smoothing techniques (eg, declaring higher
provisions or deferring income recognition in good years) contribute to reducing volatility in
reported earnings.
(b) Achieving forecasts: Where forecasts of future profits have been made, reported earnings may be
manipulated to tie in with these forecasts.
(c) Profit enhancement: This is where current year earnings are boosted to enhance the short-term
perception of performance. C
H
(d) Maintain or boost share price: Where markets can be made to believe that increased earnings A
represents improved performance, then share price may rise, or at least be higher than it would be P
in the absence of creative accounting. T
E
(e) Accounting-based contracts: Where accounting-based contracts exist (eg, loan covenants, profit- R
related pay) then any accounting policy that falls within the terms of the contract may significantly
impact on the consequences of that contract. For example, the breach of a gearing-based debt
covenant may be avoided by the use of off balance sheet financing. 24
(f) Incentives for directors: There may be personal incentives for directors to enhance profit in order
to enhance their remuneration. Examples might include: bonuses based on earnings per share
(EPS), share incentive schemes and share option schemes. Directors may also benefit more
indirectly from creative accounting by increasing the security of their position. Incentives such as
bonuses are not limited to incentives for directors and may be incentives for management who also
have the ability to manipulate results on a day-to-day basis.
(g) Taxation: Where accounting practices coincide with taxation regulations there may be an incentive
to reduce profit in order to reduce taxation. In these circumstances, however, it may be necessary
to convince not only the auditor, but also the tax authorities.
(h) Regulated industries: Where an industry is currently, or potentially, regulated then there may be
an incentive to engage in creative accounting to influence the decisions of the regulator. This may
include utilities where regulators may curtail prices if it is perceived that excessive profits are being
earned. It may also be relevant to avoid a reference to the Competition Commission.

(i) Internal accounting: A company as a whole may have reason to move profits from division to
division (or subsidiary to subsidiary) in order to affect tax calculations or justify the
closure/expansion of a particular department.
(j) Losses: Companies making losses may be under greater pressure to enhance reported
performance.
(k) Commercial pressures: Where companies have particular commercial pressures to enhance the
perception of the company there is increased risk of creative accounting. For example, a takeover
bid, and the raising of new finance.
Questionable accounting policies and inadequate disclosures may be regarded as warning signs that
there are undue pressures on management to improve performance or that there is poor corporate
governance. This might be reflected in both accounting policies and estimates adopted, but also by
manipulation of underlying transactions that might be revealed by financial statement information, or
hidden by inadequate disclosure.
'Red flags' and detection
The best detection techniques for creative accounting are a good knowledge of financial accounting
regulation and a good understanding of the business. There may, however, be more general techniques
and indicators that can suggest that a company is engaging in creative accounting practice. These
include:
(a) Cash flows: Operating cash flows are systematically out of line with reported profits over time.
(b) Reported income and taxable income: Is financial reporting income significantly out of line with
taxable income with inadequate explanation or disclosure?
(c) Acquisitions: Where a significant number of acquisitions have taken place there is increased scope
for many creative accounting practices.
(d) Financial statement trends: Indicators include: unusual trends, comparing revenue and EPS
growth, atypical year-end transactions, flipping between conservatism and aggressive accounting
from year to year, level of provisions compared to profit indicating smoothing, EPS trend and
timing of recognition of exceptional items.
(e) Ratios: Ageing analyses revealing old inventories or receivables, declining gross profit margins but
increased net profit margins, inventories/receivables increasing more than sales, gearing changes.
(f) Accounting policies: Consider if there is the minimum disclosure required by regulation, changes
in accounting policies, examine areas of judgement and discretion. Consider risk areas of: off
balance sheet financing, revenue recognition, capitalisation of expenses and significant accounting
estimates.
(g) Changes of accounting policies and estimates: Is the nature, effect and purpose of these changes
adequately explained and disclosed?
(h) Management: Estimations proved unreliable in the past, minimal explanations provided.
(i) Actual and estimated results: Culture of always satisfying external earnings forecasts, absence of
profit warnings, inadequate or late profit warnings leading to 'surprises', interim financial
statements out of line with year-end financial statements.
(j) Incentives: Management rewarded on reported earnings, profit-orientated culture exists, other
reporting pressures eg, a takeover.
(k) Audit qualifications: Are they unexpected and are any auditors' adjustments specified in the audit
report significant?
(l) Related party transactions: Are these material and how far are the directors affected?
The above is not a comprehensive list, but merely includes some main factors. Also, it is not suggested
that the above practices necessarily mean there is creative accounting but, where a number of these
factors exist simultaneously, further investigations may be warranted. Any review of such 'red flags' as
warning signs needs to be seen within the bigger picture of the current commercial situation of the
company, and the strategy it is adopting.

4.1.4 Elimination of accounting distortions and restatement
The final step of the accounting analysis is the elimination of the distortions from the financial
statements and their restatement with the correct information. We shall devote a whole section to this
topic later.
4.2 Sources and problems of accounting information

Accounting information is contained in the financial statements of a firm, namely:
 the statement of financial position;
 the statement of profit or loss and other comprehensive income or separate statement of profit or
loss and separate statement of comprehensive income disclosing other comprehensive income;
 the statement of changes in equity; and
 the statement of cash flows.
These are in addition to the notes to the financial statements and market values or prices.
Unfortunately, the accounting information contained in the above sources can be manipulated by the
management of a company, for a variety of reasons. For even when a company follows closely the
accounting standards, there may be some discretion afforded in the presentation of the accounts. That
is why the first two aspects of the financial analysis process, as defined in the previous section, deal with
the assessment and correcting of financial information.
Every financial statement produced by a corporate entity should be produced according to some
accounting standard. All EU member states, and many other countries outside the EU, have adopted the
International Financial Reporting Standards (IFRSs) for listed companies. The adoption of common
accounting standards restricts the freedom of management to record the same transaction in different
ways. The uniformity of accounting standards makes comparison between firms and across time easier.
However, this comes at the expense of flexibility in the accounting treatment of genuinely different
businesses.
One example where such a rigidity and lack of management discretion may lead to distortion of
accounting figures is IAS 38 Intangible Assets which requires firms to recognise assets for development
expenditure when they are likely to produce future economic benefits, but also requires firms to
expense the preceding research outlays when they are incurred. Development expenditures are those
incurred for the actual development of a new product. Research expenditures on the other hand are not
C
directly associated with any product, although some research expenditure will give rise to a future H
product. IAS 38 does not allow firms to distinguish between research and development expenditure in A
the early stages leading to a systematic distortion of reported results. P
T
The IASB has tried to reconcile consistency with rigidity and in many cases the standards define general E
principles rather than specific rules. A good example of this approach is IAS 17 on leasing where the R
directors have some discretion at the margin to decide which leased assets are finance leases. It is
interesting to note that the US FASB (Financial Accounting Standards Board) does not afford this
discretion and instead specifies detailed rules for the classification of leased assets. 24
Another source of potential distortion of accounting information is the requirement that management
predict the future outcome of current transactions. When a firm makes a sale on credit, accrual
accounting principles require that managers estimate the probability of collecting the future payments
from the customer. If the probability is high the transaction is treated as a sale creating trade receivables
on its statement of financial position. Managers then have to make an estimate of the receivables that
will be collected, which may differ from the realised payments.
The broad-based approach of the IASB which affords a certain degree of discretion to the management
of a company, and the nature of accrual accounting imposes an additional burden of interpretation and
judgement on the auditor and the user of the financial information.
4.3 Audit and financial statement quality

The first verification of the integrity of any financial statements produced by a company is performed by
the external independent auditors of the company. In the EU, minimum auditing standards are laid

down by the Eighth Company Law Directive, which among other provisions specifies that audits should
be carried out in accordance with the International Standards on Auditing (ISAs).
Although auditing presents an independent assessment of the firm's financial statements, auditing is not
sufficient to prevent fraudulent presentation of the financial health of a company by management
which, as the cases of Enron and Parmalat show, might not be detected by the auditors.
These failures of the auditing processes may be due to inadequate adherence to auditing rules, lack of
understanding of the business, or simply connivance on the part of the auditing team. Given these
auditing failures, the audited accounts of a company should not be accepted uncritically as the basis for
drawing conclusions on a company's historical or predicted performance.
In the following section we look at some of the areas of the financial statements and the accounting
policies that may give rise to distortions of the financial information.
5 Accounting distortions
Section overview
This section discusses the most common distortions in the accounting information contained in the
In the previous section we discussed the potential for distortion of accounting information. In this
section we discuss the most common distortions and how these may arise.
5.1 Distortions in assets

Distortion in assets takes the form of overstating assets which is reflected in increased reported earnings
(increased revenue or reduced expenses) or understating assets which is reflected in deflated earnings
(reduced revenue or increased expenses).
The main reason for the distortion of assets is due to the ambiguity or the freedom of accounting
reporting rules. We look at some of the most salient examples of the international accounting standards
and how they can give rise to this kind of distortion.
Asset distortion can be the result of earnings smoothing where earnings are overstated or understated
so as to eliminate volatility and present a smooth pattern over time.
5.1.1 Depreciation and amortisation of non-current assets

The using over time of non-current assets must be recorded in profit or loss. The depreciation of a non-
current asset should match the decline in its remaining economic life, which needs to be estimated. The
salvage value of the asset at the end of its economic life also needs to be estimated. Thus the
depreciation expenditure recognised in profit or loss is partly at the discretion of the management. Two
different companies operating in the same industry may end up with different depreciation schedules
because of the different assumptions on economic life and residual values. Lufthansa for example
assumes a shorter economic life for its aeroplanes than British Airways but the interpretation of this
accounting policy difference may be unclear.
Illustration: British Airways and Lufthansa

The German airline Lufthansa reported in its financial statements that it depreciates its aircraft over
12 years on a straight-line basis using an estimated residual value of 15% of the original cost.
By contrast, British Airways reported in its financial statements that it depreciates its aircraft over
20 years on a straight-line basis using an estimated residual value of 8% of the original cost.
The difference could lie as much in the companies' asset replacement policies as in their depreciation
policies.
The difference might be one of mere accounting policy choice where financial analysis would need to
make adjustments to compare like with like when interpreting the underlying performance of the two

companies. Alternatively, there may be differences of commercial substance that would make a different
depreciation policy acceptable as reflecting commercial reality, in which case no adjustment would be
needed.
Possible commercial explanations to justify the different depreciation treatment would be: different
utilisation of aircraft, different types of aircraft being used, different maximum speeds, more long- or
short-haul flights, different levels of maintenance and use of older planes.
In fact, any difference is likely to be a mix of accounting and commercial differences and any analysis
needs to exercise careful judgement in making relevant adjustments. An understanding of management
motivations may also help. In the case of Lufthansa the depreciation rates were used for tax purposes
whereas this was not the case with British Airways.
(Source: Krishna G. Palepu, Victor Lewis Bernard, Paul M. Healy, Business & Economics, 2007)
5.1.2 Capitalisation of development costs and intangible assets

The growth of internet, telecommunications and service companies has made the measurement of
intangibles a key issue, even though it is difficult to measure precisely their value. With financial
statements treating many intangibles as off-balance sheet assets, there may be little information to make
such valuations within the financial statements.
In many traditional industries such as the pharmaceutical industry where research and development
expenditure plays an important role, the non-recognition of research and development as capital due to
the uncertainty of future benefits may lead to valuable assets being ignored or overlooked.
The impact of ignoring intangible assets or not valuing them properly on all ratios that involve the use
of asset estimates can be significant. Profitability ratios such as the return on assets or activity ratios will
be overstated, making it difficult to analyse historical performance, to forecast performance or to value a
company.
5.1.3 Leased assets

The main issue regarding leased assets is whether lease payments should be recognised as capital costs
and hence capitalised and depreciated, or whether lease payments should be treated as an expense. In
the first case the lease is a finance lease, whereas in the second case it is an operating lease.
The distinction between the two types of leases is guided by the criteria of IAS 17 which specifies that a
lease will be classified as a finance lease if the following criteria are met: C
H
 Ownership of the asset is transferred to the lessee at the end of the lease. A
P
 The lessee has the option to purchase the asset at the end of the lease. T
 The lease term constitutes a large part of the life of the asset. E
 The present value of the lease payments is close to the fair value of the asset. R
 The asset cannot be used by somebody else without major modification.
Despite the criteria there is still scope for discretion on the part of management leading to an 24
understatement of assets classified as held under finance leases and therefore of the total assets of the
company. This will affect the gearing ratio where finance leases are treated as part of long-term debt
whereas operating leases are not. Research shows that adjustment to capitalise operating leases has
significant effects on gearing and other key ratios.
5.1.4 Sale and leaseback transactions

Some companies use sale and leaseback transactions (see Chapter 14) as a means of raising finance. This
is a common feature of certain industries such as retailing and hotels where the entity may have a
significant number of high value properties.
Where a sale and leaseback transaction results in an operating lease and the transaction is established at
fair value, any profit or loss should be recognised immediately.

Illustration: Tesco
The UK retailer Tesco boosted profit for the year ending February 2007 by 4.1% by entering into a sale
and leaseback transaction with a joint venture in which the retailer had a 50% share.
As a result Tesco recognised 50% of the gain on the sale and leaseback of 16 properties representing
£110 million and boosting profit by 4.1%. Tesco continues to use the stores in its business and reports
these as operating leases.
In its 2006 financial statements Tesco disclosed that since 1988 it has entered into sale and leaseback
transactions with a joint venture under various terms which included sale at market value, rent reviews
and an option for Tesco to repurchase at market value. The company includes in its list of critical
assumptions the classification of leases into operating and finance.
This is an extreme example, but distortions arising from sale and leaseback still occur. The UK Financial
Reporting Review Panel, in its 2012 report, noted:
'Several issuers that reported sale and leaseback transactions as operating leases but where, from
the descriptions provided, there was a question whether the risks and rewards of ownership had
been substantially transferred, indicating that the leasebacks may be finance leases.'
5.1.5 Mergers and acquisitions

Accounting for mergers and acquisitions follows two approaches: the pooling of interests method
(merger accounting) and the acquisition method (acquisition accounting).
Under the acquisition method, the cost of merger for the acquiring firm is the actual value that was paid
for the acquisition of the target company's shares. If the price paid plus the value of the non-controlling
interest is above the value of the acquiree's net assets, then the excess is recorded as goodwill on the
acquiring firm's statement of financial position.
While the pooling of interests method is not permitted by IFRS 3 Business Combinations, there is no
requirement for retrospective adjustment of previous mergers. This creates problems when financial
ratios are used for the evaluation of the historical performance of a company. To standardise the
method of consolidation, the pooling of interests needs to be reversed and replaced by the acquisition
method, which requires fair value adjustments and recognition of goodwill.
5.1.6 Revenue recognition

Managers sometimes have incentives to recognise future revenues overstating earnings and receivables.
This will, of course, be followed by a decline in the earnings in subsequent years, so unless a company
experiences a consistent growth in earnings, early revenue recognition will not help the long-term
performance of the company.
5.1.7 Allowances
Management may sometimes find it to its advantage to underestimate the expected default loss from
receivables and thus to underestimate allowances and overstate earnings and assets.
5.1.8 Discounted receivables

Companies may sell their receivables in order to boost their liquidity. There are two options for the
recording of such a sale. The first is for the transaction to be recorded as a sale. The second is for the
transaction to be recorded as a loan with the receivables being collateral. Such a transaction will be
recorded as a sale if the IAS 39 Financial Instruments: Recognition and Measurement criteria for
derecognition are met and the buyer undertakes all the risks and rewards of the receivables.
5.2 Distortions in liabilities

The most common distortion on the liability side involves:
 provisions
 unearned revenues
 post-employment benefit obligations

5.2.1 Provisions
A firm that expects a future outflow of cash due to a contractual obligation but whose exact amount is
not known will need to make a provision for such a liability. Firms, however, have the discretion to
estimate these future liabilities and the possibility to understate them on their statement of financial
position.
5.2.2 Unearned revenues

Unearned revenues arise when a company receives payments in advance of selling the good or service.
Such unearned revenues create liabilities that need to be recognised. Companies may understate such a
liability.
5.2.3 Post-employment benefit obligations

Under IFRSs, firms that provide pension benefits or other post-employment benefits to their employees
need to recognise the present value of future payments net of the assets that are dedicated to the
payment of these future benefits. The company needs to adjust these liabilities every year in the light of
current service costs, interest costs, actuarial gains and losses, past service costs and benefits paid.
Illustration: BG pension deficit

BG Group plc elected in 2006 to use the so-called 'corridor' method to account for pensions, and it
recognised a £167 million deficit, whereas a further £78 million was not recognised in the statement of
financial position as it was within the 10% corridor. This is a serious understatement of the pension
liability on the statement of financial position since £78 million represents about 47% of the recognised
pension deficit.
In 2011, IAS 19 Employee Benefits was revised and deferral of recognition outlawed, in order to prevent
such distortions as this.
5.3 Distortions in equity

Distortions in equity arise either from contingent claims or the recycling of gains and losses
(reclassification from equity to profit or loss). Contingent claims take the form of stock options or
conversion options.
C
Stock options
H
Stock options give the right to employees to buy a company's shares at a predetermined price within a A
P
specific period of time. IFRS 2 Share-based Payment requires that firms should report the cost of options
T
as an expense in profit or loss using the fair value of the option, which can be estimated using option E
valuation models. However, such models are not very accurate, as they depend on the volatility of share R
prices which is not observable and has to be estimated from market data. Thus it is possible that the
cost of stock options may not be stated correctly.
24
Conversion options
Convertible bonds can be considered as being made up of an ordinary bond and a call option on the
shares of the company. IAS 39 requires that the company values the ordinary bond component
separately from the call option component.
Reclassification (recycling) of gains and losses
Gains or losses on some items may be recorded as other comprehensive income and accumulated in
equity, and later reclassified to profit or loss. Gains or losses on other items may not be reclassified to
profit or loss. (IAS 1 Presentation of Financial Statements now distinguishes between these two types of
gains/losses.)

6 Improving the quality of financial information
Section overview
This section suggests ways of undoing the accounting distortions in the financial statements, and
produces a measure of sustainable earnings. The possibility of using cash flow data instead of earnings
is also discussed.
6.1 Undoing accounting distortions

If financial analysis reveals that a company's financial statements are deemed to be inadequate,
misleading or atypical of the industry, then it is important that adjustments are made to undo the
inadequate policies, as far as possible, in order to produce 'standardised' accounts which can form the
basis for decision-making, forecasting future performance on a comparable and valid basis and,
ultimately, contribute to an appropriate valuation.
It should be noted that accounting manipulation and 'red flags' could arise not only where management
are attempting to inflate profit. Overconservative accounting, or excessive prudence, may be as much of
an issue as aggressive earnings management when attempting to forecast future earnings from a current
earnings basis.
Key information as a starting point to make such adjustments is disclosed in the notes to the financial
statements, and the statement of cash flows. Other information in the public domain about the
company should also be used.
The following sections give examples of specific adjustments that can be made to the statement of
financial position and the statement of profit or loss (and other comprehensive income) as part of the
process of standardisation.
6.2 Statement of financial position adjustments

The statement of financial position shows the assets, liabilities and equity of a company. The two major
issues arising from accounting policies, even when they are in full compliance with GAAP, are:
 the amounts at which assets and liabilities are measured may differ significantly from their
economic values; and
 some valuable assets and significant liabilities may not be recognised at all.
Any forecast based on accounting information which is to be used for cross-sectional comparison
purposes, or as an input into a valuation model, first needs to address these issues by making
appropriate adjustments by:
 remeasuring assets and liabilities at fair market values;
 adding back (ie, recognising) off balance sheet liabilities and assets with commercial value; and
 adding back assets that have been previously written off (goodwill, impairment reviews etc).
In practice, most acquirers and investors determine firm value by calculating the sum of the market
value of the debt and the equity invested in the business. In this case, a separate valuation of individual
operational assets and liabilities rarely takes place. A large proportion of firm value is likely to be related
to the present value of future growth opportunities, and is not represented by current earnings or assets.
In contrast, lenders calculate firm value from the worst-case perspective. They often estimate the fair
value of assets in place assuming a break-up, to check that the capital of their loan is secure.
6.3 Adjusting the assets

If the carrying amount (ie, 'book value') of assets is either understated, or overstated, by comparison
with their economic values and with those of comparable companies, this can have important
implications for forecasting and valuation. As an example, some companies may wish to state assets at
cost rather than a revalued amount as, although revaluation 'improves' the statement of financial
position, it does so at the cost of higher depreciation and lower reported profit. This may affect some

companies (eg, those with profit-related remuneration schemes or with earnings-based covenants) more
than others. Some examples and motivations were discussed in the previous section.
Non-current assets
There are a number of areas that affect the recognition and recording of non-current assets, such as fair
value recognition, depreciation and amortisation, inflation, impairment and interest capitalisation. In
order to adjust the financial statements, financial analysis will be required to do the following:
(a) Revalue to fair value non-current assets which are currently recognised in accordance with the cost
model and/or assets which have not been revalued recently
(b) Standardise the depreciation method
(c) Review asset lives compared with competitors and recent replacement policy (eg, consider
profit/loss on disposal, readjustments of asset lives). See the 'British Airways and Lufthansa'
illustrative example above
(d) Review residual values (eg, a weakness in the market for secondhand aircraft caused a significant
depreciation adjustment by EasyJet in 2004)
(e) Impact of foreign currency – for non-monetary assets no adjustments are made under IAS 21 The
Effects of Changes in Foreign Exchange Rates for exchange rate movements after purchase (although
there will be an impact of foreign currency changes over time if there are consistent asset
replacements)
(f) Look for evidence of adequacy of impairment charges (eg, poor trading conditions, decline in fair
values, previous recent revaluations, rival companies' recognition of impairment in similar assets)
(g) Impact of general inflation or sector inflation
(h) Capitalisation of interest policy to be standardised with comparable companies, normally by
treating the interest as an expense and deducting it from the asset value
Intangible assets
There are two general approaches to resolving the problems generated with the accounting treatment
of intangibles. The first approach is to leave the accounting numbers as they are, but in analysing
historical performance and in forecasting the analyst should be aware that the rate of return is
understated and that it represents the lower end of the estimates. The second approach involves
recognition of the intangible asset and amortisation over their expected life.
(a) Revalue at fair value intangible assets which are currently recognised in accordance with the cost C
model, or that have not been revalued recently. This process may be very difficult in some H
circumstances, and could amount to valuing the company as a whole. However, if the purpose of A
adjustments is to forecast firm values, then the process becomes circular. P
T
(b) Recognise internally generated intangible assets at fair value where IAS 38 and other asset E
recognition criteria are not satisfied, but the assets have commercial value. (For many 'asset-light' R
companies the statement of financial position would be largely meaningless unless unrecognised
intangibles are reinstated at some estimated value.)
(c) Consider capitalisation of the commercial value of unrecognised R&D costs, particularly where 24
these are significant, and a key factor for success such as in the pharmaceuticals industry.
(d) Review the amortisation policy for intangible assets for consistency and comparability, in terms of
both asset life and residual value.
(e) Look for evidence of adequacy of impairment charges.
(f) Consider changes in the fair value of goodwill on acquisitions.
Leased assets
The distinction between finance and operating leases affects the statement of financial position and the
profit or loss and hence a large number of key ratios. A solution is to consider the recognition of long-
term operating leases on a comparable basis to finance leases. This will increase assets and thus reduce
asset turnover ratios. However, the liability will be brought on the statement of financial position and
increase debt and gearing ratios. In addition, the expensed lease costs need to be converted to interest
and a depreciation charge. Most credit rating companies follow this approach and capitalise all
operating leases.

But even when finance leases are explicitly recognised as such in the statement of financial position, it
may be sensible to do the following:
 Consider, and if necessary recompute, the method of allocating finance charges on finance leases
over the period of the lease
 Consider whether the value of assets under finance leases is understated and needs to be revalued
 Review depreciation policy and asset lives as for owned assets
Worked example: Rolls Royce

Rolls Royce treats some of its leased assets as operating leases and they are excluded from its statement
of financial position. This makes it difficult to compare it with other companies that have a different mix
of operating and finance lease. This could be corrected if all operating leases were capitalised.
Non-cancellable operating lease rental
2014 2013
£m £m
Within one year 182 179
Between one and five years 542 545
After five years 438 507
Total 1,162 1,231
Requirement
Outline the steps required in order to capitalise operating leases and the adjustments made to the
statement of financial position and profits for the purpose of financial analysis.
Solution
The following steps are required:
First an estimate is required for the annual allocation of rental payments.
Second, a discount factor needs to be adopted in order to discount the rental payments and calculate
the present value of rental payments under the operating lease. An appropriate discount rate would be
the cost of long-term debt for the company.
Third, a depreciation schedule needs to be adopted for the depreciation of the asset represented by the
operating lease.
Fourth, the rental payments need to be added to operating profit and a finance charge calculated
representing the financing costs.
Inventories
(a) Standardise for the effects of different inventory identification policy choices, including FIFO,
average cost and standard cost.
(b) Consider specific price changes in the industry.
(c) Consider adequacy of write-downs to net realisable value, particularly where inventory volumes
have increased, or where prices have fallen.
(d) To the extent of available disclosure, consider the impact of overheads being included in
inventories on a reasonable basis, particularly where inventory volumes have changed in the year.
(e) Impact of foreign currency – as inventories are a non-monetary asset, no adjustments are made
under IAS 21 for exchange rate movements after purchase (although there will be an impact of
foreign currency changes over time as there are consistent inventory replacements).
Receivables
(a) Consider adequacy of bad debt write-offs (eg, compared with competitors, prior experience,
known insolvencies among customer base, increases in receivables days ratio).
(b) Consider the likely timing of any bad debt recovery, and how it might affect liquidity.
(c) Consider impact if any factoring has taken place.

Long-term assets
(a) If stated at fair value, consider valuation method used if disclosed, and any post year end changes.
(b) Review companies on the border of control and significant influence. Equity accounting would take
only net assets into consideration, and would take an associate's liabilities off the consolidated
statement of financial position. The restatement of an associate on a full consolidation basis may be
appropriate where significant influence borders on de facto control. This may significantly affect
reported consolidated figures for highly geared associates. The information would be available to
the analyst on the basis of the disclosure in the financial statements of the individual companies.
6.4 Adjusting liabilities

The main adjustments to liabilities are:
Long-term debt
The liability may not reflect its fair value if stated at amortised cost. The appropriate adjustment is to
review the value of the liability eg, where interest rates or the credit rating of the company have
changed.
Also financial instruments containing equity and debt elements, such as convertibles, would need to be
reviewed for likelihood of conversion, and any changes in the fair value of the instruments since issue.
Deferred tax
(a) Here we should consider how much, if any, of the provision is likely to crystallise and thus create a
future cash outflow. All will reverse on individual assets. However, we must consider the different
reversal horizons (eg, there may collectively be no reversals if there is a constantly expanding pool of
non-current assets).
(b) Estimate the effects of likely changes in future tax rates which have not been recognised.
(c) Discount future cash flows arising from reversals, and calculate the present value benefit of paying
tax later.
(d) Assess recoverability of deferred tax assets (eg, on losses).
Employee benefits
(a) The present value of future obligations can be very sensitive to the assumptions made. Adjustments
to the value of the obligation may be required if the assumptions are considered unreasonable.
IAS 19 requires that the assets and liabilities are valued using the rate applicable to 'high-quality
C
corporate bonds'. This has the effect of automatically overstating the present value of liabilities in H
pension funds. A
P
(b) Stock options under IFRS 2 only reflect the market value at the granting date. The future value T
sacrifice from strongly in the money employee options may therefore be far greater than is E
reflected in the financial statements if share prices have risen since the options were granted. R
In contrast, gains arising from pension scheme curtailments should result in immediate recognition in
profit or loss and a reduction in the present value of the defined benefit obligation.
24
Illustration: British Airways
UK airline British Airways recognised a credit of £396 million in its income statement for the year ended
31.3.07, with respect to changes in a pension scheme. The recognition of £396 million represents 65%
of pre-tax profit.
The changes made to the pension scheme included a restriction in future pension increases to
movements in the Retail Price Index and an increase in the retirement age to 65.
British Airways plc
Year end 31.3.07 31.3.06
£m £m
Turnover 8,495 8,515
(Source:
https://www.britishairways.com/cms/global/microsites/ba_reports/fin_statements/fs_income.html)

Provisions
Assess probability of provision crystallising, and consider including expected values based on
probabilities.
Contingent liabilities
Consider recognition on the basis of expected values based on possibility of occurrence of certain
events.
6.5 Adjustments in the statement of profit or loss (and other comprehensive

income)
In the same way that reported statement of financial position items need to be restated into a
standardised format that reflects their fair value, income and expense items need to be adjusted on a
similar basis to improve the quality of earnings. The main adjustments needed are as follows:
(a) The removal of 'non-operating items' from reported income, in order to provide a better measure
of operating earnings that are driven by sales to make more valid like for like inter-period
comparisons, and to highlight sales margins on a consistent basis.
(b) The removal of non-recurring elements of operating earnings, in order to gain a measure of
sustainable earnings. This provides better profit forecasts and improved valuations. The most
common non-recurring elements are:
 exceptional items
 discontinued operations
 acquisitions
 elements recognised as other operating income
(c) The adjustment of costs and revenues to a fair value basis, so that they better reflect the fair value
of resources consumed and earned in the period. Frequently, this is the other side of the coin to
the statement of financial position adjustments highlighted above, but this can also involve
correcting for aggressive earnings management.
The above distinctions are not always clear, and different judgements may be formed as to what
'normal' earnings are, and what might be termed 'noise'. Moreover, even where there is agreement as to
a transaction having a non-recurring element, there is not always sufficient disclosed information in
order to make adjustments with any precision. In such cases, estimates would need to be made on the
basis of Keynes's dictum that it is better to be roughly right, than precisely wrong!
It might be worth noting, however, that in normal operating contexts, historical cost measures have
been shown by empirical evidence to be both good predictors of current performance and significant
valuation tools.
Exceptional items
As exceptional items would not normally recur, they would not form part of future earnings, and thus
should be removed. However, while any one type is unusual, exceptional items are generally very
common, and are likely to recur in some form in years to come. Indeed, it might be said that the only
exceptional thing about such costs is that it is extraordinary for companies not to have them. Care,
therefore, needs to be exercised in judging whether an item disclosed separately is, in fact, unlikely to
recur.
It is also important not always to accept the judgement of management as to what is exceptional and
what is part of normal recurring activities. One view is that exceptional costs are more likely to be
separately disclosed by management than exceptional income.
IAS 1 Presentation of Financial Statements requires that, where items of income or expenditure are
material, their nature and amount should be disclosed separately. These are sometimes called
'exceptional items', although IAS 1 does not use that phrase. The following list illustrates some such
items:
 Write-downs of inventories or of non-current assets
 Reversals of previous asset write-downs
 Restructuring costs and provisions

 Disposal of major non-current assets
 Disposals of major investments
 Litigation settlements
 Foreign currency exchange losses or gains
 Government grants
 Significant changes in the fair values of investment properties
Presentation requirements are that the items must:
 appear as a separate line item;
 be presented 'above the line' (ie, as part of pre-tax profit); and
 be presented as part of continuing activities (unless specifically covered by IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations).
IAS 1 expressly forbids the presentation of 'extraordinary items' (ie, items presented 'below the line').
Worked example: Trump Hotels & Casino Resorts

On 25 October 1999 Trump Hotels & Casino Resorts reported a third quarter EPS of $0.63 after a one-
off write-off charge for the closure of the Trump World Fair Casino Hotel.
This reported EPS was a significant increase from the 1998 third quarter EPS of $0.24. It was also well in
excess of the consensus EPS forecast of analysts, which had been $0.54. As a consequence, the share
price rose from $4 to around $4.31.
The surge in profits was initially explained by a combination of increased revenues, improved profit
margins and reduced marketing costs. All of these factors would have implied that the profit increase
was part of a like for like comparison and thus would form the basis for forecasting future earnings.
A key contribution to the improved profit was, however, not initially available. It was only on the later
publication of the more detailed 10-Q Quarterly Report that it became known that $17.2 million of
profit had been generated as a one-time gain following the abandonment of a lease for the All Star Café
at a Trump Hotel by Planet Hollywood.
Without this one-off gain, revenue would have declined and EPS would have undershot analysts'
expectations. In the year to May 2000 Trump's share price fell 56%.
Requirements
(a) In the Trump Case above, explain, with reasons, whether the key issue was primarily recognition, C
H
measurement or disclosure. A
(b) Why would the problem affect share price by so much? P
T
E
R
Solution
(a) The issue here was not one of revenue recognition. The gain was appropriately recognised in the
year. The issues were disclosure and classification. With adequate disclosure, the one-off gain of 24
$17.2 million could have been identified by analysts as a non-recurring item and thus excluded
from sustainable profit.
(b) Forecasts of future profit based on current earnings would have been much lower as sustainable
earnings forecasts would have been lower. As a result, any valuation of the company derived from
the initially disclosed basis was overstated, resulting temporarily in an excessive share price.
The Trump case therefore highlights how important it is for forecasting and valuation to separate
permanent from transitory earnings and the need for adequate disclosures to be made.
Note that, in a valuation context, historical performance is only relevant to determining share price
in so far as it acts as a guide to forecasting future performance. The greater the adjustment of
consensus future forecasts, the greater the impact on share prices. If a large proportion of the share
price value is attributable to growth (rather than assets in place), small changes in forecasts can
lead to large changes in share prices.
(Source: https://www.sec.gov/news/headlines/trumphotels.htm)

The Trump Case is extreme, but more recent examples show such distortions are still taking place. In
2013, Standard & Poor produced a report titled How Exceptional Accounting Items Can Create Misleading
Earnings Metrics, in which the author Sam C Holland argues:
'The separation of exceptional or special items that companies consider are one-off or non-
recurring in nature can lead financial statement users to focus on companies' subjective, adjusted
profit measures, rather than on the unadjusted figures that the International Accounting Standards
Board (IASB) mandates companies to disclose.
[…]
The reported amount of revenues and other income items of profit-making companies exceeds the
reported amount of debits or costs. Therefore there is no prima facie reason why one would expect
exceptional costs to have a higher reported value than exceptional credit items. However, in order
to show the adjusted operating performance in the most flattering light, companies may identify
the exceptional items that hindered business performance rather than those that helped.'
Operating Profit For Sample Of 10 Non financial FTSE 100 Companies

No. of years where adjusted Restructuring costs or
Description of adjusted operating profit is more that IFRS impairments in at least three of
Company operating profit measure operating profit four years
Bristish American Adjusted profit from 4 Yes
Tobacco PLC operations
Smiths Group PLC Headline operating profit 3 Yes
Unilever PLC Underlying operating profit 3 Yes
Whitebread PLC Underlying operating profit 3 Yes
Shire Pharmaceuticals Non GAAP operating 4 Yes
Group PLC* income
GKN Holdings PLC Trading profit 3 Yes
BG Group PLC Business Performance 3 Yes
Associated British Foods Adjusted operating profit 4 No
PLC
The Sage Group PLC Non GAAP EBITA 4 No
Serco Group PLC Adjusted operating profit 4 No
*Shire reports under U.S GAAP
The report argues that these companies' adjusted operating profits often exclude costs related to
restructuring, for example impairment of goodwill, that are in fact recurring.
Discontinued operations
A discontinued operation is a component of a company which, according to IFRS 5:
 Has been disposed of in the current period; or
 Is classified as held-for-sale, where there would normally be a co-ordinated plan for disposal in the
following period
The component might, for example, be a major line of business, operations in a particular geographical
area, or a subsidiary.
The profit or loss after tax from discontinued operations is disclosed as a single figure on the face of the
statement of profit or loss and other comprehensive income or statement of profit or loss. An analysis
should be disclosed (normally in the notes to the financial statements) to show the revenue, expenses,
pre-tax profit or loss, related income tax expense, and the profit or loss on asset disposals.
These items will not form part of sustainable future earnings, and should be removed when forecasting
future performance.
In addition, for a discontinued operation, the company should disclose the net cash flows attributable to
the operating, investing and financing activities of that operation.
Acquisitions
Where a company has made an acquisition of a subsidiary, or an associate, during the period, only the
post-acquisition profit or loss will have been included in the consolidated statement of profit or loss (and
other comprehensive income) of the period. In determining sustainable profit, consideration needs to
be given to the fact that in subsequent years a full year's profit or loss will be consolidated and,
therefore, a time adjustment will need to be made.

However, a series of other factors will also need to be considered, including:
 restructuring costs;
 profit or loss on sale of redundant assets;
 new transfer pricing arrangements;
 other costs of integration;
 changes in accounting policies to make subsidiary consistent with group policies; and
 change in accounting year end to make subsidiary coterminous with the group.
Some of these items will be disclosed, but in other cases analysts would need to make a 'best guess' on
the basis of any information that is available.
Elements recognised as other comprehensive income
IAS 1 requires certain items to be recorded as other comprehensive income and accumulated in equity.
These are as follows:
 Revaluations of tangible and intangible non-current assets (IAS 16 Property, Plant and Equipment
and IAS 38)
 Particular gains and losses arising on translating the financial statements of a foreign operation
(IAS 21)
 Gains and losses on remeasuring available-for-sale financial assets (IAS 39)
 Gains and losses on cash flow hedges (IAS 39)
 Tax (including deferred tax) on items recognised as other comprehensive income (IAS 12 Income
Taxes)
In addition, certain items are recognised directly in reserves and disclosed in the statement of changes in
equity. These are as follows:
 Equity dividends (IAS 1)
 The correction of errors from prior periods (IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors)
 The effects of changes in accounting policies (IAS 8)
While some of these items might reasonably be expected to recur, they are likely to do so in a random
and uncertain manner, with varying effects. Overall, therefore, their non-predictability needs to be
considered in evaluating future performance based on current period financial reporting. Note that C
H
these items will not affect EPS and reporting earnings directly, but they do form part of a wider measure
A
of comprehensive income achieved by a company. P
T
Accounting estimates E
The preparation of financial statements requires many estimates to be made on the basis of the latest R
available, reliable information.
Key areas in which estimates are made include the following: 24
 The recoverability of amounts owed by customers

 The obsolescence of inventories
 The useful lives of non-current assets
 The values of non-current assets
As more up to date information becomes available, estimates should be revisited to reflect this new
information. These are changes in estimates and are not changes in accounting policies or the
correction of errors.
Changes in estimates are recognised in the period in which the change arises. The effect of a change in
an accounting estimate is, therefore, recognised prospectively, ie, by recognising the change in
accounting estimate in current and future periods affected by the change. As a consequence, such items
should not normally result in large one-time charges, but may cause a reassessment of management's
ability and willingness to make reasonable estimates elsewhere in the financial statements.

Prior period errors
A prior period error is an error that has occurred even though reliable information was available.
Examples of such errors are:
 mathematical errors
 mistakes in applying an accounting policy
 oversights, or misinterpretation, of facts
 fraud
It should be noted that auditing standards clearly distinguish between fraud and errors, in that fraud is
intentional and errors are not. It is normally important to distinguish between misstatements, errors and
frauds, but the retrospective accounting treatment is the same in this instance in accordance with IAS 8.
As such, errors may relate to a number of reported periods. IAS 8 requires that these errors are to be
adjusted in those past periods rather than in the current period. They will not, therefore, affect current
earnings, but may cause doubt about the efficiency of internal controls and raise the possibility that
other similar undisclosed errors may have been made.
Re-estimating costs and revenues to fair values
It is necessary to adjust costs and revenues to a fair value basis, so that they better reflect the fair value
of resources consumed and earned in the period. This might include making adjustments that
correspond to those for the statement of financial position, but also correcting for aggressive earnings
management.
Examples of this type of adjustment might include the following:
 Adjustment of historical cost depreciation to a fair value basis
 Adjustment of historical cost amortisation of intangibles to a fair value basis
 Expensing of capitalised interest
 Adjustment for the impact of share-based payments, such as stock options, to the extent that they
do not reflect fair value changes since issue (as required by IFRS 2)
 Consideration of how much, if any, of the provision for deferred tax charged in the period is
actually likely to reverse, and thus create a future cash outflow
 Adjustment for revenue recognition if there is evidence of aggressive earnings management
through accounting policies and estimates, or through unduly advancing actual transactions
6.6 Normalising earnings

Both basic and diluted earnings can be manipulated by the management of a company directly or
indirectly. In order to render the earnings figure into a meaningful piece of information the earnings
figure needs to be adjusted to reflect the true potential and sustainable earnings of a company. The end
result of the standardisation process is a normalised/sustainable earnings schedule which not only
adjusts for the differences in recognition and measurement, but also provides a template for
standardising presentation, terminology and categorisation.

The following table represents a pro forma, although this is likely to vary with differences between
analysts and between the reporting regimes under which the companies being analysed operate.
£'000 £'000
Sustainable operating income
Sustainable revenue X
Sustainable cost of sales (X)
Sustainable gross profit X
Sustainable operating expenses (X)
Sustainable operating profit before tax XX
Income tax as reported (X)
Tax benefit from finance costs X
Tax on exceptional items X
Tax on other sustainable operating income X
Element of deferred tax charge unlikely to crystallise X/(X)
Tax on sustainable operating profit (X)
Sustainable operating profit from sales XX
Sustainable other operating income X
Tax on sustainable other operating income (X)
Sustainable other operating income after tax X
Sustainable operating profit after tax XX
Non-recurring and unusual items
Profit from discontinued operations X
Changes in estimates X/(X)
Profit/losses on sale of non-current assets X/(X)
Impairment charges X/(X)
Start-up costs expensed (X)
Restructuring costs expensed (X)
Redundancy costs (X)
Unusual provisions (X)
Changes in fair values X/(X)
Foreign currency gains/(losses) X/(X)
Other unusual charges and credits X/(X)
Tax on unusual items (X)
Non-recurring and unusual items after tax XX
Profit for the period before finance charges XX
Note: The above items are stated after standardisation adjustments to individual costs and revenues.
C
H
A
6.7 Statement of profit or loss (and other comprehensive income) P
adjustments for comparison T
E
The items adjusted above are primarily concerned with determining a comparable trend in operating R
earnings over time for one company. A key part of financial analysis is also comparing the performance
of companies in the same industry.
24
Such a process will involve normalising accounting policies and estimates across companies as well as
over time. As the above illustrative example on British Airways and Lufthansa illustrates, however, this
does not mean merely applying the same policy mindlessly to all companies irrespective of
circumstances. It may be that different policies and estimates are appropriate to the different economic
circumstances of different companies.
A particular difficulty of comparisons arises internationally, where two companies report under different
GAAP. For instance, it might be necessary to compare one company reporting under US GAAP with
another reporting under IFRS. In these circumstances, there are differences not only in accounting policy
selection within a given set of GAAP, but also between the two sets of GAAP. Further adjustments have to
be made but any comparisons may be weakened.
Items adjusted as part of pre-tax profit under any of the above headings will also require estimates to be
made of the taxation effects, including deferred tax. In so doing, the marginal rate of tax will need to be
used where this differs from the average rate.

6.8 Cash flow alternatives to earnings
One solution to the quality of earnings problems sometimes put forward is to examine cash flows instead
– the 'cash is king' view. It may be argued that operating cash flows are at least hard figures which are
independent of judgement and accounting manipulation. In particular, it may seem as though
operating cash flows are recurring and sustainable. Such a view would be inappropriate in many
circumstances.
'Depreciation and free cash flow'
First, operating cash flow adds back depreciation as an accounting number that does not involve a
movement of cash. Further down the statement of cash flows, however, there is likely to be a significant
outflow under investment activities on the acquisition of non-current assets. Such expenditure, to
sustain the asset base of the business, should be regarded as part of recurring cash outflows, as without
it the business would decline. Thus, while an arbitrary depreciation figure is excluded, a figure of cash
outflows on non-current assets which is under the discretion of management replaces it. R&D
expenditures would be a particular example of an item where there is significant management
discretion over cash flow expenditure.
'Timing of payments'
Management may have significant discretion over the timing of some types of payment. In the period
leading up to the reporting date, cash payments can be delayed to reduce cash outflows on operations,
and increase cash balances. Arguably, there is more discretion on the timing of payments in the
statement of cash flows than there is over the timing of the transactions themselves in the statement of
profit or loss and other comprehensive income.
'Unusual items'
Exceptional items are normally included in operating profit. They need to be distinguished from recurring
items in cash terms in the statement of cash flows, as well as in accruals terms in the statement of profit
or loss and other comprehensive income.
Smoothing and the long term
Some costs are recognised in profit or loss, but will not be cash transactions for some time into the
future, and thus would not appear in the current year's statement of cash flows. Examples would include
provisions under IAS 37 where the statement of profit or loss and other comprehensive income
recognises a future cash flow in the current period as an early warning signal. It is only identified in the
statement of cash flows at a much later stage.
A more extreme example is decommissioning costs which are a cash flow, perhaps a long time into the
future, but are recognised in present value terms in the statement of profit or loss and other
comprehensive income as each year passes.
In both these examples, the statement of profit or loss and other comprehensive income provides a
better guide to future forecast cash flows than the historical statement of cash flows.
'Non-cash costs'
Some costs are recognised in the statement of profit or loss and other comprehensive income but will
never be recognised in the statement of cash flows. Share-based payments under IFRS 2 involve an
annualised cost of share-based payments, such as employee share options. Such a cost may be
inaccurate, being based on the market value at the grant date, but the statement of cash flows does not
recognise this cost of equity-settled share-based payments at all. As such, the statement of cash flows
fails to capture an important element in assessing performance that is recognised in accruals-based
statements.
'Bringing forward receipts'
Companies can manipulate cash flow from receivables in a number of ways, including settlement
discounts, factoring, invoice discounting and securitisation. Such manipulation is at the discretion of the
directors in the same way, if not to the same extent, as revenue recognition in the statement of profit or
loss and other comprehensive income. Both practices have the problem of 'sustainability', but they can
artificially inflate short-term measures of performance.

Assessing the quality of cash flows is perhaps as difficult as assessing the quality of earnings, although for
different reasons. Forecasting future cash flows is key to financial analysis and corporate valuation.
However, historical cash flows are not necessarily any better than historical earnings in achieving this –
and in many cases they are worse. In any case, restatement and normalisation is as difficult as it is
necessary.
From a valuation perspective, the normalised cash flow and earnings figures are used together to
estimate the free cash flows of a business. It is the free cash flow that is discounted to deduce an
enterprise value for the business.
7 Financial ratios interpretation
Section overview
This section discusses issues of interpretation of ratios, including those based on cash flow data.
Ratio analysis is the most potent tool of financial analysis. Ratios reduce the dimensionality of the
information provided in the financial statements by summarising important information in relative
terms. Ratios are based primarily on financial information from the financial statements which, as we
have already discussed, can be manipulated by the management of a company. Attention should
therefore be paid to the accounting quantities that determine the financial ratios.
7.1 Interpretation of ratios

Some of the ratios that are used in financial analysis, beyond the accounting problems that have been
identified, convey very little information if the underlying business operation is not well understood.
Good examples are both the trade receivables and the trade payables ratios. A large sale, or a large
receipt, immediately before the year end may distort the trade receivables ratio. Furthermore, the year-
end receivables figure is likely to depend far more on the sales in the final month of the year rather than
the average. If the final month is unusual (eg, owing to seasonality or growth), the ratio may convey
very little information.
The trade payables ratio can be extremely misleading, as it is purchases that generate payables rather
than cost of sales. Even if a purchases figure is used, however, this is only possibly valid for retail
companies. For manufacturing companies, cost of sales includes not only raw material costs but also
C
production labour costs and overheads, many of which are unrelated to trade payables. This is, thus, a H
poor ratio to use for manufacturing companies. A
P
A second example is the gearing ratio. It has already been discussed that both non-current assets and T
liabilities should reflect fair values. In addition, this ratio can be useless as a relative measure unless the E
operation of the company is well understood. For example, many service-based companies may be R
'asset light'. This might include, for instance, IT and internet companies which may have intangibles
such as intellectual property rights, but would normally borrow primarily on the strength of their
tangible asset base. This may give the impression that the risk of insolvency is higher than in reality and 24
shows that to assess solvency, much more information is needed, such as: the realisable value of assets
on sale; timing of debt redemption; conversion rights; replacement or additional financing capacity.
In what follows we concentrate on the problems that arise when the return on invested capital is
calculated.
It is common for the return on invested capital to be decomposed into its constituent parts using the so-
called DuPont analysis, as follows
Profits Profits Revenue
ROCE =   = Profit margin  Asset turnover
Capital employed Revenue Capital employed
To understand what determines the ROCE we need to understand what determines the profit margin
and the asset turnover. There are two issues here that need to be assessed. The first is the source of the
return on capital, ie, whether it comes from a high profit margin or a high asset turnover. This

distinction is important when comparing companies. The second issue is the understanding of the
problems associated with the construction and interpretation of the constituent ratios. As was discussed
already in strategic analysis, beyond the accounting issues, the financial ratios need to be seen in the
context of the overall strategy of a firm both in the medium and the short term.
Profit margin in retailing and manufacturing
A key figure in all the profit margin ratios is cost of sales. This figure is, however, rather different for
retailing companies and manufacturing companies. For retailing companies, most of the cost of sales is
made up of the cost of buying goods which are later sold in the same condition. One might, therefore,
expect issues such as pricing policy, product mix and purchasing activity to affect gross profit margin,
but otherwise this figure should be reasonably comparable for companies in the same industry
operating in similar markets.
For manufacturing companies, however, the 'cost of sales' figure is more difficult to assess, as it includes
all costs in bringing goods to their final location and condition. This includes costs of production, as well
as the costs of raw materials. As a result, the gross profit margin for manufacturing companies needs to
consider additional factors to those of retail companies that relate to operating efficiency. In particular, it
is important to consider the increased possibility of manipulation of inventory value and gross profit
through allocations of overheads.
Profit margins – the base data
While profit margins, in effect, consider the relationship between two figures, it is important to
understand the individual 'line items' that make up these ratios. Without this, it is difficult to answer
such fundamental questions as why revenue has decreased.
Part of the story is in understanding the type of industry, as in the previous section but, in addition, it is
necessary to understand the strategy that drives the numbers and the accounting rules that dictate the
way they are recognised.
The following is a guide to the factors to consider in determining operating profit.
Revenue
 How is revenue changing – is there a consistent pattern over time? At what rate is revenue
increasing/decreasing?
 Is the change in revenue consistent with announced price changes?
 Has sales volume been a factor eg, new competitor, industry trends, cycles, production capacity
constraints, inventory accumulation?
 Has the sales mix changed between high-margin and low-margin products?
 Have new products been launched?
 Effect of disposals or acquisitions?
 Effects of currency translation on revenue?
Cost of sales
 Retail or manufacturing
 Impact of raw-material price changes
 Foreign currency changes
 Labour changes – wages rates or quantity of labour
 Impact of overhead costs
 Changes in inventories between opening and closing can affect overhead allocation between profit
and closing inventory
Other costs
 What are key costs (eg, R&D for pharmaceuticals, bad debts for banks)?
 Marketing and advertising costs – are these related to revenue changes?
 What proportion of costs is fixed (eg, administration)?

Fixed costs versus variable costs
Fixed costs are those that do not change significantly when sales volumes change. Variable costs are
costs that tend to change in line with sales volumes. Unfortunately, IAS 1 does not require companies to
disclose which costs are fixed and which are variable. However, certain costs may be regarded as fixed
(eg, long-term lease rentals, depreciation and, perhaps, even labour costs in the medium term). Other
costs, such as raw materials, are likely to be variable.
It is clear that some industries have high fixed costs, eg, hotels and leisure, airlines, train and bus
operators, and heavy industry processes such as glass and steel manufacture. These types of company
have high 'operating gearing', which means that profits are sensitive to changes in sales volumes.
This topic of sensitivity is dealt with in more detail below, but for now it is important to appreciate that
the relationship between revenue and profit is not linear as revenue changes. Financial analysis should,
therefore, expect profit margin changes with sales volumes, and should expect differences in comparing
large companies with smaller companies because of efficiency in the use of the asset base.
Intercompany comparisons of profit margins
Any assessments of the value of the ratios are only valid after comparisons with industry norms, or similar
competitor companies, as cost structures will vary significantly from industry to industry, so there are
few absolute benchmarks.
Rivals will often be similar but they are unlikely to be identical, and many types of differences can occur.
These may include differences in:
 size
 product mix
 market positioning, or market strategy
 cost structures
 accounting treatments that have not been possible to standardise precisely
 timings in product life cycles, or business life cycles
While it is important to identify inter-firm differences when calculating profit margin ratios, it is
necessary to treat such figures with care.
Activity ratios
Asset turnover ratio
The main activity ratio is the asset turnover ratio, which has been defined in section 1 as revenue over
C
capital employed. However, as activity ratios measure the efficiency with which the assets have been
H
used in generating revenue, the relationship between assets and revenue is only valid for the types of A
assets which help to generate revenue ie, 'operating assets'. These include: non-current assets, P
intangibles, inventory and receivables. Investments do not generate revenue, so no logical relationship T
exists with respect to this type of asset. Thus a more appropriate asset turnover ratio might be a ratio E
R
that is based on non-current assets.
Revenue
Non-current asset turnover ratio =
Non-current assets 24
This is one of the most problematic ratios in comparing different companies because companies in
different industries vary vastly in terms of the proportion of their assets in the statement of financial
position that gives rise to revenues. For a large number of companies in the service industries, such as
advertising or financial services, there may be few assets, with revenue being generated by off balance
sheet 'assets' such as human resources. In this case, there is likely to be a weak and largely meaningless
relationship between revenue and non-current assets. Conversely, in heavy industries such as
engineering, non-current assets and their efficient use are key to generating revenue and profits, and
thus a much more meaningful relationship exists.
Some problems which arise when we use the non-current asset to turnover ratio are as follows:
 Assets must be revalued to compare like with like.
 Assets added late in the year will contribute little to revenue, so the average of opening and closing
non-current assets should be used.

Inventory turnover ratio
The inventory turnover ratio should also be applied with caution. A high number of inventory days may
indicate that sales forecasts are not being met, or that there are other marketing-based problems that
mean inventories are not being sold as planned. This might be a cause of concern for analysts if it is out of
line with competitors or with previous periods.
The ratio is also useful as an inventory-efficiency measure. If the number of inventory days is high, then
it might raise the question of whether inventory is being managed appropriately, although the precise
level will vary from industry to industry. Industries that have just in time supplying, or make goods to
order, are likely to have the lowest inventory days. Moreover, some industries sell at a high profit margin
but only sell infrequently. Other companies sell at a low profit margin but, as a result, aim to turn
inventory around quickly.
Where a business is growing, it might be appropriate to take the average of opening and closing
inventories, rather than the closing inventories alone.
Problems with this ratio include:
 it can be easily managed as inventories can be run down towards the year end, but maintained at
high levels the rest of the year; and
 if a business is seasonal, then inventories will vary at different times of the year, and the ratio may
say little.
7.2 Cash flow ratios

As the discussion so far has shown, there are potentially serious problems with the use of accounting-
based ratios. An alternative set of ratios based on data from the statement of cash flows have been
proposed, known as cash flow ratios.
As the name suggests, these are ratios that are based not on accounting data from the statements of
financial position or comprehensive income but on cash data. Although these ratios are free of the
vagaries of accounting figures, one must be cautious of cash flow ratios in much the same way as
accruals-based ratios taken from financial statements. While cash flows may not be subject to the same
type of manipulation as accounting data, they can be distorted by management, as noted above.
More importantly, understanding cash flow is about understanding the inflows and outflows over time.
Capturing a snapshot in a ratio is potentially misleading without an understanding of the underlying
dynamics of the business. Nevertheless, cash flow ratios may at least highlight some issues and raise
questions even if they do not provide many answers.
7.2.1 EBITDA
Earnings before interest, taxes, depreciation and amortisation (EBITDA) is perhaps the most commonly
quoted figure that attempts to bridge the profit–cash gap. It is a proxy for operating cash flows,
although it is not the same. It takes operating profit and strips out depreciation, amortisation and
(normally) any separately disclosed items such as exceptional items.
EBITDA is not a cash flow ratio as such, but it is a widely used, and sometimes misused, approximation.
Particular reservations include the following:
(a) EBITDA is not a cash flow measure and, while it excludes certain subjective accounting practices, it
is still subject to accounting manipulation in a way that cash flows would not be. Examples would
be revenue recognition practice and items that have some unusual aspects but are not disclosed
separately and, therefore, not added back.
(b) EBITDA is not a sustainable figure, as there is no charge for capital replacement such as
depreciation in traditional profit measures or capital expenditure (CAPEX) as in free cash flow.
7.2.2 EBITDAR
EBITDAR adds back operating lease rental costs to the EBITDA figure. Certain user groups view
operating leases as a form of off balance sheet finance. By adding back operating lease rentals,
consistency is achieved between companies that use finance and operating leases.
The EBITDAR figure is sometimes used when calculating valuations of companies for acquisition
purposes.

Worked example: Calculate EBIT, EBITDA and EBITDAR
Fin plc and Op plc operate in the same industry and are of similar size. Both have entered into a number
of significant lease arrangements to obtain the use of key operating assets. Fin plc has classified these
lease arrangements as finance leases in accordance with IAS 17 Leases. Conversely, Op plc has classified
its lease agreements as operating leases. The following amounts have been extracted from the income
statements of Fin plc and Op plc.
Fin plc Op plc
£'000 £'000
Gross profit 300 300
Depreciation of leased assets (60) –
Operating lease rentals – (80)
Other operating expenses (100) (100)
Operating profit 140 120
Finance lease interest expense (20) –
Other interest expense (30) (30)
Profit before taxation 90 90
The profitability measures can be calculated as follows:

£'000 £'000
EBIT 140 120
EBITDA (140 + 60)/120 200 120
EBITDAR (140 + 60)/(120 + 80) 200 200
This simple example demonstrates the objective of calculating EBITDAR to facilitate comparison where
operating leases are significant.
7.2.3 EBITDA/Interest
This is a variant of the interest cover ratio referred to in your earlier studies and the overview. It uses
EBITDA instead of operating profit on the grounds that EBITDA is a closer approximation to sustainable
cash flows generated from operations.
7.2.4 Total Debt/EBITDA

This ratio looks at how difficult a company finds it to service its debt commitments from operations. This
figure is often used as the basis of a lending covenant by a bank to a company. The higher the ratio, the
higher the perceived risk of default on the loan. C
H
A
7.2.5 Operating cash flows P
T
This shows the ability to generate cash from assets. Again this is similar to calculating the ratio of E
operating profit to revenue or to total assets. R
Net operating cash flows

Operating cash flows = × 100%
Revenue 24
This ratio is the amount of cash generated relative to sales. Revenues can also be adjusted by opening
and closing receivables so that both the numerator and the denominator are in cash terms. Essentially,
this is the cash flow equivalent of 'operating profit/revenue', but it should be greater as operating profit
is stated after depreciation whereas there is no equivalent charge for non-current assets in net operating
cash flows.
An alternative ratio to look at is:
Operating cash flows   100%
Total assets
7.2.6 Investment cash flows

Investment cash flows   100%
CAPEX

This is a ratio showing CAPEX cover, ie, the number of times CAPEX is covered by operating cash flow.
In a service industry this ratio would be high, whereas in a capital-intensive industry a lower ratio would
be expected in most years. Where CAPEX is variable from year to year, the ratio is likely to be volatile, so it
is particularly important to look at a trend over a number of years.
7.2.7 Financing cash flows

'Financing cash flows' normally concern the availability of cash to repay debt (ie, the free cash flow). This
can be defined in a number of ways, and free cash flow measures (eg, net operating cash flows less
CAPEX) would be one proxy.
Total Debt
Debt repayments (in years) =
Free cash flow
This ratio shows the potential to repay debt in a given time, rather than when debt will actually be
repaid.
Free cash flow
Cash flow interest cover =
Interest payments
As noted above, this shows the number of times interest payments are covered, but after replacing non-
current assets.
Free cash flow
Debt servicing =
Interest + Principal payments
This shows the number of times interest and capital repayments (where debt is repayable by
instalments) are covered, after replacing non-current assets.
7.2.8 Market to book ratio

This is not a cash flow ratio but the market value element is free of accounting distortions. The market to
book ratio shows the relationship between the going concern value of the company, and the carrying
amount of its net assets. It thus reflects asset backing. This ratio is likely to be highest for companies
with unrecognised intangible assets, such as IT companies. If non-current assets have not been revalued,
this would also increase this ratio. A ratio of less than 1:1 is common in some industries such as
investment trusts, but otherwise it may indicate going concern issues or, possibly, asset-stripping
potential.
Market value of equity shares
Market to book ratio =
Carrying value of equity (ie, net assets)
8 Forecasting performance
Section overview
This section presents a number of methodologies for forecasting the future performance of a company
and discusses the various issues involved, such as aggregate versus disaggregated forecasts and the
forecasting of the effects of discrete events such as mergers and acquisitions.
Once the data from the financial statements of the company have been adjusted and through the
analysis of the firm's business strategy the drivers of sustainable earnings have been identified, then the
future performance may be predicted taking into account the future macroeconomic and industry
conditions.
8.1 The production of forecasts

The production of financial forecasts is based on a model of business operation which attempts to
identify the long-term drivers of growth of a company. To identify these drivers, a historical analysis of
the company should be undertaken based on the financial information derived from company accounts
and market data. To obtain the right picture we need to follow the steps of accounting analysis and

possible restatement of the accounts as explained in the previous section. We also need to perform a
strategic, competitive and corporate analysis in order to assess the underlying economic conditions of
the company.
Growth drivers and business strategy
The growth drivers are the factors that affect the revenues and costs of an enterprise and hence its
earnings. To understand these drivers, and how they will change over time, it is essential that the analyst
understands a company's business model. This includes understanding:
 the main strategies available to the company
 its product or service
 its manufacturing technology and production methods
 its marketing strategy
 its knowledge and skills base
 the competitive and industry environment within which it operates
 its competitive advantage within an industry (if any)
 the durability of that competitive advantage
 the regulatory and other constraints on the company
The analysis of the business strategy would explain certain characteristics of the firm, for example high
profit margins due to competitive advantages. Similarly, higher efficiency will be reflected in better
activity ratios. However, forecasting is not a mere extrapolation of the past. The future industry
conditions as well as the future macroeconomic environment will be a significant factor in the
determination of performance.
Industry conditions
The industry conditions that may affect the performance of a company include:
 price competition
 product/service innovation
 marketing and distribution innovation
 technology, and cost reduction
 quality improvement
 imitation
 new entrants
 diversification
 mergers and acquisitions C
H
A
8.2 Forecasting revenues P
T
Revenue is normally the starting point in setting up a forecasting model. As in the case of earnings, E
though, we need to find the sustainable revenue figure to forecast. Revenues can be forecast either for R
the whole company or according to IFRS 8 Operating Segments for each business or geographical
segment.
24
Segment reporting allows separate revenue and profit margin forecasts to be made for each segment,
together with a separate analysis of risk. These could then be aggregated to produce a more accurate
company-wide performance forecast. There are many methods to forecast revenues, and we shall review
some of them below.

8.2.1 Market share method
In the market share method, the assumption made is that the share of a company's sales in the industry
remains stable. Forecasting takes place in two stages. In the first stage, the sales for the whole industry
are forecast. In the second stage the revenue of a specific company may be predicted using its market
share.
Industry revenue can be predicted by postulating a relationship between industry sales and some
macroeconomic aggregates such as gross domestic product (GDP), inflation rate, interest rates or tax
rates.
An alternative method of forecasting industry revenue is to identify microeconomic factors that affect
the demand and price of the products of an industry. These include factors such as the price and
income elasticity of demand for the products of the industry, seasonality in demand and any other
factors which are particular to the industry.
Interactive question 2: Forecasting revenue

You are given the following information on GeroCare, a company operating for the last 10 years in the
healthcare industry.
Year Industry sales GeroCare sales
£m £m
20X2 1,200 180
20X3 1,325 198
20X4 1,450 218
20X5 1,600 240
20X6 1,780 264
Requirement
If industry sales are expected to grow by 20% in 20X7, what is a reasonable forecast for the GeroCare
sales in 20X7?
8.2.2 Modelling company-specific revenue

An alternative approach to forecasting revenues, which may be more appropriate for a company which
does not have a stable market share, is to construct a model for a specific company, which makes
revenues a function of various factors. The factors that affect revenue generation normally are:
CAPEX
In stable markets, revenue growth comes from expanding the volume of sales and this comes either
from increased productivity, or more commonly from new investment for replacement of existing
capital or expansion. Thus CAPEX is a key variable that impacts on revenue. Where a company is
expanding its non-current asset base by engaging in CAPEX in excess of that needed merely to sustain
its asset base, one might expect additional revenues to be generated.
The impact of this increase needs to be modelled by the relationship between non-current assets and
revenue. The existing relationship is captured as we have seen in earlier sections by the non-current
asset turnover ratio. The key question in modelling this is whether this ratio remains fairly constant over
time.
The acquisition of intangibles
The acquisition of intangibles would clearly impact on revenue forecasts. If a company were to acquire a
valuable brand, then revenue might be expected to increase as a result, independently of any other
factors. However, as IAS 38 Intangible Assets stands, it creates problems of recognition and measurement
of intangible assets. Indeed, the problem is not so much assessing the revenue impact of recognised
intangibles as attempting to model the impact and value of off balance sheet intangibles.

8.3 Forecasting costs
The key factor in modelling costs is to determine the profit margin. This involves establishing a
relationship between costs and revenues.
Fixed costs and variable costs
One possible approach is to separate out cash costs from accounting costs. To the extent possible on
the basis of public information, the cash costs should then be separated into fixed costs and variable
costs. This is because revenue grows over time (if indeed it does), but not all costs behave linearly, and it
is important to have a clear idea how costs are to change in relation to revenues.
Non-cash items in recurring earnings include depreciation and amortisation. These may be regarded as
fixed costs, and are dealt with in more detail below.
In terms of other costs, the standard line by line presentation in published financial statements does not
make a ready distinction between fixed and variable costs, so estimates need to be made.
While all costs tend to be variable in the longer term, for large changes in revenue, there are some costs
which do not vary proportionally with sales in the short run. This is not to say that they do not change
at all, as inflationary and other factors may impact on them. They should be adjusted independently of
other variable costs, and using separate considerations.
Potentially the largest fixed costs are employment costs, although much will depend on how employees
are paid and the company's current policy on recruitment or redundancies, but this comes back to an
analyst's knowledge of the business. Fortunately, employee costs are separately disclosed under IAS 19,
so these costs can be estimated separately.
One difficulty is that, for a manufacturing company, cost of sales includes fixed cost and variable cost
estimates, and it is not always clear which employee costs are included and what proportion of
employee costs has been rolled into inventories.
The major variable cost is often raw materials, although this varies from industry to industry. For retail
companies, the assumption that cost of sales is entirely variable is normally reasonable, and there are
fewer problems.
Operating leverage
The separation of fixed and variable costs in forecasting helps these costs to be separately modelled
according to the factors that drive them, but it also has another purpose. The relationship between fixed
and variable costs, once established, can be used to estimate a company's operating gearing, and this
has important implications for risk assessment. C
H
In essence, operating gearing means that the greater the level of fixed costs, then the more variable the A
profit margin as revenue changes. Thus high operating gearing means high risk from revenue changes. P
T
As a result, for high operating gearing firms in particular, profit margin is unlikely to be proportional to E
R
revenues where there is growth, or a decline. For example, a manufacturing company with high fixed
costs will more than double profits if sales double, as fixed costs do not increase with the extra sales.
Structural changes 24
In modelling cost structures, care needs to be taken that there are not structural changes in the
company, or the industry, within the planning horizon, that will alter the overall level of costs or the
balance of fixed and variable costs.
These changes may be difficult to foresee, but may include:
 technology changes
 sale and leaseback arrangements
 shifts in the product mix – perhaps identified in segment disclosures
 increased CAPEX to replace labour
Any known disclosure by the company or trends should be considered in this respect.

8.4 Forecasting non-current assets, depreciation and CAPEX
The significance of non-current assets varies from industry to industry. For some service industries, they
are immaterial, and thus very simple assumptions will suffice. For heavy manufacturing industries, where
there are cycles, there are many more problems.
It is not just the level of non-current assets that matters. Some companies have a large number of small
items, while other companies may have a small number of large items (eg, oil rigs). Similarly, one non-
current asset may be acquired as a unit, but be replaced and depreciated in several components.
As already noted, the relationship between non-current assets and revenue is important. The impact is
likely to vary from industry to industry, but it needs to be established whether the company is growing,
the demands this will make on CAPEX, and the nature of the non-current asset turnover ratio in
measuring the efficiency with which non-current assets generate revenue.
The simplest assumption – that revenue and non-current assets will vary linearly (ie, the ratio is constant)
– may be reasonable in many cases. If so, it gives us a CAPEX forecast, as well as helping with a revenue
forecast. However, caution must be exercised in this assumption.
Thus, if we can forecast depreciation, then we can forecast the CAPEX to sustain non-current assets, and
the additional CAPEX necessary to accommodate growth. For this to be valid, however, depreciation will
need to be based on fair values rather than historical cost, but this should have resulted from our earlier
standardisation process.
A key forecasting error can be to obtain reasonable profit projections but underestimate the CAPEX
required to sustain and grow the business. Given that free cash flow is essentially calculated as cash from
earnings less CAPEX less working capital changes, then this can result in an overvaluation of a business.
Thus, a valid depreciation forecast is crucial in this respect, even though it is not, of itself, a cash flow.
Depreciation can be difficult to forecast, as different assets are depreciated at different rates and,
although IAS 16 requires disclosures, they are frequently ranges of asset lives rather than for each
individual asset.
Estimates can be made from the gross asset values where straight-line depreciation is used, but this
assumes that no assets are already fully depreciated. Alternative methods are to estimate average lives
for each type of asset or remaining lives.
If asset lives are not too long, we can retrace the additions to each type of non-current asset from
previous years' financial statements, then attempt to model forward separate depreciation charges,
disposals and other types of derecognition. Any disclosed profit or loss on disposal may give an
indication of whether depreciation policies are proving inadequate or overprudent.
In terms of CAPEX, to grow the business – rather than merely compensate for depreciation – it is
important to develop growth or no-growth scenarios over the planning horizon. More obviously,
however, for the forthcoming 12 months companies may disclose, in the notes to the financial
statements, the level of capital commitments entered into, and this can be used as an element of a
short-term CAPEX forecast.
Intangibles amortisation can be forecast in the same way, although in this case there needs to be more
care with unrecognised expenditure under IAS 38. Although unrecognised as an asset, such expenditure
may have important implications for future revenue, and costs and will need to be modelled separately.
Interactive question 3: Forecasting capital expenditure

SouthWest Electric is an electricity supplier in England. Revenues have been stable for the last five years
and all the capital expenditure has been dedicated to updating its network. Approval for the creation of
a new town of 50,000 people has been given by the Government and SouthWest Electric expects sales
to increase by 15% over the next five years.
Requirement
Which of the financial ratios will you use to get a rough idea of the capital requirements of SouthWest
Electric, and what are the factors that may affect its accuracy?

8.5 Forecasting working capital needs
Working capital is needed to sustain the business, and constantly needs to be replaced. If the business is
not growing, then the cost of circulating working capital is already included in the profit forecast. If,
however, the business is growing, then it is likely that more investment in working capital will be
needed. For example, if revenue is increasing, then more inventories are normally needed to supply
customers, and more receivables will usually arise from increased sales. The increase in working capital
as a business grows can thus be viewed as an additional cash expenditure on financing the incremental
working capital. Conversely, if a business is declining, then working capital is released, generating
additional cash.
The simplest way to forecast changes in working capital requirements is to assume a linear relationship
between changes in working capital and changes in revenues. This can be achieved using an
appropriate financial ratio. Using the historical ratio values and revenue changes as the driver, non-cash
working capital needs can be estimated. These then become part of our forecast free cash flow
estimation.
There are other components of working capital such as prepayments and accruals, but these normally
have little causal relationship with revenue drivers and should therefore be considered on the basis of
individual circumstances.
8.6 Forecasting equity

The simplest forecast model is the so-called 'clean surplus' model, according to which any changes in
equity result merely from retained profits. Equity at the end of a period is equal to the beginning of
period value plus earnings minus dividend payments. With dividends being determined by
management, equity is simply determined by earnings.
The 'dirty surplus' model, on the other hand, assumes that equity is affected by items of other
comprehensive income. These items are likely to prove difficult to estimate, unless there are some
known or systematic effects (eg, with the foreign currency translation of an overseas subsidiary). Much
will depend on understanding the particular circumstances of individual companies in this case.
In addition, changes in equity include capital items such as new share issues and share buybacks. These
changes in the equity capital of a company should be considered when forecasting statements of
financial position, as they change the financial structure of the company.
Unfortunately, unless the company has announced a share buyback or a share issue, then any attempt
to forecast these is largely guesswork. Even if a share issue, or a share buyback, seems likely within the
C
forecasting horizon, the timing is at best uncertain. Similarly, the pricing of any issue or buyback is H
unknown, as the current share price is unlikely to be a good predictor of future price, which is itself A
uncertain. P
T
E
Interactive question 4: Forecasting equity R
At the reporting date of 31 December 20X6, equity capital for Granthar plc was £50 million. The
company predicts earnings of £27 million for 20X7 and has announced a dividend for 20X7 of 20p per
24
share. There are 40 million shares issued.
Requirement
Using the clean surplus model what is your prediction of the level of the company's equity at
31 December 20X7?
8.7 Forecasting funding requirements

Forecasting funding requirements is equivalent to forecasting the needs of the company in long-term
debt, short-term debt and cash. Some models simply forecast net debt as a single item which arises from
the operating and investment activities and working capital needs of the company. This simple approach
leaves open the question of how, specifically, the funding will be put in place, and loses key pieces of
information available in the financial statements, such as maturity dates on existing debt.

One approach is, therefore, to consider how long-term debt will be raised, and how it will mature.
Long-term debt is thus the independent variable. Short-term debt and cash are therefore the residuals
(or the dependent variables) needed to match the funding needs from other forecasts.
8.8 Forecasting and acquisition and consolidation

In most situations of financial analysis of listed companies it will be necessary to evaluate not an
individual company, but a group of companies. In order to do this it is necessary to understand the
impact of consolidation on performance forecasting, and the potential for value creation (or value
destruction) in mergers and acquisitions.
The following table provides a summary and reminder of the different types of investment and the
required accounting for them:
Investment Criteria Required treatment in group accounts
Subsidiary Control (> 50% rule) Full consolidation (IFRS 10)

Associate or joint Significant influence (20% + Equity accounting (IAS 28)
venture rule)/joint arrangement where
parties with joint control have
rights to net assets
Joint operation Joint arrangement where parties Line-by-line recognition of assets, liabilities,
with joint control have rights to revenues and expenses (IFRS 11)
assets and obligations for
liabilities
Investment which Asset held for accretion of wealth As for single company accounts (per IAS 39)
is none of the
above
IAS 28 requires that associates and joint ventures should normally be accounted for using the 'equity
method'. Equity accounting is sometimes called 'one-line consolidation', as there is only one amount
shown for an associate in profit or loss (being the parent company's share of the associate's profit), and
one amount shown in the statement of financial position (being the cost of investment plus share of
post-acquisition reserves).
As the statement of cash flows begins with profit before tax, it already includes the parent's share of the
associate's profit. It is, therefore, necessary to adjust the associate's profit so that only the dividends from
associates are recognised.
In terms of modelling the associate's contribution to the group, it is normal to consider the associate
separately, as it is likely to be affected by different factors from other group revenue and group margins.
8.9 Forecasting the impact of mergers and acquisitions

Modelling would normally assume that there are no major structural changes. Thus, when a merger,
acquisition, disposal or spin-off takes place, the forecasting model needs to be amended to take account
of these changes. For a company that acquires another company, there are two major effects that need
to be incorporated in the forecasting model. These are synergies and the financing of acquisition.
There are three types of synergies that must be modelled:
(1) Synergies that lead to revenue enhancement
(2) Synergies that lead to cost reduction
(3) Synergies that lead to capital efficiency
Revenue enhancement
Revenue enhancement can come from a range of beneficial factors including increased market presence;
enhanced market power; cross-selling opportunities; reduced price competition; and improved ability to
service customers.

It might be noted, however, that most of these factors refer to horizontal integration where the
acquisition is made in a similar or overlapping market. Where there is vertical integration, such as where
a company buys a major customer or supplier, then there is a perverse effect that consolidated revenue
in the financial statements may fall. This is because sales from one group company to another are not
external sales, and are not reported as revenue. Cost of sales to the purchasing company will also fall, and
so – because of this accounting treatment – profit will not change. However, the profit margin would
appear much greater in the consolidated accounts than it was in the sum of the two previously
independent companies.
A further note of caution in assessing post-acquisition performance is that where an acquisition takes
place during a year, only the post-acquisition element of profit or loss items is consolidated.
Cost reduction
The most obvious cost reductions are common costs, eg, head office and functions such as marketing,
administration, treasury and distribution. Other areas include reductions in management and, perhaps,
procurement economies in terms of discounts.
In modelling such costs, an assessment will need to be made of the proportion of total costs that can be
eliminated in the merged entity.
A word of warning, however, may be necessary. In the period immediately following the merger, there
may be reorganisation and integration costs such that, in the short term, costs may actually increase
compared with the two independent entities. However, such costs are transitory and do not form part
of the normalised earnings of the combined entity. If fully disclosed separately they should be reversed
but, if not, an estimate will need to be made.
Capital efficiency
The combined entity may be able to use non-current assets more efficiently, thus enabling some
disposals to take place or at least reductions in CAPEX in the short term. Similarly, there may be more
efficient use of inventories where there is some overlap of product ranges, resulting in greater working
capital efficiency. This might well be a significant value driver for forecast synergies.
Financing the acquisition
It is important to separate out the investment decision from the finance decision in modelling any
acquisition.
An extreme case is a leveraged buy-out where most of the cash to make the acquisition is borrowed in
the expectation that future operating profits will be sufficient to repay the debt and interest. In these
C
circumstances there is likely to be a significant increase in financial risk, due to increased financial H
gearing. As such, the financing cash flows and net debt need to be considered carefully, as does the A
discount rate that must be used in relation to forecast operating flows. P
T
E
8.10 Forecasting the impact of reorganisation and reconstructions R
Companies periodically tend to change the scope and nature of their existing activities as part of
strategic change projects. This can involve reconstructing, reorganising, downsizing, cost reduction 24
exercises and similar schemes. The intention of such schemes is normally to improve profitability in the
short or long run and, ultimately, to add value to the business.
When such schemes are announced, however, analysts need to estimate the impact of these changes on
value. Financial analysis, and financial disclosures, are part of the jigsaw in making such estimates of
value creation (if any) arising from the changes.
If a closure, withdrawal or reconstruction relates to a separate segment which is separately disclosed
under IFRS 8, then the impact, at least historically, is isolated. Reasonable predictions can then be made
of the consequences of the closure, withdrawal or reconstruction. Unfortunately, such happy
coincidences are rare, and it is more likely that financial statements will provide only some general clues
as to the consequences of reconstructions, even when used alongside other available information.
Nevertheless, the above performance forecasting methodology can be used to estimate changes in
future profits arising from a reconstruction and thereby help to assemble a revised valuation for the
company.

Moreover, in the set of financial statements published after any material reconstruction, financial
reporting disclosures can provide additional, if retrospective, information about the consequences of any
reconstruction (eg, exceptional items under IAS 1). Any initial forecasts can then be amended to re-
evaluate longer-term valuation consequences.
Key point summary
 When a merger, acquisition, disposal or spin-off takes place, there are important effects that will
need to be reassessed by forecasting performance in the context of the proposed changes in
ownership, structure and financing.
 Synergies enhance value: These may include revenue enhancement, cost reduction and capital
efficiency.
 Financing the acquisition: It is important to separate out the investment decision from the finance
decision as, in modelling any acquisition, these will have separate effects.
 Operating decisions impact on value creation: Two key value drivers are profit margins and asset
activity. These can be analysed by the use of accounting ratios.
 Financial reporting information, alongside other sources of information, can help estimate the
impact of reorganisations and reconstructions on corporate value.
8.11 Forecasting the effects of funding policy

Financial statement analysis can help analysts measure and model some of the consequences of
financing decisions for valuation. In so doing, financial statements can act as one input into valuation
models to assess how corporate values are affected by financing decisions.
Raising equity finance in a perfectly efficient capital market should not impact on value. Economic
theory tells us that it is operating and investing activities, not financing decisions, that impact on value.
The reason for this is that value creation is not about increasing the value of the company: it is about
increasing the wealth of the shareholders. Raising new equity at market value in an efficient market will
increase the value of the company, but only by the value of the share issue, leaving shareholder wealth
constant. Share price would be constant if the shares were issued at market value.
However, to the extent that markets are not efficient, financing can impact on shareholder value. If, on
the basis of inside information, directors perceive that market prices are in excess of the intrinsic value of
shares, then a share issue may add to the wealth of existing shareholders.
Conversely, if directors perceive that market prices are lower than the intrinsic value of shares, then a
share repurchase may add to the wealth of existing shareholders.
This is not the same as saying that, when a share issue is announced, share prices may change. This will
depend on the 'news' value on the announcement day, and any perceived positive net present value from
the project that is being financed by the share issue.
The role of financial statement analysis is that the new shares, the new cash flows from any project, and
any changes in financial or operating risk can be built into a model to provide new forecasts of the value
creation of the new financing and associated operations.
8.12 Forecasting scenarios and sensitivity analysis

Having made a range of individual forecasts, it might seem logical to assume that the overall outcome
will be reasonable. Unfortunately, this is not necessarily the case.
The estimates are likely to be single values, or 'point estimates', which only really represent our 'best guess'
from a range of possible outcomes in each case. Once these point estimates have been put together,
however, it is necessary to test the reasonableness of the whole picture to ensure that, for instance, we
have not estimated revenues at one end of a reasonable range and CAPEX at the other end of its
reasonable range, producing an unreasonable and inconsistent result.
One way to test the reasonableness and consistency of the forecast figures is to recompute the basic
ratios based on the forecast figure, to see if they make sense.

Another feature of checking reasonableness is to consider various scenarios and see if the modelled figures
change significantly when the scenarios change. This might include some strategic effects, such as a
new entrant into the industry, declining industry demand perhaps due to new substitutes, or suppliers
forcing price increases for raw materials.
8.13 Risk assessment

In order to assess the impact of estimation errors, sensitivity analysis is a useful tool, but it does not say
how probable the alternative outcomes are, and does not of itself measure risk.
Consideration should, however, be given to risk and the potential for variation in the estimate that has
been forecast. Consideration can be given to the following:
(a) How well diversified is the company (eg, does it depend on one product or service)?
(b) Volatility of earnings can be specifically measured using standard deviations.
(c) If the business is cyclical, do the variations change according to the economic business cycle and is
the risk largely systematic? If so, an accounting beta can be estimated by plotting the covariance of
a company's earnings against an index such as market earnings of FTSE 100 companies, or even
GDP variation.
(d) If the business is risky, is it appropriate to make prudent estimates of variables in forecasting
performance? This may, however, just result in a pessimistic forecast without regard for upside
variation.
If the risk is default risk, then an assessment of the company's liquidity arrangements, including
contingent funding, may be appropriate. Credit rating agencies, such as Standard & Poor's, or Moody's,
may also give an indication of default risk.
8.14 Cash flow forecasting and valuation

The end product of forecasting is normally the valuation of an enterprise based on discounting future cash
flows. The forecasting process has, therefore, taken earnings and figures in the statement of financial
position and produced a free cash flow forecast. From this, appropriate risk-adjusted discount rates can
be used to determine value, or test the value creation of various strategic and corporate finance
decisions. The internal rate of return can also be used, based on cash flows, as the economic equivalent
of ROCE.
The end product of financial analysis is the understanding of how value is created and how forecasting
earnings can be built into valuation models to assess the impact of different operating, investment and
financing decisions. The last issue requires the use of spreadsheet models that capture the relationship C
between drivers and value. H
A
Value creation can be affected by a variety of investment, operating and financing decisions taken by a P
company. This section looks at examples of some of these decisions, and considers the role of financial T
analysis in assessing the consequences of such decisions for value creation by those external to the E
R
company concerned.
Having made forecasts, then other cash flow measures such as payback can also be used or, similarly,
other expressions of profit and adjustments thereto can be made such as economic value added (or 24
TM
EVA ).
Although we have concentrated so far on forecasting individual figures for the statement of profit or loss
and other comprehensive income or the statement of financial position, the most common use of
forecasting financial statements is to produce a valuation of the entity.
The quantity that is forecast for valuation purposes is the free cash flow to the firm defined as
FREE CASH FLOW = FCFF = EARNINGS BEFORE INTEREST AND TAXES (EBIT)
Less: TAX ON EBIT
Plus: NON-CASH CHARGES
Less: CAPITAL EXPENDITURES
Less: NET WORKING CAPITAL INCREASES
Plus: SALVAGE VALUES RECEIVED
Plus: NET WORKING CAPITAL DECREASES
The future FCFF will need to be discounted using an appropriate discount factor that will be consistent
with the risk of the cash flow.

9 Data and analysis
Section overview
Professional accountants have to use their common sense and judgement when they analyse data.
They are often required to draw conclusions or make recommendations on the basis of information in
business reports and financial statements. The analysis of such data is normally both quantitative and
qualitative. It is important that accountants should be aware of the limitations of any data they are
using when they make such conclusions or recommendations.
9.1 What is data?

The word 'data' has several meanings. It is commonly associated with input to a computer, or 'raw data'
which is processed to obtain meaningful information. For the purpose of this chapter, a useful definition
of data is: 'Facts from which other information may be inferred'.
Professional accountants are often presented with reports and statements, from which they are expected
to identify issues and draw conclusions. In other words, they have to analyse the data and consider its
implications. Analysis of data is also relevant to the auditor. The auditor will analyse data in the financial
statements in order to draw a conclusion which will form the basis of the auditor's report.
Reports and statements vary in nature. They may be internally produced business reports or financial
reports, as well as externally published financial statements.
9.2 Characteristics of data

A useful starting point is an appreciation of the characteristics or qualities of data. Information should be
reliable; but data often lacks reliability, for any of the following reasons.
(a) Incomplete. Data is often incomplete, in the sense that it does not tell the user everything that he
or she needs to know. Incomplete information is a source of evidence, but not enough for the
evidence to be conclusive. The user should want to learn more before reaching a conclusion.
Incompleteness of data can be a particular problem with external reports, whose purpose may be
only indirectly related to the interests and concerns of the report user.
(b) Lacks neutrality. Information may lack neutrality. A report may contain opinions and
recommendations that reflect the opinions and bias of the report writer. Professional scepticism
may need to be applied in interpreting such data or placing reliance on it.
(c) Inaccurate. The data in a report or statement may be inaccurate, or the user of the report or
statement may suspect that it is inaccurate. Alternatively, data may be insufficiently accurate for the
requirements of the user. Without confidence in the accuracy of data, the user cannot make
reliable conclusions.
(d) Unclear. Information may lack clarity, especially when it comes from an external source. Lack of
clarity may be due to:
(i) poor expression of ideas in an external report by the report author, or lack of clarity about
the assumptions on which information in the report is based; or
(ii) deliberate lack of transparency by the information provider. An example of this might be
press releases by a competitor organisation, whose statements about a particular item of news
may be deliberately obscure without being untruthful.
(e) Historical. Historical data may be used to make forecasts or conclusions about the future.
However, any historical-based prediction is inevitably based on the assumption that what has
happened in the past is a valid guide to what will happen in the future. This may not be the case.
(f) Not up to date. When events in the business environment are changing rapidly, information may
get out of date very quickly. There is a risk that any data in a report or statement is no longer
accurate because it is no longer up to date.

(g) Not verifiable. Some data or information may not be verifiable. Management may want
corroboration of a fact or allegation, but there may not be an alternative source for checking its
accuracy. This is often the case in employment disputes at work: two individuals may contest
claims made by the other, and there may be no way of checking whose allegations are correct.
(h) Source. Information may come from a source that is not entirely reliable. This may be a particular
problem with secondary data from external sources.
Accountants must use the data that is available to them, even though it is not 100% reliable. They may
have to qualify their opinions or judgements according to their view about how much reliance they can
place on it. A major problem is often incompleteness.
Data may lack relevance as well as reliability.
(a) There may be a risk of drawing unjustified conclusions from available data, and interpreting data in
ways that the facts do not properly justify. The data user may imagine that there is evidence to
justify a conclusion, when the evidence from the data is not at all conclusive.
(b) With financial data, there may be a risk of using financial statements prepared under the accruals
concept to make conclusions when cash flows and incremental costs should be used.
An accountant may want to use data to make comparisons, such as comparing the performance of
different companies or different segments of a business. Unfortunately, data may not be properly
comparable. For example, comparing sets of data about the performance of two rival companies may
not be entirely reliable because the available data for the two companies:
 has been collected in different ways;
 is based on different assumptions; or
 is presented differently, under different headings.
9.3 Financial data analysis

You could be expected to analyse financial data about any of the following areas:
(a) The financial markets. You may be asked to comment on data about conditions in the financial
markets, such as interest rates or exchange rates, and implications of changes in market conditions
for the organisation
(b) Revenue, profitability and costs – and pricing
(c) Cash flow or liquidity C
H
(d) Capital structure A
P
If you are given financial data for analysis, you should consider the adequacy or limitations of the T
information and be aware of what the information does not tell you. What is missing could be more E
important than what the report or statement contains. R
(a) Data about profitability may present product profitability, when you should be more concerned
with customer profitability, distribution channel profitability or market segment profitability.
24
(b) Data about profitability may be provided, when you should be more concerned about cash flow
and funding.
(c) Cost and management accounting information may be presented in a traditional format, such as
an absorption costing or marginal costing statement, when you may consider that another
approach to presenting information is needed – for example, an activity-based costing statement,
or information about particular aspects of cost that traditional statements do not analyse, such as
quality costs.
The challenge with analysing financial information may be not so much to demonstrate your knowledge
of financial analysis as to demonstrate your understanding of the limits of financial analysis when
insufficient or inappropriate data is available.

Worked example: Financial data
Wizard Ltd is a specialist component manufacturer for the aerospace industry employing 54 people. It
has two main customers located in North America. The relative success of Wizard over the last few years
has attracted interest from a number of potential industry buyers. One of Wizard's main customers,
Draco plc, is now considering making a bid for the entire share capital of Wizard, effectively bringing
Wizard's services in-house. Draco is concerned that the specialist products that Wizard supplies it with
allow it to charge, in the words of the Draco purchasing manager, 'outrageous prices'.
The financial adviser to Draco has obtained the following information relating to Wizard.
Extracts from the financial statements of Wizard for 20X5
$'000
Revenue 14,730
Cost of sales 8,388
Other costs 5,202
Profit after tax 798
Dividend paid 390
Inventories 1,392
Receivables 876
Cash 192
Payables 1,464
Equity share capital 600
Information obtained from the Aeronautical Trade Association
Average P/E ratio (for quoted companies) 9.0
Average annual growth in reported post-tax profits (20X4–20X5) 3.0%
Average pre-tax profit margin 5.1%
Average pre-tax ROCE 13%
Average receivables days 78
Average payables days 34
Average revenue per employee $154,200
The finance director of Draco has provided the following summary of Draco's recent performance:
20X5 20X4 20X3 20X2
$m $m $m $m
Revenue 58.75 55.60 50.30 50.50
Pre-tax profit 4.40 7.15 7.75 10.05
Dividend paid 0.40 2.50 2.50 2.50
Requirement
Analyse the financial position and performance of Wizard as at the end of 20X5.
Solution/Evaluation
Measure Industry Wizard Workings
Gross ROCE 99.7% (14,730 – 8,388) / (600 + 5,760)
Pre-tax ROCE 13% 17.9% 1,140 / (600 + 5,760)
Gross profit rate 43.1% (14,730 – 8,388) / 14,730
Pre-tax profit rate 5.1% 7.7% 1,140 / 14,730
Non-current assets turnover 2.75 14,730 / 5,364
Receivables days 78 22 (876 / 14,730)  365
Payable days 34 64 (1,464 / 8,388)  365
Inventory days 61 (1,392 / 8,388)  365
Revenue per employee $ 154,200 272,778 (14,730 / 54)  1,000
Pre-tax profit per employee $ 7,864 21,111 (1,140 / 54)  1,000
Dividend cover 2.05 798 / 390
Current ratio 1.68 (1,392 + 876 + 192) / 1,464
Quick ratio 0.73 (876 + 192) / 1,464

Analysis
Pre-tax ROCE and pre-tax profit rate – These are 38% and 51% higher than industry average, which
supports the view that Wizard is able to charge high prices. This would appear to be a result of the
specialism of the services that Wizard provides. Additionally, there may be strict cost control within
Wizard, further allowing it to generate higher margins. Should Wizard be acquired by Draco, then the
products will be available at 'cost', thereby saving Draco money, while allowing it to potentially benefit
from the premium prices it can charge to Wizard's other main customer.
Receivables days – At 22, these are exceptionally low compared to the industry average. This is
probably due to the fact that Wizard only has two main customers, making it possible to form close
working relationships. Given the specialism that Wizard provides, it is likely that its customers do not
want to sour this relationship by delaying payment. There is no reason to believe that this will change if
Draco acquires the company.
Payables days – At 64, this is almost twice the industry average and reflects either a strict cash
management policy within Wizard, or potentially a cash flow problem. Given the high profitability
within Wizard, and its healthy balance sheet, it would appear that Wizard has squeezed its suppliers
quite hard. Once acquired by Draco, this strategy may need to change to bring it in line with company
policy.
Inventory days – At 61, this indicates the time that inventory is held by Wizard. This demonstrates that
the production process within Wizard is about two months and may be a reflection of the complexity of
the manufacturing process that it undertakes. It may be a result of the safety checks, which are a key
feature of supply in the aerospace industry, and the time taken to do this may contribute to the 61-day
figure.
Revenue and profit per employee – These are, respectively, 77% and 168% higher than industry
average, which is a further reflection of the profitability and revenue generation abilities of Wizard. This
is further evidence of its ability to charge high prices and possibly control costs. Interestingly, we are
told nothing about the salaries within Wizard and it may be that as a smaller firm, their salaries may be
different to those within Draco. Should Wizard's salaries be higher than Draco's, this could lead to
demands for higher wages among Draco's workforce. In terms of costs, it may well be that once Wizard
is acquired, the greater purchasing power which a larger company would have may lead to further
economies of scale and even cheaper supplies.
Dividend cover – As Wizard is not a listed company, its dividend ratio is not strictly comparable with
Draco's. What is relevant is that it evidences Wizard's ability to pay dividends and hence generate cash.
This is potentially good news for Draco as it has recently cut its own dividends, which will have
C
disappointed shareholders. H
A
Liquidity ratios – Without industry statistics, these are in themselves fairly meaningless. However, the
P
current ratio is greater than one, indicating good liquidity, and the quick ratio is close to one. Allied with T
its low receivables and high payables days, this indicates that Wizard does not appear to have cash flow E
problems. R
Overall – It would appear from the above analysis that Wizard is a profitable company that does not
appear to have any liquidity or working capital concerns.
24
The type of analysis performed above may also be performed by the auditor as part of the analytical
procedures at the risk assessment stage of the audit. The use of data analytics tools allows this analysis to
be carried out at a more granular level than has historically been the case.
9.4 Approach to analysing financial data

If you are given financial data for analysis, you should expect to carry out some numerical analysis. You
will have to decide yourself how to do the analysis.
(a) If you are given data for more than one year, you should measure changes over time. If you are
given financial data about a competitor, you should try to make a comparative analysis.
(b) There may be value in carrying out cost-volume-profit analysis (breakeven analysis) on data that
you are given, but you will need to state your assumptions about fixed and variable costs.

(c) If you are given information about historical performance and targets, you should try to carry out
numerical analysis of the extent to which the organisation is on track for meeting its targets.
Show all your numerical workings and state clearly the assumptions you have made.
10 Management commentary
Section overview
Some of the limitations of financial statements may be addressed by a management commentary. The
IASB has issued a practice statement on a management commentary to supplement and complement
10.1 Need for a management commentary

In the UK, companies have been encouraged to produce an Operating and Financial Review, explaining
the main factors underlying a company's financial position and performance, and analysing the main
trends affecting this. A Reporting Statement on the OFR was issued in January 2006.
Financial statements alone are not considered sufficient without an accompanying explanation of the
performance, eg, highlighting a restructuring that has reduced profits or the cost of developing a new
business channel in the current period which will generate profits in the future.
Perhaps more importantly, a good management commentary not only talks about the past position and
performance, but also about how this will translate into future financial position and performance.
The Conceptual Framework for Financial Reporting acknowledges that 'general purpose financial reports
do not and cannot provide all of the information that existing and potential investors, lenders and other
creditors need. Those users need to consider pertinent information from other sources, for example,
general economic conditions and expectations, political events and political climate, and industry and
company outlooks' (para OB6).
Typically, larger companies are already making disclosures similar to a management commentary, eg, as
a 'Directors' Report', but the aim of the IASB is to define internationally what a management
commentary should contain. For example, a good commentary should be balanced and not just
highlight the company's successes.
A management commentary would also address risks and issues facing the entity that may not be
apparent from a review of the financial statements, and how they will be addressed.
10.2 IFRS Practice Statement

In 2010, the IASB issued an IFRS Practice Statement Management Commentary, which is the international
equivalent of the Operating and Financial Review.
The main objective of the Statement is that the IASB can improve the quality of financial reports by
providing guidance 'for all jurisdictions, in order to promote comparability across entities that present
management commentary and to improve entities' communications with their stakeholders'. In
preparing this guidance, the IASB team has reviewed existing requirements around the world, such as
the OFR, Management's Discussion and Analysis (MD&A) in the US and Canada, and the German
accounting standard on Management Reporting.
10.3 Scope
The IASB has published a Practice Statement rather than an IFRS on management commentary. This
'provides a broad, non-binding framework for the presentation of management commentary that relates
to financial statements that have been prepared in accordance with IFRSs'.
This guidance is designed for publicly traded entities, but it would be left to regulators to decide who
would be required to publish management commentary.

This approach avoids the adoption hurdle ie, that the perceived cost of applying IFRSs might increase,
which could otherwise dissuade jurisdictions/countries not having adopted IFRSs from requiring their
adoption, especially where requirements differ significantly from existing national requirements.
10.4 Definition of a management commentary

The following preliminary definition is given in the Practice Statement:
Definition
Management commentary: A narrative report that provides a context within which to interpret the
financial position, financial performance and cash flows of an entity. It also provides management with
an opportunity to explain its objectives and its strategies for achieving those objectives.
(IFRS Practice Statement)
10.5 Principles for the preparation of a management commentary

When a management commentary relates to financial statements, then those financial statements
should either be provided with the commentary or the commentary should clearly identify the financial
statements to which it relates. The management commentary must be clearly distinguished from other
information and must state to what extent it has followed the Practice Statement.
Management commentary should follow these principles:
(a) To provide management's view of the entity's performance, position and progress
(b) To supplement and complement information presented in the financial statements
(c) To include forward-looking information
(d) To include information that possesses the qualitative characteristics described in the Conceptual
Framework
10.6 Elements of a management commentary

The Practice Statement says that to meet the objective of management commentary, an entity should C
include information that is essential to an understanding of the following: H
A
(a) The nature of the business P
T
(b) Management's objectives and its strategies for meeting those objectives E
R
(c) The entity's most significant resources, risks and relationships
(d) The results of operations and prospects

24
(e) The critical performance measures and indicators that management uses to evaluate the entity's
performance against stated objectives
The Practice Statement does not propose a fixed format, as the nature of management commentary
would vary between entities. It does not provide application guidance or illustrative examples, as this
could be interpreted as a floor or ceiling for disclosures. Instead, the IASB anticipates that other parties
will produce guidance.
However, the IASB has provided a table relating the five elements listed above to its assessments of the
needs of the primary users of a management commentary (existing and potential investors, lenders and
creditors).

Element User needs
Nature of the The knowledge of the business in which an entity is engaged and the external
business environment in which it operates.
Objectives and To assess the strategies adopted by the entity and the likelihood that those
strategies strategies will be successful in meeting management's stated objectives.
A basis for determining the resources available to the entity as well as
obligations to transfer resources to others; the ability of the entity to generate
Resources, risks and
long-term sustainable net inflows of resources; and the risks to which those
relationships
resource-generating activities are exposed, both in the near term and in the
long term.
The ability to understand whether an entity has delivered results in line with
expectations and, implicitly, how well management has understood the
Results and prospects
entity's market, executed its strategy and managed the entity's resources, risks
and relationships.
Performance The ability to focus on the critical performance measures and indicators that
measures and management uses to assess and manage the entity's performance against
indicators stated objectives and strategies.
10.7 Advantages and disadvantages of a compulsory management commentary

Advantages Disadvantages
Entity Entity
 Promotes the entity, and attracts investors,  Costs may outweigh benefits
lenders, customers and suppliers  Risk that investors may ignore the financial
 Communicates management plans and statements
outlook
Users Users
 Financial statements not enough to make  Subjective
decisions (financial information only)  Not normally audited
 Financial statements backward looking  Could encourage companies to de-list
(need forward-looking information) (to avoid requirement to produce MC)
 Highlights risks  Different countries have different needs
 Useful for comparability to other entities
10.8 Management commentary in the UK

From 2006 to 2013, management commentary in the UK was provided in the form of an Operating and
Financial Review. The Companies Act 2006 had a further requirement for all companies, other than
those classified as small, to provide a business review within the directors' report. In 2013 the business
review was replaced by a separate strategic report, again for all companies other than those classified as
small. In response to the new regulations, the FRC issued guidance in 2014 dealing specifically with the
preparation of the strategic report. Key features are as follows:
(a) The strategic report should be a separate component of the directors' report.
(b) The strategic report should contain a fair review of the company's business and a description of the
principal risks it faces.
(c) The review should be balanced and comprehensive.
(d) If it is necessary for an understanding of the development, performance or position of the business,
the review should include analysis using financial Key Performance Indicators (KPIs).
(e) Large companies should also include non-financial KPIs in their analysis, where appropriate.
(f) Where appropriate, the review should include references to and additional explanations of amounts
included in the annual accounts for example 'exceptional' items and items disclosed separately.

11 Summary
Section overview
This section provides a summary of the areas covered so far in this chapter.
Financial statements can help analysts in evaluating a company's activities by:

 providing disclosures about a firm's current financial position and historical performance;
 providing information from which financial models can be constructed to forecast future
performance and position; and
 helping to evaluate the value creation potential of financial decisions using valuation models.
While financial statements may have other uses for other users, for the analyst the key link is that
between financial statements and the valuation process. This is not to suggest that financial statements
provide a valuation. Rather, they are an input, along with other sources of information, into valuation
models.
This chapter has attempted to provide a methodology for how the raw financial reporting information
contained in the financial statements of a company can be interpreted, adjusted and standardised and
then used for analysis, decision-making, forecasting and valuation. In this way the information will help
with the assessment of the impact on value of key operating, investment and financing decisions.
The chapter considered how weaknesses of financial reporting information, such as weaknesses inherent in
accounting practice, as well as any 'creativity' by management, can distort the usefulness of such
information. Any forecasting or valuation model, no matter how sophisticated, is likely to be of little
worth if it uses inappropriate information. The quality of earnings and of other accounting information
was thus considered in order to normalise earnings as a prerequisite for any consistent forecasting of
sustainable earnings and valuation modelling.
Accounting ratios then considered how the adjusted figures could be interpreted by examining ratios
and other relationships against predetermined benchmarks to highlight unusual features and changes.
This analysis helps us understand the current financial position and historical performance of the company.
Also, however, to the extent that the relationships represented by ratios are sustainable over time, they
can be built into valuation models in order to predict the consequences of changing one variable for
other variables.
C
Forecasts of future earnings were examined based on adjusted financial information. In this context, H
forecasting depends on many sources of information, of which financial statements are only one. For A
P
financial statements to be useful, however, it is necessary to:
T
 understand their integrated nature; E
R
 recognise how separate components interact; and
 comprehend the many pages of detailed supporting information presented in an annual report.
Moreover, it is necessary to understand the strategic and behavioural context within which financial 24
reporting is taking place, in order to forecast future performance on the basis of financial reporting
information.
Some of the defects of financial statement analysis have been addressed in the IASB's Management
Commentary, and, in the UK, the FRC's guidance on the Strategic Report.

12 Audit focus on fraud
Section overview
 It is important for auditors to understand their responsibilities for detecting fraud and plan their
audit to maximise the chance of detection and ultimately control audit risk.
 In this section we will look at the following:
– An introduction as to why fraud is a difficult area for both business and auditor
– What fraud means
– The types of fraud that a business can suffer
– The types of risk factor that the auditor should look out for when planning an audit
– How the auditor should then address the risk of fraud occurring
– How fraud should be reported, if at all
– The ongoing debate of the expectation gap and the role of the auditor in the detection of
fraud
12.1 Introduction
In sections 4 and 5 above, we looked at the manipulation of information in the financial statements by
creative accounting, and some of the 'red flags' that may indicate creative accounting practice.
Creative accounting can be one form of fraudulent financial reporting. While some creative accounting
practices are clearly fraudulent, others are, strictly, allowable, but nevertheless show a less than ethical
attitude on the part of the company directors.
In this section, we will look at the auditor's responsibilities in respect of not just creative accounting, but
fraud in general. This is the scope which has been adopted by the ISAs.
While one would hope that businesses were trying to address and minimise fraud, it is clear that the
opposite is happening. Businesses are, in fact, in many cases complacent when it comes to fraud. The
Global Economic Crime Survey by PwC revealed that of the companies surveyed only 17% of them
believed that they would be a victim of fraud and yet 48% of the companies had been affected. With
this in mind, it remains clear that fraud is still a risk to business and to the auditor.
12.2 What is fraud?

ISA (UK) 240 (Revised June 2016) The Auditor's Responsibilities Relating to Fraud in an Audit of Financial
Statements provides guidance for the auditor. The main revisions to the standard relate to issues relating
to PIEs. ISA 240 provides the following definitions.
Definition
Fraud: An intentional act by one or more individuals among management, those charged with
governance, employees or third parties, involving the use of deception to obtain an unjust or illegal
advantage.
Fraud risk factors: Events or conditions that indicate an incentive or pressure to commit fraud or
provide an opportunity to commit fraud. (ISA 240.11)
Fraud may be perpetrated by an individual, or colluded in with people internal or external to the
business. It is a contributing factor to business risk.
It is the fact that fraud is a form of deceit that makes its prevention and detection difficult for both
business and the auditor. The perpetrator of the fraud does not want to be detected and will go out of

their way to be successful. Fraud should be distinguished from error where the latter arises from a
genuine mistake with no intention to deceive.
While management may be concerned with different levels of fraud, it is only fraud that results in a
material misstatement in the financial statements that is of concern to the auditor.
Specifically, there are two types of fraud causing material misstatement in financial statements:
(1) Fraudulent financial reporting
(2) Misappropriation of assets
12.3 Fraudulent financial reporting

This fraud has a direct impact on the financial statements and will arise from any of the following:
 Manipulation, falsification or alteration of accounting records/supporting documents
 Misrepresentation (or omission) of events or transactions in the financial statements
 Intentional misapplication of accounting principles (ISA 240.A3)
Such fraud may be carried out by overriding controls that would otherwise appear to be operating
effectively, for example by recording fictitious journal entries or improperly adjusting assumptions or
estimates used in financial reporting.
You will recall in the Parmalat example in Chapter 5 that the scenario also raises the question as to
whether auditors can simply rely on bank confirmations when they relate to substantial sums of assets.
Do these confirmations constitute sufficient and appropriate audit evidence?
Point to note:
As a result of the IAASB Disclosures Project, the revised ISA emphasises that fraudulent financial
reporting can result from omitting, obscuring or misstating disclosures. (ISA 240.A4)
12.3.1 Aggressive earnings management

Aggressive earnings management is an example of creative accounting. It occurs when management
alters the financial statements in order to mislead stakeholders about the financial position or
performance of the business or to influence the outcome of contracts. It usually involves the artificial
enhancement of revenue and profit. Businesses are likely to be at risk of this when:
(a) there has been an adverse market reaction and so management may want to present a healthier
picture about the company than is in fact the case; C
H
(b) management bonuses are tied into targets and there may be a personal conflict between what A
management want for themselves and what is good for the company; P
T
(c) the business wants to reduce its tax liabilities and in this case profits may be deliberately reduced; E
or R
(d) the business needs to remain within certain financial parameters (limits, ratios) in order to achieve
new funding or so as not to be in breach of loan covenants. Profit overstatement could be an issue, 24
as well as understatement of liabilities and overstatement of assets.
Auditors should be on the alert for issues such as unsuitable revenue recognition, unnecessary accruals,
reduced liabilities, overstatement of provisions, reserves accounting and large numbers of immaterial
breaches of financial reporting requirements to see whether together, they constitute fraud.
12.4 Misappropriation of assets

This is the theft of the entity's assets (for example, cash, inventory). Employees may be involved in such
fraud in small and immaterial amounts; however, it can also be carried out by management for larger
items who may then conceal the misappropriation, for example by:
 Embezzling receipts (for example, diverting them to private bank accounts)
 Stealing physical assets or intellectual property (inventory, selling data)
 Causing an entity to pay for goods not received (payments to fictitious vendors)
 Using assets for personal use (ISA 240.A5)

12.5 Responsibilities with regard to fraud
The business
Management and those charged with governance in an entity are primarily responsible for preventing
and detecting fraud. It is up to them to put a strong emphasis within the company on fraud
prevention. We have already covered the principles of this in Chapter 3.
The auditor
Auditors are responsible for carrying out an audit in accordance with international auditing
standards.
12.6 The auditor's approach to the possibility of fraud

12.6.1 General
The objectives of the auditor in this area are set out early in ISA 240:
(a) To identify and assess the risks of material misstatement of the financial statements due to fraud
(b) To obtain sufficient appropriate audit evidence regarding the assessed risks of material
misstatement due to fraud, through designing and implementing appropriate responses
(c) To respond appropriately to fraud or suspected fraud identified during the audit
An overriding requirement of the ISA is that auditors are aware of the possibility of there being
misstatements due to fraud.
As we have seen in Chapter 6, the auditor shall maintain an attitude of professional scepticism
throughout the audit. He/she must recognise the possibility that a material misstatement due to fraud
could exist, notwithstanding the auditor's past experience of the honesty and integrity of management
and those charged with governance.
This requires that the auditor continue to question the sufficiency and appropriateness of the evidence
collected during the audit. As seen in Chapter 3, threats to auditor independence could impact on the
auditor's ability to maintain such scepticism.
Members of the engagement team should discuss the susceptibility of the entity's financial statements
to material misstatements due to fraud.
Interactive question 5: The possibility of fraud

You are an audit partner of Dupi Ltd. The company operates a chain of sandwich bars throughout the
south of England. The company is owned by three directors. At your last meeting with the client, you
were informed that the company was hoping to expand and open up some shops in the north of
England. The directors had not yet formalised the strategy for the expansion or its financing.
You have received the following letter:
'I have been an employee of this company for a number of years. Unfortunately, I have come across
some information which I am not sure what to do about. There have been a number of journals relating
to revenue for which I have not been able to obtain an explanation. The effect of these journals is to
increase revenue substantially. Not sure if this is relevant to you'.
The planning meeting with the audit team for this year's audit is scheduled for next week.
Requirement
What are the issues that you would raise at the planning meeting?

12.7 Risk assessment procedures
As discussed in Chapter 5, the auditor will undertake risk assessment procedures as set out in
ISA (UK) 315 Identifying and Assessing the Risks of Material Misstatement through Understanding of the
Entity and its Environment which will include assessing the risk of fraud. These procedures will include the
following:
 Inquiries of management and those charged with governance (eg, as to whether there have been
any incidences of fraud, the nature of the fraud and the outcome)
 Consideration of when fraud risk factors are present (some businesses are more susceptible to
fraudulent activity than others eg, poor control environment, cash based business, dominant senior
management, poor staff relations, need for more finance, increased competition, poor market
performance)
 Consideration of results of analytical procedures (eg, any unusual fluctuations in business year-on-
year ratios and also those compared to industry norm)
 Consideration of any other relevant information (eg, press reports)
In identifying the risks of fraud, the auditor is required by the ISA to carry out some specific procedures.
The auditor must:
 make inquiries of management regarding their assessment of the risk and their processes for
identifying and responding to the risks of fraud;
 make inquiries of management, those charged with governance and others within the entity (and
the internal audit function where there is one), to determine whether they have knowledge of any
actual, suspected or alleged fraud;
 obtain an understanding of how those charged with governance exercise oversight of
management's processes for identifying and responding to the risks of fraud;
 consider whether other information obtained by the auditor indicates risks of material
misstatement due to fraud; and
 evaluate whether the information obtained from other risk assessment procedures and related
activities indicates fraud risk factors exist. (ISA 240.17–.24)
Interactive question 6: Finding out about suspected fraud

Following on from Dupi Ltd (Interactive question 5), outline the information that the auditor would seek C
from the client. H
A
See Answer at the end of this chapter. P
T
E
R
12.8 Examples of fraud risk factors
Appendix 1 to ISA 240 provides further analysis of the two types of fraud depending on the conditions 24
that exist in the client's business community:
 Incentives/pressures
 Opportunities
 Attitudes/rationalisations

FRAUDULENT
FINANCIAL REPORTING
Incentives/pressures Opportunities Attitudes/rationalisations

Financial stability/profitability is Ineffective communication or
Significant related-party
threatened enforcement of the entity’s
transactions
Pressure for management to values or ethical standards by
Assets, liabilities, revenues or
meet the expectations of third management
expenses based on
parties Known history of violations of
significant estimates
Personal financial situation of securities laws or other laws
Domination of management
management threatened by and regulations
by a single person or small
the entity's financial A practice by management of
group
performance committing to achieve
Complex or unstable
Excessive pressure on aggressive or unrealistic
organisational structure
management or operating forecasts
Internal control components
personnel to meet financial Low morale among senior
are deficient
targets management
Relationship between
management and the current
or predecessor auditor is
strained
MISAPPROPRIATION OF
ASSETS
Incentives/pressures Opportunities Attitudes/rationalisations
Personal financial obligations Large amounts of cash on Overriding existing controls

Adverse relationships between hand or processed Failing to correct known
the entity and employees with Inventory items that are small internal control deficiencies
access to cash or other assets in size, of high value, or in Behaviour indicating displeasure
susceptible to theft high demand or dissatisfaction with the entity
Easily convertible assets, such Changes in behaviour or
as bearer bonds, diamonds, lifestyle
or computer chips
Inadequate internal control
over assets
Figure 24.1: Fraud Risk Factors

In addition, remember that some specific 'red flags' indicating creative accounting are set out in
section 4.
When identifying and assessing the risks of material misstatement at the financial statement level, and at
the assertion level for classes of transactions, account balances and disclosures, the auditor must identify
and assess the risks of material misstatement due to fraud. Those assessed risks that could result in a
material misstatement due to fraud are significant risks and accordingly, to the extent not already done
so, the auditor must obtain an understanding of the entity's related controls, including control activities
relevant to such risks (ISA 240.27).
The auditor:
 identifies fraud risks;
 relates this to what could go wrong at a financial statement level; and
 considers the likely magnitude of potential misstatement.

Point to note:
When identifying and assessing fraud risk there is a presumption that there are risks of fraud in revenue
recognition. (ISA 240.26)
Interactive question 7: Sellfones

You are an audit manager for Elle and Emm. You are carrying out the planning of the audit of Sellfones
plc, a high street retailer of mobile phones in the UK, for the year ending 30 September 20X7. The
notes from your planning meeting with Pami Desai, the financial director, include the following:
(1) One of Sellfones's main competitors ceased trading during the year due to the increasing pressure
on margins in the industry and competition from online retailers.
(2) A new management structure has been implemented, with 10 new divisional managers appointed
during the year. The high street shops have been allocated to these managers, with approximately
20 branch managers reporting to each divisional manager. The divisional managers have been set
challenging financial targets for their areas with substantial bonuses offered to incentivise them to
meet the targets. The board of directors have also decided to cut the amount that will be paid to
shop staff as a Christmas bonus.
(3) In response to recommendations in the prior year's Report to Management, a new inventory
system has been implemented. There were some teething problems in its first months of operation
but a report has been submitted to the board by Steven MacLennan, the chief accountant,
confirming that the problems have all been resolved and that information produced by the system
will be accurate. Pami commented that the chief accountant has had to work very long hours to
deal with this new system, often working at weekends and even refusing to take any leave until the
system was running properly.
(4) The company is planning to raise new capital through a share issue after the year end in order to
finance expansion of the business into other countries in Europe. As a result, Pami has requested
that the auditor's report is signed off by 15 December 20X7 (six weeks earlier than in previous
years).
(5) The latest board summary of results includes:
9 Months to 30 June 20X7 Year to 30 September 20X6
(unaudited) (audited)
£m £m
Revenue 320 Revenue 280
Cost of sales 215 Cost of sales 199
C
Gross profit 105 Gross profit 81
H
Operating expenses (89) Operating expenses (70) A
P
Exceptional profit on T
sale of properties 30 – E
Profit before tax 46 11 R
(6) Several shop properties owned by the company were sold under sale and leaseback arrangements.
Requirements 24
(a) Identify and explain any fraud risk factors that the audit team should consider when planning the
audit of Sellfones plc.
(b) Link the fraud risk to what could go wrong in the financial statements of Sellfones.
12.9 Responding to assessed risks

Having identified risk factors, the auditor must then come up with responses to the assessed risks. The
auditor needs to assess if the fraud potentially has a material impact on the financial statements and
how best to address it. In particular the auditor must:
 ensure that personnel with the required skill and ability are assigned to the audit;
 test the appropriateness of journal entries recorded in the general ledger and other adjustments
made in the preparation of the financial statements;

 review accounting estimates for biases and evaluate whether the circumstances producing the bias,
if any, represent a risk of fraud; and
 evaluate for significant transactions that are outside the normal course of business whether the
business rationale (or lack of) suggests fraudulent financial reporting or misappropriation of assets.
Interactive question 8: Specific audit procedures

Following on from Interactive questions 5 and 6, outline the steps that the auditor should now integrate
into the audit procedures for Dupi Ltd.
12.10 Evaluation of audit evidence

The auditor evaluates the audit evidence obtained to ensure it is consistent and that it achieves its aim of
answering the risks of fraud. This will include a consideration of results of analytical procedures and
other misstatements found. The auditor must also consider the reliability of written representations
by management.
The auditor must obtain written representation that management accepts its responsibility for the
prevention and detection of fraud and has made all relevant disclosures to the auditors. (ISA 240.39)
12.11 Documentation
The auditor must document the following:
 The significant decisions as a result of the team's discussion of fraud
 The identified and assessed risks of material misstatement due to fraud
 The overall responses to assessed risks
 Results of specific audit tests
 Any communications with management (ISA 240.44–.46)
12.12 Reporting
There are various reporting requirements in ISA 240.
If the auditor has identified a fraud or has obtained information that indicates a fraud may exist, the
auditor must communicate these matters as soon as practicable to the appropriate level of
management.
If the auditor has identified fraud involving:
(a) management;
(b) employees who have significant roles in internal control; or
(c) others, where the fraud results in a material misstatement in the financial statements,
then the auditor must communicate these matters to those charged with governance as soon as
practicable. (ISA 240.40-.41)
The auditor should also make relevant parties within the entity aware of significant deficiencies in the
design or implementation of controls to prevent and detect fraud which have come to the auditor's
attention, and consider whether there are any other relevant matters to bring to the attention of those
charged with governance with regard to fraud.
The auditor may have a statutory duty to report fraudulent behaviour to regulators outside the entity.
For example, in the UK, anti money laundering legislation imposes a duty on auditors to report
suspected money laundering activity. Suspicions relating to fraud are likely to be required to be reported
under this legislation. If no such legal duty arises, the auditor must consider whether to do so would
breach their professional duty of confidence. In either event, the auditor should take legal advice.

12.12.1 PIEs
For audits of the financial statements of PIEs, when the auditor suspects fraud the auditor must inform
the entity (unless prohibited by law or regulation) and invite it to investigate. If the entity does not
investigate the matter the auditor must inform the relevant authorities. (ISA 240.41R-1 & .43R-1)
12.13 Withdrawal from the engagement

The auditor should consider the need to withdraw from the engagement if the auditor uncovers
exceptional circumstances with regard to fraud. (ISA 240.38)
Worked example: Auditor resignation

'The sub-prime lender meltdown in the US has seen Grant Thornton resign as auditor for two troubled
lenders, the companies have revealed in separate regulatory filings.'
'Accredited Home Lenders Holding and Fremont General said separately that Grant Thornton had
resigned as their auditor after advising them that it needed to 'significantly expand' the scope of its
audit of their 2006 financial statements.
'News of Grant Thornton's resignation came at the same time that New Century Financial, a leader in
the once-booming subprime lending industry, filed for bankruptcy.'
(Source: Accountancy Age, 2007)
Remember that in the UK the auditor has the right to resign from office at any time. This is a way of
preserving independence and integrity as well as a way of addressing threats to independence.
12.14 Bribery Act

The Bribery Act 2010 completed the UK's implementation of the OECD Convention on the Bribery of
Foreign Public Officials as well as bringing domestic anti-bribery legislation up to date. The Act came
into force on 1 July 2011. The key points are as follows:
 Bribery is an intention to encourage or induce improper performance by any person, in breach of
any duty or expectation of trust or impartiality.
C
 Bribery may amount to an offence for the giver ('active bribery') and the receiver ('passive bribery'). H
A
 Improper performance will be judged in accordance with what a reasonable person in the UK
P
would expect. This applies even if no part of the activity took place in the UK and where local T
custom is very different. E
R
 Reasonable and proportionate hospitality is not prohibited.
 Facilitation payments (payments to induce officials to perform routine functions they are otherwise
obligated to perform) are bribes. 24
 An additional offence of bribing a foreign public official has been added.

 If companies (or partnerships) fail to prevent bribes being paid on their behalf they have
committed an offence punishable by an unlimited fine.
 A defence will be having 'adequate procedures' in place for the prevention of bribery.
 If a bribery offence is committed by a company (or partnership) any director, manager or similar
officer will also be guilty of the offence if they consented or were involved with the activity which
took place.

12.15 The expectation gap
As we have seen, fraud is a sensitive issue. When it happens, the question that is always asked is 'who's
to blame?' The answer can only be one of two: management or the auditor? Management's
responsibilities for prevention and detection of fraud are set out in governance and the auditor's in ISA
240, but the public are still not clear about the division of responsibility. The expectation gap arises from
a difference in opinion as to what the public perceive the role of the auditor to be and what the auditor
actually does.
There continues to be much discussion as to what could be done to narrow this gap, with the auditing
profession taking the lead. This is being done with a view to protecting its members.
12.15.1 Narrowing the expectation gap

The expectation gap could, theoretically, be narrowed in two ways.
Educating users
The auditor's report as outlined in ISA 700 includes an explanation of the auditor's responsibilities
including that relating to fraud. A further suggestion is that auditors could highlight circumstances
where they have had to rely on directors' representations.
Suggestions for expanding the auditor's role have included the following:
 Requiring auditors to report to boards and audit committees on the adequacy of controls to
prevent and detect fraud (For statutory audits of PIEs the auditor is required to report in the
additional report to the audit committee any significant matters involving actual or suspected non-
compliance with laws and regulations including those related to fraud. (ISA 240.A63-1)
 Encouraging the use of targeted forensic fraud reviews
 Increasing the requirement to report suspected frauds
Extending the auditor's responsibilities
Research indicates that extra work by auditors with the inevitable extra costs is likely to make little
difference to the detection of fraud because:
 most material frauds involve management;
 more than half of frauds involve misstated financial reporting but do not include diversion of funds
from the company;
 management fraud is unlikely to be found in a financial statement audit; and
 far more is spent on investigating and prosecuting fraud in a company than on its audit.

Summary
Analysis and interpretation
Users and
user focus
Ratios and Business strategy

Cash Accounting Ethical
analysis and
relationships flow analysis issues
economic
factors
Non-financial Financial • Industry analysis Choice of accounting

performance performance • Competitive analysis treatments, judgements
measures measures and disclosure notes
Reporting Accounting
requirements distortions
arising from
business and
economic
events Improving the
C
quality of H
financial information A
P
T
E
Adjusting R
assets and Adjusting
liabilities income
24

Self-test
1 Digicom Distributors Ltd
You are Paula Jones, a manager of John Mills and Co. Your client, Digicom Distributors Ltd, has for
several years been a family-owned company selling telephones and answering machines through
its own dealer network in the south of England. In May 20X0 the company was bought by two
brothers, Peter and Charles Brown.
Shortly thereafter the company acquired the exclusive UK distribution rights to a revolutionary new
video mobile phone, manufactured in South Korea, which sells for about half the price of
competitive products and is fully compatible with all British mobile telephone networks.
During the year ended 31 August 20X1 expansion has been rapid under the new management.
The following points should be noted.
(1) The distribution rights for the South Korean phone cost £850,000. The rights were acquired
for a period of 10 years, and the directors of Digicom Distributors Ltd decided to capitalise the
initial cost and amortise it over the ten-year period on a straight-line basis. The current
carrying amount is £744,000.
(2) The new phone received extensive media acclaim during October and November 20X0,
accompanied by regional television advertising campaigns. Since then monthly sales have
increased from £500,000 to £1,600,000.
The advertising campaign cost the company £1,000,000. The directors believe that it will
have long-term benefits for the sales of the phone and, consequently, they decided to
capitalise the advertising cost and amortise it over the same period as the distribution rights.
The current carrying amount for the advertising expenditure is £925,000.
(3) Sales of the new phone now account for 75% of the company's revenue. The level of credit
sales has remained constant at 30% of total sales.
(4) The company has purchased dealer networks from three other companies and is negotiating
to purchase two more, which will then complete its national coverage.
(5) Employee numbers have increased rapidly from 40 to 130. This includes administration staff at
head office, where numbers have risen from 12 to 28.
(6) In June 20X1 the central distribution and servicing department moved from head office into
larger premises in Milton Keynes. The total cost of the relocation was £625,000, which has
been included in administrative expenses.
The move was necessary to handle not only the increased inventory and pre-delivery checks,
but also the rising level of after-sales warranty work caused by manufacturing defects in the
new phone.
The company has maintained its warranty policy of providing for 1% of revenue each year.
The movements in the warranty provision for the current year are as follows.
£'000
At 31 August 20X0 262
Provision for year 160
Provision used (94)
At 31 August 20X1 328

Draft accounts of Digicom Distributors Ltd as at 31 August 20X1 were as follows:
Statement of profit or loss and other comprehensive income for the year ended
31 August 20X1
20X1 20X0
£'000 £'000
Revenue 16,000 5,200
Cost of sales (12,400) (4,264)
Gross profit 3,600 936
Distribution costs (837) (425)
Administrative expenses (2,253) (609)
Operating profit/(loss) 510 (98)
Finance costs (320) (35)
Profit/(loss) before tax 190 (133)
Tax on profit or loss (15) (10)
Profit/(loss) for the period 175 (143)
Revaluation surplus 400 –
Total comprehensive income 575 (143)
Statement of financial position as at 31 August 20X1

20X1 20X0
Non-current assets £'000 £'000 £'000 £'000
Intangible assets 1,669 829
8,292 3,393
Current assets
Inventories 778 520
Receivables 814 215
1,842 1,135
Current liabilities
Bank overdrafts 975 150
Trade payables 2,734 678
3,709 828
Net current assets/(liabilities) (1,867) 307
C
Total assets less current liabilities 6,425 3,700
H
Non-current liabilities A
Bank loan (2,084) – P
Provisions (328) (262) T
4,013 3,438 E
R
Share capital 100 100
Revaluation reserve 900 500
24
4,013 3,438
Requirement
Assess the profitability, liquidity and solvency of the company.
2 CD Sales plc
CD Sales plc, a listed company, was a growth-orientated company that was dominated by its
managing director, Mr A Long. The company sold quality music systems direct to the public. A
large number of salespersons were employed on a commission-only basis. The music systems were
sent to the sales agents who then sold them direct to the public using telephone sales techniques.
The music systems were supplied to the sales agents on a sale or return basis and CD Sales
recognised the sale of the equipment when it was received by the sales agents. Any returns of the
music systems were treated as repurchases in the period concerned.

The company enjoyed a tremendous growth record. The main reasons for this apparent expansion
were as follows.
(1) Mr A Long falsified the sales records. He created several fictitious sales agents who were
responsible for 25% of the company's revenue.
(2) At the year end, Mr Long despatched nearly all of his inventories of music systems to the sales
agents and repurchased those that they wished to return after the year end.
(3) 20% of the cost of sales was capitalised. This was achieved by falsification of the purchase
invoices with the co-operation of the supplier company. Suppliers furnished the company
with invoices for non-current assets but supplied music systems.
(4) The directors of the company enjoyed a bonus plan linked to reported profits. Executives
could earn bonuses ranging from 50% to 75% of their basic salaries. The directors did not
query the unusually rapid growth of the company, and were unaware of the fraud perpetrated
by Mr A Long.
Mr A Long spent large sums of money in creating false records and bribing accomplices in order to
conceal the fraud from the auditor. He insisted that the auditor should sign a 'confidentiality'
agreement which effectively precluded the auditor from corroborating sales with independent third
parties, and from examining the service contracts of the directors. This agreement had the effect of
preventing the auditor from discussing the affairs of the company with the sales agents.
The fraud was discovered when a disgruntled director wrote an anonymous letter to the stock
exchange concerning the reasons for the CD Sales growth. The auditor was subsequently sued by a
major bank that had granted a loan to CD Sales on the basis of interim financial statements. These
financial statements had been reviewed by the auditor and a review report issued.
Requirements
(a) Explain the key audit procedures which would normally ensure that such a fraud as that
perpetrated by Mr A Long would be detected.
(b) Discuss the implications of the signing of the 'confidentiality' agreement by the auditor.
(c) Explain how the 'review report' issued by the auditor on the interim financial statements
differs in terms of its level of assurance from the auditor's report on the year-end financial
statements.
(d) Discuss whether you feel that the auditor is guilty of professional negligence in not detecting
the fraud.
3 Makie Ltd
You are the audit manager for the audit of Makie Ltd, a UK company operating in the
manufacturing sector.
During the audit this year, the audit junior identified that the stores manager had been creating
false purchases, creating suppliers on the purchase ledger with his own bank account details.
He had attempted to conceal the fraud by creating false orders, goods received notes and purchase
invoices. The fraud was identified when this supplier was selected for creditor circularisation. It is
apparent that this fraud took place over a period of at least three years.
The finance director estimates that the fraud has cost the company £500,000 which is material to
The MD is blaming the auditors for not detecting this fraud and is threatening to sue the firm for
negligence.
Requirements
(a) Draft a letter to the MD explaining the following:
 The responsibilities of directors and auditors relating to fraud
 The procedures required by professional standards in relation to fraud
(b) Draft an email to the audit partner giving your opinion as to whether the firm is negligent.

4 Redbrick plc
Redbrick plc is a listed company operating in the civil engineering business generating an annual
revenue of £350 million. Your firm has been the auditors of this company for many years.
The assignment partner received the following letter from the chairman of the audit committee of
Redbrick plc.
'It has come to light that the MD and FD of one of our smaller subsidiaries, Tharn Ltd, have
been engaging in fraudulent activities for some years. This has included use of Redbrick plc's
assets on contracts for their own benefit. (They set up their own company particularly for this
purpose.)
Also it looks as if there has been accounting manipulation that has caused profits and revenue
to be recognised inappropriately thus enhancing the performance of Tharn Ltd, although
there is no suggestion of misappropriation of assets in this case.
Quite frankly I am not sure why we have been paying you as auditors all these years when you
cannot discover such obvious fraud as this appears to be. I do not expect a detailed evaluation
of the matter at this stage but I would like some explanation of why this problem has not
been discovered and reported by you.'
The revenue of Tharn Ltd was £12 million in the last financial year. Tharn Ltd specialises in drainage
construction, enhancement and clearance.
Requirement
As an audit senior, draft a response for the assignment partner to the letter from the chairman of
the audit committee of Redbrick plc.
C
H
A
P
T
E
R
24

Technical reference
1 ISA 240
 Auditor's objectives relating to fraud ISA 240.10
 Assess risk of material misstatement ISA 240.16–.27
 Responding to assessed risks ISA 240.28–.33
 Reporting fraud ISA 240.40–.43R-1
2 ISA 315
 Risk assessment procedures ISA 315.5–.10


ROCE = 820/6,450 = 12.71%
Profit margin = 820/6,000 = 13.67%
Asset turnover = 6,000/6,450 = 0.93 times
Capital employed = equity + non-current liabilities + current liability for interest bearing borrowings –
cash and cash equivalents = 4,090 + 2,445 + 195 – 280
Using the two alternative definitions of the capital employed yields
(a) Capital employed = total assets – current liabilities = 7,370 – 835 = 6,535
ROCE = 820/6,535 = 12.55%
(b) Capital employed = total assets – adjusted current liabilities = 7,370 – 640 = 6,730
ROCE = 820/6,730 = 12.18%
When alternative definitions of capital employed are used, there is a small impact on ROCE.

Industry revenues are expected to grow by 20% in 20X7 to reach £2,136 million. The market share of
GeroCare has been stable at about 15% for the last 5 years. Assuming the market share remains the
same in 20X7, the forecast revenues for GeroCare are £320 million (= 0.15  £2,136m).

Revenue
The asset turnover ratio defined as will produce a rough estimate of the assets
Non-current assets
required to produce the new level of sales. The factors that will affect the accuracy of this ratio are: (a)
its stability over time (b) the mix between new capital expenditure for expansion and replacement and C
(c) the level of capital efficiency. H
A
P
E
According to the clean surplus model, equity is determined solely by retained earnings. For 20X7 the R
predicted earnings are £27 million and dividend payments £8 million. Retained earnings therefore for
20X7 amount to £19 million and adding this amount to the value of equity at 31 December 20X6 yields
the level of equity for 31 December 20X7, namely £69 million. 24

In this situation the issues that should be raised are as follows:
(a) The audit is likely to be higher risk than in previous years due to the receipt of the anonymous
letter.
(b) The letter that has been received must be treated with the strictest confidence.
(c) There will need to be a thorough review of journal activity and any unusual ones should be
brought to the attention of the audit manager for discussion with the client.
(d) Given that the company is hoping to expand, the team need to be made aware of the fact the
company will be under pressure to present a strong financial performance and position in order to
acquire the necessary finance.
(e) Incidences of management override of controls will need to be noted as they may indicate fraud.

Management may not be aware of the letter and so the auditor will have to proceed with caution.
There will be some general queries that the auditor should make. These will need to be ascertained from
the client management, internal audit and employees.
 How management identify and address fraud
 Whether or not they are aware of any incidences of fraud
 If so, what the fraudulent activity was and what impact, if any, it had on the financial statements.
What controls, if any, have been implemented to address the deficiencies of the system
The auditor will also have to link the findings of the above inquiries to the anonymous letter to ascertain
its validity.
The auditor should ask for draft accounts to review revenue for reasonableness. The reason for any
unusual fluctuations should be discussed with management and validated. The auditor should also
ascertain whether or not there have been any changes in accounting policy, as this may validate the
journals.
The auditor should also ascertain whether there have been any changes in key personnel and the
reasons behind the change. It may be possible that the person who wrote the letter was sacked by the
company for querying the journal entries.
In addition, the auditor should ascertain the trading conditions of the client and identify any pressures
that management may be under to misstate the financial statements.
(Check the following sections in ISA (UK) 240 if you struggled to answer this question: ISA 240.17,
ISA 240.32, ISA 240.A41–.A44.)

In this scenario there are a large number of factors that should alert the auditors to the possibility of
misstatements arising from fraudulent financial reporting, and others that could indicate a risk of
misstatements arising from misappropriation of assets.
(1) Operating conditions within the industry
The failure of a competitor in a highly competitive business sector highlights the threat to the
survival of a business such as Sellfones and this could place the directors under pressure to
overstate the performance and position of the company in an attempt to maintain investor
confidence, particularly given the intention to raise new share capital.
Financial statement issue
This could mean that revenue may be overstated and costs understated. In addition, the
appropriateness of going concern as a basis for the preparation of the financial statements will
need to be questioned. This will be a particular issue if there is no alternative source of finance for
the expansion. The shareholders may be unwilling to purchase more shares if the market is
struggling.
(2) Management structure and incentives
It is not clear in the scenario how much involvement the new divisional managers have in the
financial reporting process but the auditors would need to examine any reports prepared or
reviewed by them very carefully, as their personal interest may lead them to overstate results in
order to earn their bonuses.
Revenue may be overstated and bonuses may not be calculated correctly or properly accrued for.
(3) New inventory system/chief accountant
The problems with the implementation of the new inventory system suggest that there may have
been control deficiencies and errors in the recording of inventory figures. Misstatements, whether
deliberate or not, may not have been identified. The amount of time spent by the chief accountant

on the implementation of the new inventory system could be seen as merely highlighting the
severity of the problems, but the fact that he has not taken any leave should also be considered as
suspicious and the auditors should be alert to any indication that he may have been involved in any
deliberate misstatement of figures.
Inventory may not be correctly stated and this will impact on profit and current assets. In addition,
inventory may not be appropriately valued, as net realisable value could be lower given the
collapse of the main competitor and cheaper products being available on the internet.
(4) Results
The year on year results look better than might be expected given the business environment. The
gross profit margin has increased to 32.8% (20X6 28.9%) and the operating profit margin has
increased to 5% (20X6 3.9%). This seems to conflict with what is known about the industry and
should increase the auditors' professional scepticism in planning the audit.
This links up with overstatement of revenue, understatement of costs, manipulation of the
inventory figure and the incentive for the branch managers to misstate performance.
(5) Exceptional gain
The sale and leaseback transaction may involve complex considerations relating to its commercial
substance. It may not be appropriate to recognise a gain or the gain may have been miscalculated.
The transaction may not have been correctly accounted for. It could be a means of enhancing
performance by treating the leaseback as an operating lease when in fact it may be more
appropriate to treat it as a finance lease. This could mean that non-current assets and more
importantly liabilities may be understated.
(6) Time pressure on audit
The auditors should be alert to the possibility that the tight deadline may have been set to reduce
the amount of time the auditors have to gather evidence after the end of the reporting period and
this may have been done in the hope that certain deliberate misstatements will not be discovered.
C
The pressure may lead to an increased chance of errors creeping into the financial statements. H
A
(7) Risk of misappropriation of assets
P
The nature of the inventories held in the shops increases the risk that staff may steal goods. The risk T
E
is perhaps increased by the fact that the attitude of the staff towards their employer is likely to have R
been damaged by the cut in their Christmas bonus. The problems with the new inventory
recording system increase the risk that any such discrepancies in inventory may not have been
identified. A manual inventory count should be considered for the year end and a review of the 24
results of any reconciliations between physical inventory and that recorded on the system will be
important.
Once again, inventory may be misstated, especially if the new system is relied on.
Overall, this year's audit will be a high risk one given the changes to the business, the market conditions,
the bonus issues for divisional managers and the potential lack of completeness and accuracy of the
inventory records.

Having assessed the audit of Dupi Ltd as high risk, the following steps will now need to be taken.
(a) It is likely that staff who are familiar with the client and who have experience of high risk audits
should be assigned to this audit.

(b) The letter states that revenue could be misstated and as a result further work on the relevance of
the accounting policy and appropriateness of any changes will need to be carried out. The team
should also look out for potential understatement of expenses. Cut-off will be a risky area and one
that could easily be manipulated in order to overstate performance.
(c) The auditor should consider whether it is worth performing surprise visits. This may be of use when
looking at the area of internal controls in the revenue cycle, especially where there are instances of
management override. The auditor will need to focus on the results of any tests of control in the
revenue cycle and the reasons behind any breakdown in the controls. The level of substantive
testing may need to be increased as a result of lack of reliance on control procedures.
(d) Test the appropriateness of journal entries recorded in the general ledger and other adjustments
made in the preparation of the financial statements. Reasons for journal entries to revenue should
be ascertained and corroborated with other audit evidence. It is unlikely that revenue can simply be
overstated without impacting on other areas of the financial statements – are there any
recoverability issues with receivables? This could indicate false sales.
(e) Detailed post year end work on cut-off and reversal of journal entries should be carried out to
identify any window dressing transactions. Credit notes may have been issued after the year end to
reverse out the revenue increase.
Finally, the auditor's knowledge of the client will also be a factor in determining the audit procedures for
Dupi Ltd. The auditor will need to check whether or not there have been any issues with management
integrity or incompetence in previous audits. This would indicate that a lesser degree of reliance can be
placed on written representations by management and more reliance will be required from external
third-party evidence.

1 Digicom Distributors Ltd

Assessments
Profitability
The company's gross profit margin is strengthening due to the South Korean phone, which can be
purchased at very competitive prices and still be sold at half the price of competitive products. This
can be further illustrated by comparing the 207% increase in revenue with a 285% increase in
gross profit.
Similarly, overheads have only increased by 199%, even including one-off relocation expenses.
Therefore, costs are being controlled despite the expansion, and the net margin is also
strengthening. However, the overheads do not include all charges for advertising (see below). If
these were included net profit would clearly fall. In addition, the company's warranty provisions do
not appear to be calculated correctly and the expense is probably understated.
Return on capital employed has improved on the previous year, as the company has turned from a
loss-making position to a profit. However, ROCE may be misleading, as there is some doubt as to
the suitability of capitalising advertising expenditure and/or the cost of distribution rights. If these
were charged as expenses, the company would continue to be in a loss-making position.
The improving profitability of the company is very reliant on the continued success of the South
Korean phone and, in a rapidly changing industry, this cannot be guaranteed.
Liquidity
Liquidity has deteriorated in the period, as evidenced by both the current and quick ratios. The
company has insufficient current assets from which to meet its current liabilities as they fall due.
This is coupled with very clear signs of overtrading, whereby the inventory turnover ratio has
increased dramatically on the previous year. The company is holding very low levels of inventory
compared to its increased levels of revenue, which may result in stock-outs and loss of goodwill.
This low level of inventory appears to be caused by insufficient funds to finance the purchase of
inventory. The company must raise further long-term finance if serious liquidity problems are to be
avoided. C
H
Solvency A
P
The company is highly geared. Moreover, the gearing ratio in the appendix does not include the T
excessive overdraft included in current liabilities. Hence, actual gearing is even higher. Similarly, E
interest cover at 1.6 times is poor. R
The company must raise more funds to survive, particularly if further expansion is to continue.
However, lenders will see Digicom Distributors Ltd as a high risk investment and will therefore 24
expect a high return.

Appendix: Accounting ratios
Year ended 31 August
20X1 20X0
Profitability
Return on capital employed
Operating profit 510 (98)
  7.9%  (2.6)%
Total assets – Current liabilities 6,425 3,700
Gross profit margin

Gross profit 3,600 936
  22.5%  18.0%
Revenue 16,000 5,200
Efficiency
Asset turnover
Revenue 16,000 5,200
  2.5 times  1.4 times
Total assets – Current liabilities 6,425 3,700
Inventory turnover
Cost of sales 12,400 4,264
  15.9 times  8.2 times
Inventories 778 520
Receivables collection period
Re ceivables 814 215
  365  365  62 days  365  50 days
Credit sales 16,000  30% 5,200  30%
Payables payment period

Payables 2,734 678
  365  365  80 days  365  58 days
Cost of sales 12,400 4,264
Liquidity
Current ratio
Current assets 1,842 1,135
  0.50  1.37
Current liabilities 3,709 828
Quick ratio
Current assets – Inventory 1,842 – 778 1,135 – 520
  0.29  0.74
Current liabilities 3,709 828
Solvency
Debt/equity ratio
Long-term debt 2,084
=  0.52
Capital and reserves 4,013
Interest cover
Operating profit 510
  1.6
Interest 320

2 CD Sales plc
(a) There are various key audit procedures which would have uncovered the fraud perpetrated by
Mr A Long. Note that the first two tests would bring to the attention of the auditor the
substantial inherent and control risk surrounding the accounts of CD Sales, thus increasing the
perceived audit risk, and putting them on their guard.
Analytical procedures
The auditor should perform analytical procedures in order to compare the company's results
with those of other companies in the same business sector. In particular, the audit should look
at sales growth rates and gross profit margins, but also inventory holding levels, non-current
assets and return on capital. This should indicate that the company's results are unusual for
the sector, to a great extent.
Review of service contracts
The auditor should examine the directors' service contracts. It is unusual for all directors to be
paid such substantial bonuses, although the payment of bonuses of some sort to directors is
common business practice. It is the size of the bonuses in proportion to the directors' base
salaries which is the problem here. It increases both the inherent and control risk for the
auditor because it reduces the directors' objectivity about the performance of the company.
Audit risk is thus increased.
Testing of sales, purchases and inventories
(i) The main audit test to obtain audit evidence for sales would be to require direct
confirmations from the sales agents. These confirmations would also provide evidence for
the balance owed to CD Sales at the year end and the inventories held by the agent at
the year end. Replies to such confirmations should be sent direct to the auditor who
would agree the details therein to the company's records or reconcile any differences.
Where replies are not received, alternative procedures would be carried out which might
include visits to the agents themselves to examine their records.
(ii) A selection of agents should, in any case, be visited at the year end to confirm the
inventories held on sale or return by physical verification. The auditor should count such
inventories and consider obsolescence, damage etc.
(iii) Fictitious agents might be discovered by either of test (i) or (ii), but a further specific
procedure would be to check authorisation of and contracts with all sales agents.
Correspondence could also be reviewed from throughout the year. C
H
(iv) The practice of 'selling' all the inventories to the agents and then repurchasing it after the A
year end should be detected by sales and purchases cut-off tests around the year end. All P
transactions involving inventory items returned after the year end should be examined. T
E
Testing of non-current assets R
Non-current asset testing should help to identify inventory purchases which have been
invoiced as non-current assets.
24
(i) Samples of additions to non-current assets can be checked to the non-current asset
register and to the asset itself.
(ii) Physical verification will ensure that an asset is being used for the purposes specified, and
this should be relatively straightforward to check as the assets will each have individual
identification codes.
(iii) Where the assets cannot be found, then it may be possible to trace the asset to
inventories, perhaps via the selling agents' confirmation, or to sales already made.
Related parties
The level of collusion with suppliers makes detection of fraud difficult, but the auditor may be
put on guard if he discovers that the suppliers are related parties to CD Sales. A related party
review would normally take place as part of an audit.

(b) The type of 'confidentiality agreement' signed by the auditor of CD Sales reduces the scope of
the audit to such an extent that it has become almost meaningless.
While it is understandable that companies would wish to protect sensitive commercial
information, the auditor has the right to any information he feels is necessary in the
performance of his duties. This agreement clearly circumvents that right. Moreover, such
information would still be protected if released to the auditor, because the auditor is under a
duty of confidentiality to the client.
In reducing the scope of the audit to this extent, the agreement prevents the auditor
obtaining sufficient appropriate evidence to support an audit opinion. The auditor's report
should therefore be modified on the grounds of insufficient evidence, possibly to the extent of
a full disclaimer.
In failing to issue such a modification, the auditor may well have acted negligently and even
unlawfully in signing such an agreement.
(c) A review of interim accounts is very different from an audit of year-end financial statements. In
an auditor's report a positive assurance is given on the truth and fairness of the financial
statements. The level of audit work will be commensurate with the level of assurance given;
that is, it will be stringent, testing the systems producing the accounts and the year-end
figures themselves using a variety of appropriate procedures.
In the case of a review of interim financial statements, the auditor gives only negative
assurance, that he has not found any indication that the interim accounts are materially
misstated. The level of audit work will be much less penetrating, varied and detailed than in a
full audit. The main audit tools used to obtain evidence will be analytical procedures and
direct inquiries of the company's directors.
(d) It is not the duty of the auditor to prevent or detect fraud. The auditor should, however,
conduct the audit in such a way as to expect to detect any material misstatements in the
financial statements, whether caused by fraud or error. The auditor should undertake risk
assessment procedures in order to assess the risk that fraud is occurring both at the financial
statement and the assertion level and plan his procedures accordingly. Where fraud is
suspected or likely, the auditor must carry out additional procedures in order to confirm or
deny this suspicion.
Even if a fraud is uncovered after an audit, the auditor will have a defence against a
negligence claim if it can be shown that auditing standards were followed and that no
indication that a fraud was taking place was received at any time.
Application of principles
In this particular case, Mr A Long has taken a great deal of trouble to cover up his fraudulent
activities, using accomplices, bribing people, cooking up fictitious documents etc. When such
a high-level fraud is carried out, the auditor might find it extremely difficult to uncover the
true situation or even realise anything was amiss. The auditor is also entitled to accept the
truth of representations made to him and documents shown to him which purport to come
from third parties.
On the other hand, the auditor should have a degree of professional scepticism. The auditor
should be aware of the risks pertaining to actions. The suspicions of the auditor should have
been aroused by the rapid growth rate of the company and fairly standard audit procedures
on cut-off and non-current assets should have raised matters which required explanation.
Where the auditor has been most culpable, however, is in signing the confidentiality
agreement. This restricted the scope of the audit to such an extent that the auditor should
have known that there was insufficient evidence to support their opinion. The auditor will
therefore find it difficult to defend a negligence claim.

3 Makie Ltd
(a) A N Auditors
Any Street
Any Town
Managing Director
Makie Ltd
Any Road
Any Town
Dear Sir
Fraud at Makie Ltd
I refer to the recently discovered fraud during the audit for this year. I appreciate your feelings
on this subject and thought it might be helpful if I could summarise the auditors' and
directors' responsibilities in this area.
In addition, as I am sure you are aware, auditors must follow professional standards and I
thought you might find a summary of these rules useful.
Responsibility for fraud
The responsibility for preventing and detecting fraud lies with those charged with governance
of Makie Ltd (the management). Fraud is normally prevented by implementing internal
controls which should be regularly reviewed for robustness and errors by those charged with
governance. The auditor considers the risk of material misstatement in the financial
statements whether due to fraud or error, and adapts the audit procedures as necessary to
reduce risk to an acceptably low level.
The auditor cannot be held responsible for the prevention of fraud under any circumstances. If
a fraud is uncovered, the auditor will assess its materiality and may carry out additional tests.
The detection of fraud is not the objective of the audit as stated in the engagement letter, so
the auditor cannot be held responsible.
Professional standards
An auditor considers the risk of fraud and error in the financial statements, and aims for the
financial statements to be free of material misstatements whether caused by fraud or error. If a
fraud is detected, we are required to investigate the matter further. We managed to
C
investigate in this case and revealed the full extent of the fraud, which was well concealed and H
complex. We are also required to consider the risk of fraud when planning an audit as part of A
our risk assessment procedures, including understanding how management assess risk of P
fraud and the systems and controls they have put in place to detect and prevent it. T
E
In addition, we consider whether any specific factors exist that may increase the risk of a fraud R
occurring and design the nature, timing and extent of our audit procedures to give us the
best chance of detecting material fraud or errors.
24
We also consider that, regardless of management integrity in previous years, it is possible that
a fraud could still be committed by management or senior staff.
Having said this, it can never be guaranteed that an audit will detect a fraud, and there is a
chance that even material frauds will be missed, perhaps due to them not appearing in our
samples or due to their complexity.
I hope the above points help you to appreciate our respective responsibilities in this area, but
if further clarification is needed I would be delighted to meet you to discuss this further.
Yours faithfully
Audit Manager

(b) Draft email
To: Audit Partner
From: Audit Manager
Subject: Makie fraud
I have written to the MD of Makie summarising our respective responsibilities for preventing
and detecting fraud, and the work required by our professional standards in this area.
I hope this letter resolves the scenario, but the MD is threatening to sue the firm for
negligence.
In order to prove negligence, the MD would have to prove that the firm didn't follow
professional standards. As the standards clearly state that the responsibility for prevention and
detection lies with management, this should not be an issue, although we do have a duty of
care and a loss has been suffered.
I feel it is very unlikely that a claim would succeed in court but, due to negative publicity this
would attract, we may wish to consider an out of court settlement if the situation escalates.
I will keep you informed of all developments.
Audit Manager.
4 Redbrick plc
To: The chairman of the audit committee of Redbrick plc
From: Audit senior
Date: XX/XX/XXXX
Subject: Draft response to letter concerning Tharn Ltd
Thank you for your letter regarding the matters that have occurred in Tharn Ltd. This response only
sets out our general responsibilities as auditors in respect of the discovery of fraud and error.
ISA (UK) 240 (Revised June 2016) The Auditor's Responsibilities Relating to Fraud in an Audit of
Financial Statements is the auditing standard which deals with auditors' responsibilities in these
cases.
The definition of fraud in ISA 240.11a is:
'Fraud is the intentional act by one or more individuals among management, those charged with
governance, employees, or third parties, involving the use of deception to obtain an unjust or
illegal advantage.'
It would appear on the basis of your letter as though the MD and FD of Tharn Ltd may have
committed two types of fraud:
 Intentional misstatements resulting from fraudulent financial reporting (this can include
misstated measurements resulting in the overstatement of revenue as you suggest the MD
and FD have done)
 Intentional misstatements resulting from misappropriation of assets (this can include using
business assets for personal use as in this case)
The responsibilities of those charged with governance and management
in the context of fraud
The primary responsibility for the prevention and detection of fraud rests with both those charged
with governance and management. This is likely to include the audit committee. Management
should therefore have put in place appropriate procedures to prevent and detect fraud which may
 A culture of honesty
 Ethical behaviour policy and corporate guidelines
 Appropriate internal controls
 Appropriate policies for hiring, training and promoting employees

Inherent limitations of an audit in the context of fraud
ISAs recognise that there are inherent limitations in an audit whereby material misstatements may
arise even where an audit is properly carried out. As a result, only reasonable assurance can be
given, not absolute assurance.
You do not suggest the value of the fraudulent activity but, given the size of Tharn Ltd in the
context of the Redbrick group, the materiality may be relatively small in the group financial
statements, if not in Tharn's own financial statements, although this matter would need to be
ascertained.
The risk of a material misstatement is higher from fraud than it is from error, as fraud can be
complex and sophisticated and, by its nature, it is likely to be concealed to a greater or lesser
extent. If there was any collusion between the MD and the FD then the concealment may be
greatest. This is particularly the case given the seniority of their positions and thus their ability to
override internal controls.
The probability of detection in the audit process will also depend on:
 the skill of the perpetrator(s)
 the scale of the fraud
 the frequency of the fraud
 the internal controls of the company
The responsibilities of the auditor for detecting material misstatement due to fraud
An auditor is required to obtain reasonable assurance that the financial statements, taken as a
whole, are free from material misstatement whether caused by fraud or error. Absolute assurance is
not possible therefore the discovery of fraud after the event does not of itself indicate that the audit
has not been carried out in accordance with ISAs.
Audit evidence is persuasive, rather than conclusive; thus, for instance, normal reasonable reliance
on internal controls can be rendered invalid by collusion.
Further evidence
Further evidence should be obtained as a matter of urgency to ascertain the nature, scope and
materiality of the fraud. At that stage we can provide a more detailed response to the specific
matters you raise.
C
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CHAPTER 25
Assurance and related

services
Introduction
Topic List
1 Assurance
2 Engagements to review financial statements
3 Due diligence
4 Reporting on prospective information
5 Agreed-upon procedures
6 Compilation engagements
7 Forensic audit
Technical reference
1369
Introduction
 Explain the nature of a range of different assurance engagements
 Evaluate the evidence necessary to report at the appropriate level of assurance

 Evaluate risk in relation to the nature of the assurance engagement and the entity or
process for a given scenario
 Design and determine procedures necessary to attain the relevant assurance objectives in
a potentially complex scenario
 Explain the roles and responsibilities that auditors may have with respect to a variety of
different types of information and design procedures sufficient to achieve agreed
objectives
 Explain the nature and purposes of due diligence procedures (for example: financial,
commercial, operational, legal, tax, human resources) and plan procedures required to
achieve a range of differing financial objectives
 Appraise and explain the nature and purpose of forensic audit and prepare and plan
procedures required to achieve a range of differing objectives
Specific syllabus references for this chapter are: 16(a)–(d), 17(b)–(d)

1 Assurance
Section overview
 You have covered the concept of assurance and the principles in ISAE 3000 (Revised) in your
earlier studies. This section provides a brief summary.
 ISAE 3402 and ISAE 3410 apply ISAE 3000 (Revised) to an engagement to report on controls at a
service organisation and engagements to report on greenhouse gas statements.
 ISAE 3420 concerns reporting on the pro forma information contained in a prospectus.
1.1 Introduction
You have been introduced to the concept of Assurance and International Standard on Assurance
Engagements (ISAE) 3000 (Revised) Assurance Engagements Other than Audits or Reviews of Historical
Financial Information in the Assurance and Audit & Assurance papers at the Professional Level. The
remainder of section 1 provides revision of the key points.
Note: ISAEs have not been adopted in the UK.
1.2 Concept of assurance
Definition
Assurance engagement: An assurance engagement is one in which a practitioner aims to obtain
sufficient appropriate evidence in order to express a conclusion designed to enhance the degree of
confidence of the intended users other than the responsible party about the outcome of the evaluation
or measurement of a subject matter against criteria.
The most common type of assurance engagement is the audit. This has been covered earlier in this
Study Manual.
1.3 Assurance engagements other than audits or reviews of historical financial

information
ISAE 3000 (Revised) establishes basic principles and essential procedures for the performance of
assurance engagements. It does not concern audits or reviews of historical financial information which
are covered by ISAs and International Standards on Review Engagements (ISREs).
ISAE 3000 (Revised) distinguishes between the two types of assurance engagement:
 Reasonable assurance engagements aim to reduce assurance engagement risk to an acceptably
low level in the circumstances of the engagement as the basis for the assurance practitioner's
conclusion. The practitioner's conclusion is expressed in a form that conveys the practitioner's
opinion on the outcome of the measurement or evaluation of the underlying subject matter against C
criteria. H
A
 Limited assurance engagements give a lower level of assurance. The nature, timing and extent P
of the procedures carried out by the practitioner in a limited assurance engagement would be T
limited compared with what is required in a reasonable assurance engagement. Nevertheless, the E
procedures performed should be planned to obtain a level of assurance which is meaningful, in the R
practitioner's professional judgement. To be meaningful, the level of assurance obtained by the
practitioner is likely to enhance the intended users' confidence about the subject matter
information to a degree that is clearly more than inconsequential. 25
Assurance and related services 1371

Some of the salient points here may be summarised thus.
Assurance Level of risk Conclusion Procedures Example
Reasonable Low Positive expression – High 'The management

opinion expressed has operated an
effective system of
internal controls'
Limited Acceptable in the Negative expression Limited, but still 'Nothing has come
circumstances – whether matters provides a to our attention
have come to meaningful level of that indicates
attention indicating assurance significant
material deficiencies in
misstatement internal control'
Notes
1 The statutory audit is an example of a reasonable assurance engagement.
2 Remember the negative expression of opinion provides assurance of something in the absence of
any evidence arising to the contrary. In effect the auditor is saying, 'I believe that this is reasonable
because I have no reason to believe otherwise'.
Assurance engagements performed by professional accountants are normally intended to enhance the
credibility of information about a subject matter by evaluating whether the subject matter conforms in
all material respects with suitable criteria, thereby improving the likelihood that the information will
meet the needs of an intended user. In this regard, the level of assurance provided by the professional
accountant's conclusion conveys the degree of confidence that the intended user may place on the
credibility of the subject matter.
There is a broad range of assurance engagements, which may include any of the following areas:
(a) Engagements to report on a wide range of subject matters covering financial and non-financial
information
(b) Attestation engagements (where the underlying subject matter has not been measured or
evaluated by the practitioner, and the practitioner concludes whether or not the subject matter
information is free from material misstatement) and direct engagements (where the underlying
subject matter has been measured and evaluated by the practitioner, and the practitioner then
presents conclusions on the reported outcome in the assurance report)
(c) Engagements to report internally and externally
(d) Engagements in the private and public sector
Specific examples of assurance assignments include the following:
 Assurance attaching to special purpose financial statements
 Adequacy of internal controls
 Reliability and adequacy of IT systems
 Environmental and social matters
 Risk assessment
 Regulatory compliance
 Verification of contractual compliance
Elements of an assurance engagement
An assurance engagement will normally exhibit the following elements.
(a) A three-party relationship involving:
(i) a practitioner (the auditor or member of the engagement team)
(ii) a responsible party (the client company)
(iii) an intended user (eg, investors, regulators)
(b) Subject matter (ie, the information or issue to be attested)

(c) Suitable criteria (ie, standards or benchmarks to evaluate the subject matter)
(d) Evidence (sufficient appropriate evidence needs to be gathered to support the required level of
assurance)
(e) An assurance report (a written report containing the practitioner's assurance conclusion is issued
to the intended user, in the form appropriate to a reasonable assurance engagement or a limited
assurance engagement)
Acceptance and continuance
The practitioner must consider a number of factors before accepting or continuing an assurance
engagement. These include whether:
 there is any reason to believe that relevant ethical requirements will not be satisfied;
 the practitioner is satisfied that the team have the appropriate competence and capabilities; or
 the basis on which the engagement is to be performed has been agreed.
The practitioner must also establish whether the preconditions for an assurance engagement are present.
Planning
Planning an assurance engagement will normally include consideration of the following:
 Terms of the engagement
 The expected timing and nature of the communication required
 Characteristics of the subject matter and the identified criteria
 The engagement process
 Understanding the entity, the environment and the risks
 Identifying intended users and their needs
 The extent to which the risk of fraud is relevant
 Resource requirements to complete the assignment
 The impact of the internal audit function
The practitioner should also:
 obtain an understanding of the subject matter;
 assess the suitability of the criteria to evaluate or measure the subject matter; and
 consider materiality and engagement risk.
Obtaining evidence
The practitioner should obtain sufficient appropriate evidence on which to base the conclusion. The
practitioner must consider risk and appropriate responses to those risks depending on whether the
assurance engagement is a limited assurance engagement or a reasonable assurance engagement. The
practitioner may also:
 obtain representations from responsible parties;
 consider the effect of subsequent events; and
 consider the effect of work performed by a practitioner's expert or an internal auditor.
Conclusions
The professional accountant must express a conclusion in writing that provides a level of assurance as to
whether the subject matter conforms in all material respects with the identified suitable criteria. C
H
The ISAE does not require a standardised format for reporting. However, it states that the assurance A
report will normally include the following elements: P
T
 A title that indicates the report is an independent assurance report E
R
 An addressee
 An identification or description of the level of assurance obtained by the practitioner
25
 The subject matter information (the outcome of the measurement or evaluation of the underlying
subject matter against the criteria; for example, 'The company's internal controls operated
effectively in terms of criteria X in the period')

 When appropriate, identification of the underlying subject matter (the phenomenon that is
measured or evaluated; for example, the interim financial statements for the six months ended
31 March 20X5 in a review of interim financial statements)
 An identification of the applicable criteria (assertions, measurement methods, interpretations,
regulations)
 A description of significant inherent limitations (for example, noting that a historical review of
internal controls does not provide assurance that the same controls will continue to operate
effectively in the future)
 When the applicable criteria are designed for a specific purpose, a statement alerting readers to
this fact and that, as a result, the subject matter information may not be suitable for another
purpose
 Responsible parties and their responsibilities, and the practitioner's responsibilities
 Statement that the work was performed in accordance with ISAE 3000 (Revised) (or another subject
matter specific ISAE, where relevant)
 A statement that the firm of which the practitioner is a member applies ISQC 1, or other equivalent
 A statement that the practitioner complies with the independence and other ethical requirements
of the IESBA Code (or equivalent)
 An informative summary of work performed (including, for limited assurance engagements, a
statement that the nature, timing and extent of work performed is different from that carried out
for a reasonable assurance engagement, and therefore a substantially lower level of assurance is
provided)
 Conclusion
 Signature
 Report date
 Location of practitioner giving the report
The practitioner's conclusion provides a level of assurance about the subject matter. Absolute assurance
is generally not attainable as a result of such factors as:
 the use of selective testing;
 the inherent limitations of control systems;
 the fact that much of the evidence available to the practitioner is persuasive rather than conclusive;
 the use of judgement in gathering evidence and drawing conclusions based on that evidence; and
 in some cases, the characteristics of the subject matter.
Therefore, practitioners ordinarily undertake engagements to provide one of only two distinct levels:
reasonable assurance and limited assurance. These engagements are affected by various elements; for
example, the degree of precision associated with the subject matter, the nature, timing and extent of
procedures, and the sufficiency and appropriateness of the evidence available to support a conclusion.
Unmodified and modified conclusions
An unmodified opinion is expressed when the practitioner concludes the following:
 In the case of a reasonable assurance engagement, that the subject matter information is prepared,
in all material respects, in accordance with the applicable criteria
 In the case of a limited assurance engagement, that, based on the procedures performed and the
evidence obtained, no matters have come to the attention of the practitioner that causes them to
believe that the subject matter information is not prepared in all material respects, in accordance
with the applicable criteria.
A modified conclusion will be issued where the above does not apply.
1.3.1 Conforming amendments

A number of conforming amendments have been made to ISAE 3000 (Revised) resulting from the
changes made to ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements by the

IAASB following the conclusion of its NOCLAR (non-compliance with laws and regulations) project.
These become effective for periods beginning on or after 15 December 2017. The key points are as
follows:
Planning and performing the engagement
The practitioner may have additional responsibilities under law, regulation or ethical requirements
regarding non-compliance with laws and regulations which differ or go beyond responsibilities under
ISAE 3000.
Communication with management and those charged with governance
Issues surrounding the requirement to communicate suspected non-compliance with laws and
regulations may be complex. For example in some jurisdictions communication may be restricted or
prohibited. The practitioner may consider it appropriate to obtain legal advice.
Reporting to an appropriate authority outside the entity
This may be appropriate for the following reasons:
(a) Law, regulation or ethical requirements require it
(b) The practitioner has determined that reporting is an appropriate action in the circumstances
(c) Law, regulation or ethical requirements provide the practitioner with the right to do so
In some instances reporting to authorities outside the entity may give rise to confidentiality issues. The
practitioner may consult internally, obtain legal advice or consult with a regulator or professional body in
order to understand the implications of different courses of action.
1.4 ICAEW Publication

The ICAEW publication Sustainability Assurance: Your Choice summarises the IAASB approach to assurance
as follows:
Figure 25.1: IAASB Approach to Assurance Engagements
C
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Interactive question 1: Assurance engagement (1)
You are the auditor of Knoll plc. Investors in the company have recently expressed concern regarding the
company's compliance with corporate governance requirements. As a result you have been asked by the
directors to undertake an assurance engagement to assess the risk management procedures adopted by
Knoll plc.
Requirements
(a) Explain why the investors would require assurance regarding risk management procedures.
(b) Identify the elements in the above scenario normally exhibited by an assurance engagement.
(c) Explain the matters you would consider before accepting this engagement.
Interactive question 2: Assurance engagement (2)

One of your audit clients, Kelly plc, has borrowed £30 million from Bond Bank plc. The lending
agreement requires that the company meets certain covenants and that the directors of Kelly plc provide
the bank with an annual statement of compliance. Your firm has been asked to report on this statement
and the bank have requested that the report should be made directly to them.
Requirements
(a) To whom should the letter of engagement be addressed?
(b) List the key issues which the letter of engagement should cover.
(c) Outline the procedures which the auditor would perform in order to report on the compliance
statement.
1.5 Assurance reports on controls at a service organisation

1.5.1 Introduction
ISAE 3402 Assurance Reports on Controls at a Service Organisation expands on how ISAE 3000 (Revised) is
to be applied in a reasonable assurance engagement to report on controls at a service organisation. It
deals with assurance engagements carried out by a practitioner to provide a report for user entities and
their auditors on the controls at a service organisation. It only applies when the service organisation is
responsible for, or otherwise able to make a statement about, the suitable design of controls. This means
that it does not apply where the assurance engagement is to:
(a) Report only on whether controls at the service organisation operated as described; or
(b) Report on controls at a service organisation other than those related to a service that is likely to be
relevant to user entities' internal control as it relates to financial reporting
Point to note:
Minor conforming amendments have been made to ISAE 3402 resulting from the changes made to
ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements made by the IAASB
following the conclusion of its NOCLAR (non-compliance with laws and regulations) project.
1.5.2 Objectives
ISAE 3402 states that the objectives of the service auditor are as follows:
(a) To obtain reasonable assurance about whether, in all material respects, based on suitable criteria:
(i) The service organisation's description of its system fairly presents the system as designed and
implemented throughout the specified period or as at a specified date
(ii) The controls related to the control objectives stated in the service organisation's description of
its system were suitably designed throughout the specified period

(iii) Where included in the scope of the engagement, the controls operated effectively to provide
reasonable assurance that the control objectives stated in the service organisation's description
of its system were achieved throughout the period
(b) To report on the matters in (a) above
1.5.3 Requirements
ISAE 3402 requires the service auditor to carry out the following procedures:
 Consider acceptance and continuance issues
 Assess the suitability of the criteria used by the service organisation
 Consider materiality with respect to the fair presentation of the description, the suitability of the
design of controls and, in the case of a type 2 report, the operating effectiveness of controls
 Obtain an understanding of the service organisation's system
 Obtain evidence regarding:
– The service organisation's description of its system
– Whether controls implemented to achieve the control objectives are suitably designed
– The operating effectiveness of controls (when providing a type 2 report)
 Determine whether, and to what extent, to use the work of the internal auditors (where there is an
internal audit function)
Notes
1 A 'type 1' report is a report on the description and design of controls at a service organisation.
2 A 'type 2' report is a report on the description, design and operating effectiveness of controls at a
service organisation.
1.5.4 Written representations

The service auditor must request the service organisation to provide the following written
representations in the form of a representation letter addressed to the service auditor:
(a) Reaffirmation of the statement accompanying the description of the system
(b) That it has provided the service auditor with all relevant information and access
(c) That it has disclosed to the service auditor any of the following of which it is aware:
(i) Non-compliance with laws and regulations, fraud or uncorrected deviations
(ii) Design deficiencies in controls
(iii) Instances where controls have not operated as described
(iv) Subsequent events
1.5.5 Content of the service auditor's assurance report

ISAE 3402 requires the report to contain the following basic elements:
(a) A title that clearly indicates that the report is an independent service auditor's assurance report
(b) An addressee
(c) Identification of: C
H
(i) the service organisation's description of its system, and the service organisation's statement; A
and P
T
(ii) those parts of the service organisation's description of its system that are not covered by the
E
service auditor's opinion (if any) R
(d) Identification of the applicable criteria, and the party specifying the control objectives
(e) A statement that the report is intended only for user entities and their auditors
25
(f) A statement that the service organisation is responsible for:
(i) preparing the description of its system, and the accompanying statement;
(ii) providing the services covered by the service organisation's description of its system;

(iii) stating the control objectives; and
(iv) designing and implementing controls to achieve the control objectives stated in the service
organisation's description of its system
(g) A statement that it is the service auditor's responsibility to express an opinion on the service
organisation's description, on the design of controls related to the control objectives, and in the
case of a type 2 report on the operating effectiveness of those controls
(h) A statement that the firm applies ISQC 1
(i) A statement that the practitioner complies with the IESBA Code or other professional requirements
(j) A statement that the engagement was performed in accordance with ISAE 3402
(k) A summary of the service auditor's procedures
(l) A statement of the limitations of controls
(m) The service auditor's opinion expressed in a positive form
(n) Date
(o) Name of the service auditor
1.5.6 Auditor's opinion

For a type 1 report the service auditor will express his opinion as to whether the description fairly
presents the service organisation's system and that the controls related to the control objectives stated in
that description were suitably designed.
In addition to the above for a type 2 report the auditor will also express an opinion as to whether the
controls tested operated effectively throughout the specified period.
1.5.7 Modified opinions

Where the auditor cannot agree with the details of the report or is unable to obtain sufficient
appropriate evidence, a modified report must be issued.
1.6 Assurance engagements on greenhouse gas statements
1.6.1 Background
In June 2012, the IAASB issued ISAE 3410 Assurance Engagements on Greenhouse Gas Statements.
Point to note:
Minor conforming amendments have been made to ISAE 3410 resulting from the changes made to ISA
250 Consideration of Laws and Regulations in an Audit of Financial Statements by the IAASB following the
conclusion of its NOCLAR (non-compliance with laws and regulations) project.
Definitions
Greenhouse gas statement: A statement setting out constituent elements and quantifying an entity's
greenhouse gas emissions for a period (sometimes known as an emissions inventory) and, where
applicable, comparative information and explanatory notes including a summary of significant
quantification and reporting policies.
Greenhouse gases (GHGs): Carbon dioxide (CO2) and any other gases required by the applicable
criteria to be included in the GHG statement, such as: methane; nitrous oxide; sulphur hexafluoride;
hydrofluorocarbons; perfluorocarbons; and chlorofluorocarbons.
All businesses emit GHGs either directly or indirectly. Recently the demand for companies to publish
information about their emissions has increased. As a result the public require confidence that GHG
statements are reliable. ISAE 3410 aims to enhance this confidence. Reasons for preparing a GHG
statement include the following:
 It may be required under a regulatory disclosure regime.
 It may be required as part of an emissions trading scheme.
 A company may wish to make voluntary disclosures.

1.6.2 Assurance
An engagement performed in accordance with ISAE 3410 must also comply with the requirements of
ISAE 3000 (Revised). Depending on the circumstances the engagement may provide limited or
reasonable assurance about whether the GHG statement is free from material misstatement, whether
due to fraud or error. ISAE 3410 does not specify the circumstances under which a reasonable or limited
assurance engagement will be performed. This will normally be determined by law or regulation or
based on the reason behind the performance of the engagement.
1.6.3 Process
The key stages for this type of engagement are similar to those for any assurance assignment. These are
as follows:
 Plan the engagement
 Obtain an understanding of the entity and its internal control
 Identify and assess the risks of material misstatement
 Design overall responses to the assessed risk of material misstatement and further procedures
 Obtain written representations
 Form an assurance conclusion
The detail of the ISAE adopts a '2 column approach' detailing specific issues which apply to a limited
assurance engagement and those which apply to a reasonable assurance engagement. For example:
Understanding the entity
The understanding required to perform a limited assurance engagement will be less than that required
for a reasonable assurance engagement. In particular, for a limited assurance engagement there is no
requirement to:
 obtain an understanding of control activities relevant to the engagement (although an
understanding of other aspects of internal control should be obtained); or
 evaluate the design of controls and determine whether they have been implemented.
Identifying and assessing risk
Risk assessment procedures will be less extensive in a limited assurance engagement. For example, the
assessment of the risks of material misstatement with respect to material types of emissions and
disclosures does not need to be performed at the assertion level.
Overall responses and further procedures
ISAE 3410 identifies varied procedures depending on the assurance provided. In particular, the nature
and extent of procedures will depend on the nature of the assignment. For example, analytical
procedures for a reasonable assurance engagement should be assertion based.
1.6.4 Reporting
ISAE 3410 requires the assurance report to include the following basic elements:
(a) A title which clearly indicates that the report is an independent assurance report
(b) The addressee
C
(c) Identification and description of the level of assurance, either reasonable, or limited H
A
(d) Identification of the GHG statement P
T
(e) A description of the entity's responsibilities E
R
(f) A statement that the GHG quantification is subject to inherent uncertainty
(g) If the GHG statement includes emissions deductions that are covered by the practitioner's
conclusion, identification of those emissions deductions, and a statement of the practitioner's 25
responsibility with respect to them
(h) Identification of the applicable criteria
(i) A statement that the firm applies ISQC 1

(j) A statement that the practitioner complies with the IESBA Code or other professional requirements
(k) A description of the practitioner's responsibility including:
(i) a statement that the engagement was performed in accordance with ISAE 3410; and
(ii) a summary of the work performed as the basis of the practitioner's conclusion. In the case of a
limited assurance engagement, this must include a statement that the procedures performed
in a limited assurance engagement vary in nature and timing from, and are less in extent than
for a reasonable assurance engagement. Consequently the level of assurance obtained in a
limited assurance engagement is substantially lower than the assurance that would have been
obtained had a reasonable assurance engagement been performed.
(l) In a reasonable assurance engagement the conclusion shall be expressed in a positive form. In a
limited assurance engagement the conclusion must be expressed in a form that conveys whether a
matter(s) has come to the practitioner's attention to cause the practitioner to believe that the GHG
statement is not prepared, in all material respects in accordance with applicable criteria.
(m) If the practitioner expresses a conclusion that is modified, the report must include a section that
provides a description of the matter giving rise to the modification and a section containing the
modified opinion.
(n) The practitioner's signature
(o) The date of the assurance report
(p) The location and jurisdiction where the practitioner practises
Appendix 2 of ISAE 3410 includes illustrative examples of reports for both reasonable and limited
assurance engagements.
1.7 Reporting on information contained in a prospectus

1.7.1 Reporting on the compilation of pro forma financial information
Assurance assignments relate to a wide range of engagements, the nature of which is likely to be
determined by contract as well as by statute. They include major investment, divestment, financing and
restructuring strategies where additional credibility is needed for one or more of the contracting parties.
In December 2011 the IAASB issued ISAE 3420 Assurance Engagements to Report on the Compilation of Pro
Forma Financial Information Included in a Prospectus. The project was undertaken in the context of the
increasing globalisation of capital markets that has made it important for the financial information used
in capital market transactions to be understandable across borders and for assurance to be provided to
enhance users' confidence in how such information is produced. The key points to note are as follows:
 Pro forma financial information is defined as financial information shown together with adjustments
to illustrate the impact of an event or transaction on unadjusted financial information as if the event
had occurred or the transaction had been undertaken at an earlier date selected for the purposes of
illustration. This is achieved by applying pro forma adjustments to the unadjusted financial
information.
 The practitioner's sole responsibility is to report on whether the pro forma financial information has
been compiled in all material respects by the responsible party on the basis of applicable criteria.
The practitioner has no responsibility to compile the pro forma information.
 The practitioner must perform procedures to assess whether the applicable criteria used in the
compilation of the pro forma information provide a reasonable basis for presenting the significant
effects directly attributable to the event or transaction. The work must also involve an evaluation of
the overall presentation of the pro forma financial information.
 To maximise its applicability globally ISAE 3420 prescribes the wording of the opinion although it
allows two alternative forms:
– The pro forma financial information has been compiled, in all material respects, on the basis of
the (applicable criteria).
– The pro forma financial information has been properly compiled on the basis stated.

1.7.2 Other guidance
The APB (now FRC) has also issued guidance in this area in Standard for Investment Reporting (SIR) 1000
Investment Reporting Standards Applicable to All Engagements in Connection with an Investment Circular.
Definition
Investment circular: Any document issued by an entity pursuant to statutory or regulatory requirements
relating to securities on which it is intended that a third party should make an investment decision,
including a prospectus, listing particulars, a circular to shareholders or similar document.
The approach which the reporting accountant is required to take is very similar to that for the statutory
audit:
 Agree the terms
 Comply with ethical requirements and quality control standards
 Plan the work and consider materiality
 Obtain sufficient appropriate evidence
 Document significant matters
 Adopt an attitude of professional scepticism
 Express an opinion (modified if required)
Note: The detail of ISAE 3420 and SIR 1000 is not examinable.
2 Engagements to review financial statements
Section overview
 A review is a type of assurance service which provides a reduced degree of assurance concerning
the proper preparation of financial statements.
 One specific example is the review of interim financial information that may be performed by the
independent auditor.
 Where no material matters come to the attention of the auditor an expression of negative
assurance should be given.
2.1 Nature of a review engagement

The objective of a review of financial statements is to enable a practitioner/auditor to state whether
anything has come to the practitioner/auditor's attention that causes the practitioner/auditor to
believe that the financial statements are not prepared, in all material respects, in accordance with an
identified financial reporting framework.
An external review is an exercise similar to an audit, which is designed to give a reduced degree of
assurance concerning the proper preparation of historical financial information. Negative assurance is
given on review assignments.
C
Guidance is provided in International Standard on Review Engagements (ISRE) 2400 (Revised) H
Engagements to Review Historical Financial Statements. This ISRE applies to reviews of historical financial A
P
statements by a practitioner other than the entity's auditors. It does not address a review of an entity's T
financial statements or interim financial information performed by the auditor of the entity. E
R
In September 2012, the IAASB issued ISRE 2400 (Revised), effective for reviews of financial statements for
periods ended on or after 31 December 2013. The revised ISRE aims to describe the review as a distinct
assurance engagement which is different from an audit in key respects, including the performance of the
25
engagement and reporting. It has been issued in response to an increased demand for services other
than audit. This has been driven by the fact that in many jurisdictions there are exemptions from the
mandatory audits of financial statements. In the UK, for example, companies which meet the small
company criteria are exempt from statutory audits. These small companies, as well as unincorporated

businesses, may want their financial statements to be reviewed by chartered accountants, despite not
being required to have an audit.
Point to note:
Conforming amendments have been made to ISRE 2400 (Revised) resulting from the changes made to
ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements by the IAASB following
the conclusion of its NOCLAR (non-compliance with laws and regulations) project.
In October 2013, the ICAEW issued a technical guidance on ISRE 2400 (Revised), recognising the
growing demand for review engagements outside the framework of the statutory audit. The technical
guidance can be accessed here: www.icaew.com/~/media/corporate/files/Technical/technical-
releases/audit/aaf-0913.ashx?la=en
Note: This ISRE has not been adopted in the UK.
2.2 Engagement quality

ISRE 2400 (Revised) highlights a number of factors to ensure that engagement quality is maintained.
 Compliance with ethical standards including independence requirements.
 Planning and performing the engagement with professional scepticism.
 Exercising professional judgement in the performance of the review engagement. In a review this
judgement is essential particularly regarding decisions about the procedures which need to be
performed and assessing the sufficiency and appropriateness of evidence obtained.
 Requiring the engagement partner to take overall responsibility for the engagement, including
direction, supervision, planning and performance in compliance with professional standards and
the firm's quality control policies. The engagement partner must also ensure that the team has the
appropriate competence and capabilities including assurance skills.
2.3 Acceptance and continuance

One of the important aspects of the revised ISRE is that it includes safeguards to ensure that a review
engagement is not undertaken unless it is appropriate to the circumstances. For example, if the
practitioner believes that an audit would be more appropriate, this should be recommended to the
client. In other cases where circumstances preclude an assurance engagement, a compilation
engagement or other accounting service may be suggested.
The terms of the engagement should be recorded in an engagement letter or other written agreement.
It should include the following matters:
(a) The intended use and distribution of the financial statements and any restrictions on use
(b) Identification of the applicable financial reporting framework
(c) The objectives and scope of the review engagement
(d) The responsibilities of the practitioner
(e) The responsibilities of management (including the responsibility to provide the practitioner with all
information required)
(f) A statement that the engagement is not an audit and that the practitioner will not express an audit
opinion
(g) Reference to the expected form and content of the report to be issued (and a statement that the
report may differ from this)
2.4 Materiality
The accountant should apply similar materiality considerations as would be applied if an audit opinion
on the financial statements were being given. ISRE 2400 (Revised) requires the practitioner to determine
materiality for the financial statements as a whole and apply this in designing procedures and evaluating
results. Although there is a greater risk that misstatements will not be detected in a review than in an

audit, the judgement as to what is material is made by reference to the information on which the
practitioner is reporting and the needs of those relying on that information, not to the level of assurance
provided.
2.5 Procedures
In overview the work performed by the practitioner is as follows:
(a) Inquiry and analytical procedures are performed to obtain sufficient appropriate audit evidence to
come to a conclusion about the financial statements as a whole. These must address all material
items in the financial statements including disclosures and must address areas where material
misstatements are likely.
(b) If sufficient appropriate evidence has not been obtained by these procedures, further procedures
are performed.
(c) Additional procedures are performed where the practitioner becomes aware of matters that indicate
that the financial statements may be materially misstated.
2.5.1 Understanding the business

The practitioner is required to obtain an understanding of the business including:
 Relevant industry
 Nature of the entity (eg, operations, ownership structure)
 Accounting systems and accounting records
 Selection and application of accounting policies
2.5.2 Inquiry
Inquiry is one of the key techniques used by the practitioner in a review. Evaluating the responses is an
integral part of the process. Specific inquiries include the following matters:
 How management makes significant accounting estimates
 Identification of related parties and related party transactions
 Whether there are significant, unusual or complex transactions, events or matters that have affected
or may affect the financial statements (eg, significant changes in the entity's business, changes to
terms of finance or debt covenants, significant transactions near the end of the reporting period)
 Actual, suspected or alleged fraud, illegal acts or non-compliance with laws and regulations
 Whether management has identified and addressed events after the reporting period
 Basis for management's assessment of the entity's ability to continue as a going concern
 Events or conditions that cast doubt on the entity's ability to continue as a going concern
 Material commitments, contractual obligations or contingencies
 Material non-monetary transactions or transactions for no consideration in the reporting period
2.5.3 Analytical procedures

Analytical procedures can help the practitioner with:
C
 obtaining or updating an understanding of the entity and its environment; H
A
 identifying inconsistencies or variances from expected trends, values or norms; P
T
 providing corroborative evidence in relation to inquiry or other analytical procedures; and E
 serving as additional procedures when the practitioner becomes aware of matters that indicate that R
the financial statements may be materially misstated.
In designing analytical procedures ISRE 2400 (Revised) requires the practitioner to consider whether the
25
data available is adequate for these purposes.

2.5.4 Other procedures
The practitioner must obtain evidence that the financial statements agree with, or reconcile to, the
underlying accounting records.
Written representations will be sought stating that management have fulfilled their responsibilities and
that certain matters have been disclosed (eg, re related parties, fraud, going concern).
2.5.5 Procedures to address specific circumstances

ISRE 2400 (Revised) identifies three areas which must be addressed specifically:
 related parties
 fraud and non-compliance with laws and regulations
 going concern
2.5.6 Related parties

The practitioner is required to remain alert for circumstances which might indicate the existence of
related-party relationships or transactions. Where transactions outside the entity's normal course of
business are identified the practitioner must discuss them with management, in particular inquiring
about the nature of the transactions, whether related parties are involved and the business rationale (or
lack of) of those transactions.
2.5.7 Fraud and non-compliance with laws and regulations

Where there is an indication of fraud or non-compliance with laws and regulations, the practitioner
must:
 communicate the matter to the appropriate level of management/those charged with governance;
 request management's assessment of the effects if any on the financial statements;
 consider the implications for the practitioner's report;
 determine whether law, regulation or ethical requirements require that the matter should be
reported to a third party outside the entity; and
 determine whether law, regulation or ethical requirements establish responsibilities under which
reporting to an authority outside the entity may be appropriate.
When making decisions about reporting identified or suspected non-compliance with laws and
regulations to an appropriate authority outside the entity the practitioner may have to consider complex
issues. The practitioner may consult internally, obtain legal advice or consult with a regulator or
professional body in order to understand the implications of different courses of action.
2.5.8 Going concern

If the practitioner becomes aware of conditions (financial, operating or other) which cast significant
doubt on the entity's ability to continue as a going concern, he/she must ask management about plans
for future actions that might have a bearing on this. The feasibility of any plans should also be assessed.
The practitioner must evaluate whether management's responses are sufficient to determine whether the
going concern assumption still applies and should assess responses in the light of all other information
obtained during the review.
2.6 Conclusions and reporting

ISRE 2400 (Revised) states that the practitioner must express an unmodified conclusion on the financial
statements as a whole when the practitioner has obtained limited assurance to be able to conclude that
nothing has come to the practitioner's attention that causes him to believe that the financial statements
are not prepared in all material respects in accordance with the applicable financial reporting framework.
The following is an example of a report with an unmodified opinion taken from ISRE 2400 (Illustration 1):

Independent Practitioner's Review Report
(Appropriate addressee)
Report on the financial statements
We have reviewed the accompanying financial statements of ABC Company, which comprise the
statement of financial position as at December 31, 20X1, and the statement of comprehensive income,
statement of changes in equity and statement of cash flows for the year then ended, and a summary of
significant accounting policies and other explanatory information.
Management's Responsibility for the Financial Statements
Management is responsible for the preparation and fair presentation of these financial statements in
accordance with the International Financial Reporting Standard for Small and Medium-sized Entities, and
for such internal control as management determines is necessary to enable the preparation of financial
statements that are free from material misstatement, whether due to fraud or error.
Practitioner's Responsibility
Our responsibility is to express a conclusion on the accompanying financial statements. We conducted
our review in accordance with International Standard on Review Engagements (ISRE) 2400 (Revised),
Engagements to Review Historical Financial Statements. ISRE 2400 (Revised) requires us to conclude
whether anything has come to our attention that causes us to believe that the financial statements,
taken as a whole, are not prepared in all material respects in accordance with the applicable financial
reporting framework. This Standard also requires us to comply with relevant ethical requirements.
A review of financial statements in accordance with ISRE 2400 (Revised) is a limited assurance
engagement. The practitioner performs procedures, primarily consisting of making enquiries of
management and others within the entity, as appropriate, and applying analytical procedures, and
evaluates the evidence obtained.
The procedures performed in a review are substantially less than those performed in an audit conducted
in accordance with International Standards on Auditing. Accordingly, we do not express an audit
opinion on these financial statements.
Conclusion
Based on our review, nothing has come to our attention that causes us to believe that the financial
statements do not present fairly, in all material respects (or do not give a true and fair view of) the
financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and cash
flows for the year then ended, in accordance with the International Financial Reporting Standard for
Small and Medium-sized Entities.
Date PRACTITIONER
Address
For financial statements prepared using a compliance framework (as opposed to a fair presentation
framework) the following alternative opinion is allowed:
'Based on our review, nothing has come to our attention that causes us to believe that the financial
statements are not prepared, in all material respects, in accordance with the applicable financial
reporting framework.'
If it is necessary to modify the opinion the practitioner must use an appropriate heading ie, Qualified C
Conclusion, Adverse Conclusion or Disclaimer of Conclusion. A description of the matter must also be H
given in a basis for conclusion paragraph immediately before the conclusion paragraph. A
P
The practitioner may conclude that the financial statements are materially misstated. The matters may T
have the following effects. E
R
Impact Effect on report
Material Express a qualified opinion of negative assurance 25
Pervasive Express an adverse opinion that the financial statements do not give a true and
fair view

The practitioner may feel that there was an inability to obtain sufficient appropriate evidence (there has
been a limitation in the scope of the work he intended to carry out for the review). If so, he should
describe the limitation. The limitation may have the following effects.
Impact Effect on report
Material to one area Express a qualified opinion of negative assurance due to amendments which
might be required if the limitation did not exist
Pervasive Do not provide any assurance
2.7 Review of interim financial information performed by the independent

auditor of the entity
This subject is covered by ISRE 2410 Review of Interim Financial Information Performed by the Independent
Auditor of the Entity which gives guidance on the specific review engagements that fall outside the scope
of ISRE 2400 (ie, because they are performed by the entity's auditor). The key distinction between the
two standards is that ISRE 2410 is written on the basis that the independent auditor will be able to make
use of the knowledge of the entity that has been obtained during the audit in performing the review,
while this knowledge is not available to a practitioner who is not the entity's auditor.
Note: The IAASB issued a revised international version of ISRE 2410 in 2007, which has not been
promulgated by the FRC in the UK.
ISRE (UK and Ireland) 2410 applies only to the review of interim financial information by the entity's
auditor. The international standard, by contrast, applies to all reviews of historical information by the
entity's auditor, not limiting its scope to interim financial information.
The following sections are based on ISRE (UK and Ireland) 2410.
2.7.1 Procedures
The procedures outlined below follow the same pattern as an audit but, because this is a review not an
audit, which gives a lower level of assurance, they are not as detailed as audit procedures.
The auditor should possess sufficient understanding of the entity and its environment to understand the
types of misstatement that might arise in interim financial information and to plan the relevant
procedures (mainly inquiry and analytical review) to enable him to ensure that the financial information
is prepared in accordance with the applicable financial reporting framework. This will usually include the
following:
 Reading last year's audit and previous review files
 Considering any significant risks that were identified in the prior year audit
 Reading the most recent and comparable interim financial information
 Considering materiality
 Considering the nature of any corrected or uncorrected misstatements in last year's financial
statements
 Considering significant financial accounting and reporting matters of ongoing importance
 Considering the results of any interim audit work for this year's audit
 Considering the work of internal audit
 In the UK and Ireland, reading management accounts and commentaries for the period
 In the UK and Ireland, considering any findings from prior periods relating to the quality and
reliability of management accounts
 Asking management what their assessment is of the risk that the interim financial statements might
be affected by fraud

 Asking management whether there have been any significant changes in business activity and, if so,
what effect they have had
 Asking management about any significant changes in internal controls and the potential effect on
preparing the interim financial information
 Asking how the interim financial information has been prepared and the reliability of the underlying
accounting records
A recently appointed auditor should obtain an understanding of the entity and its environment, as it
relates to both the interim review and final audit.
The key elements of the review will be as follows:
 Inquiries of accounting and finance staff
 Analytical procedures
Ordinarily, procedures would include the following:
 Reading the minutes of meetings of shareholders, those charged with governance and other
appropriate committees
 Considering the effect of matters giving rise to a modification of the audit or review report,
accounting adjustments or unadjusted misstatements from previous audits
 If relevant, communicating with other auditors auditing different components of the business
 Performing analytical procedures designed to identify relationships and unusual items that may
reflect a material misstatement
 Reading the interim financial information and considering whether anything has come to the
auditors' attention indicating that it is not prepared in accordance with the applicable financial
reporting framework
 Agreeing the interim financial information to the underlying accounting records
 In the UK and Ireland, for group interim financial information, reviewing consolidation adjustments
for consistency
 In the UK and Ireland, reviewing relevant correspondence with regulators

Auditors should make inquiries of members of management responsible for financial and accounting
matters about the following:
 Whether the interim financial information has been prepared and presented in accordance with the
applicable financial reporting framework
 Whether there have been changes in accounting policies
 Whether new transactions have required changes in accounting principles
 Whether there are any known uncorrected misstatements
 Whether there have been unusual or complex situations, such as disposal of a business segment
 Significant assumptions relevant to fair values C
H
 Whether related-party transactions have been accounted for and disclosed correctly A
P
 Significant changes in commitments and contractual obligations T
E
 Significant changes in contingent liabilities including litigation or claims R
 Compliance with debt covenants
 Matters about which questions have arisen in the course of applying the review procedures 25
 Significant transactions occurring in the last days of the interim period or the first days of the next
 Knowledge or suspicion of any fraud

 Knowledge of any allegations of fraud
 Knowledge of any actual or possible non-compliance with laws and regulations that could have a
material effect on the interim financial information
 Whether all events up to the date of the review report that might result in adjustment in the interim
financial information have been identified
 Whether management has changed its assessment of the entity being a going concern
In the UK and Ireland, when comparative interim financial information is presented the auditor should
consider whether accounting policies are consistent and whether the comparative amounts agree with
the information presented in the preceding interim financial report.
The auditor should evaluate discovered misstatements individually and in aggregate to see if they are
material. In the UK and Ireland, the amount designated by the auditor, below which misstatements that
have come to the auditor's attention need not be aggregated, is the amount below which the auditor
believes misstatements are clearly trivial.
The auditor should obtain written representations from management that it acknowledges its
responsibility for the design and implementation of internal control, that the interim financial
information is prepared and presented in accordance with the applicable financial reporting framework
and that the effect of uncorrected misstatement is immaterial (a summary of these should be attached to
the representations). Written representation should also state that all significant facts relating to frauds
or non-compliance with law and regulations and all significant subsequent events have been
disclosed to the auditor.
The auditor should read the other information accompanying the interim financial information to ensure
that it is not inconsistent with it.
If the auditors believe a matter should be adjusted in the financial information, they should inform
management as soon as possible. If management does not respond within a reasonable time, then the
auditors should inform those charged with governance. If they do not respond, then the auditor should
consider whether to modify the report or to withdraw from the engagement and the final audit if
necessary. If the auditors uncover fraud or non-compliance with laws and regulations, they should
communicate that promptly with the appropriate level of management. The auditors should
communicate matters of interest arising to those charged with governance.
2.7.2 Reporting
In the UK and Ireland, the auditor should not date the review report earlier than the date on which the
financial information is approved by management and those charged with governance.
The following example of a review report is taken from ISRE 2410 (Appendix 8) to illustrate the wording
that would be used under a specific legal framework. The review report relates to a company listed in the
UK or Ireland preparing a half-yearly financial report in compliance with IAS 34 as adopted by the
European Union.
Independent review report to XYZ plc

Introduction
We have been engaged by the company to review the condensed set of financial statements in the half-
yearly financial report for the six months ended ... which comprises [specify the primary financial
statements and the related explanatory notes that have been reviewed]. We have read the other
information contained in the half-yearly financial report and considered whether it contains any
apparent misstatements or material inconsistencies with the information in the condensed set of financial
statements.
Directors' Responsibilities
The half-yearly financial report is the responsibility of, and has been approved by, the directors. The
directors are responsible for preparing the half-yearly financial report in accordance with the [Disclosure
and Transparency Rules of the United Kingdom's Financial Services Authority] [Transparency (Directive
2004/109/EC) Regulations 2007 and the Transparency Rules of the Republic of Ireland's Financial
Regulator].

As disclosed in note X, the annual financial statements of the [group/company] are prepared in
accordance with IFRSs as adopted by the European Union. The condensed set of financial statements
included in this half-yearly financial report has been prepared in accordance with International
Accounting Standard 34 Interim Financial Reporting, as adopted by the European Union.
Our Responsibility
Our responsibility is to express to the Company a conclusion on the condensed set of financial
statements in the half-yearly financial report based on our review.
Scope of Review
We conducted our review in accordance with International Standard on Review Engagements (UK and
Ireland) 2410 Review of Interim Financial Information Performed by the Independent Auditor of the Entity
issued by the Auditing Practices Board for use in [the United Kingdom][Ireland]. A review of interim
financial information consists of making enquiries, primarily of persons responsible for financial and
accounting matters, and applying analytical and other review procedures. A review is substantially less in
scope than an audit in accordance with International Standards on Auditing (UK and Ireland) and
consequently does not enable us to obtain assurance that we would become aware of all significant
matters that might be identified in an audit. Accordingly, we do not express an audit opinion.
Conclusion
Based on our review, nothing has come to our attention that causes us to believe that the condensed set
of financial statements in the half-yearly report for the six months ended ... is not prepared, in all
material respects, in accordance with International Accounting Standard 34 as adopted by the European
Union and [the Disclosure and Transparency Rules of the United Kingdom's Financial Services Authority]
[the Transparency (Directive 2004/109/EC) Regulations 2007 and the Transparency Rules of the Republic
of Ireland's Financial Regulator].
AUDITOR
Date
Address
The following examples of modified reports are taken from ISRE 2410 as issued by the IAASB. No specific
UK and Ireland versions exist, although in practice the UK-specific unmodified version of the review
report would be tailored to include a modified opinion.
Review report: Departure from the applicable financial reporting framework

Basis for Qualified Conclusion
Based on information provided to us by management, ABC Entity has excluded from property and long-
term debt certain lease obligations that we believe should be capitalised to conform with (indicate
applicable financial reporting framework). This information indicates that if these lease obligations were
capitalised at March 31, 20X1, property would be increased by $ , long-term debt by
$ , and net income and earnings per share would be increased (decreased) by $ , and
$ , respectively for the three-month period then ended.
Qualified Conclusion
Based on our review, with the exception of the matter described in the preceding paragraph, nothing C
has come to our attention that caused us to believe that the accompanying interim financial information H
does not give a true and fair view of (or 'does not present fairly, in all material respects,') the financial A
P
position of the entity as at March 31, 20X1, and of its financial performance and its cash flows for the
T
three-month period then ended in accordance with (indicate applicable financial reporting framework, E
including the reference to the jurisdiction or country of origin of the financial reporting framework when R
the financial reporting framework used is not International Financial Reporting Standards).
AUDITOR
25
Date
Address

Review report: Limitation on scope not imposed by management
Scope paragraph
Except as explained in the following paragraph, we conducted our review in accordance with
International Standard on Review Engagements (UK and Ireland) 2410 Review of Interim Financial
Information Performed by the Independent Auditor of the Entity. [Followed by standard Scope paragraph
wording.]
Basis for Qualified Conclusion
As a result of a fire in a branch office on (date) that destroyed its accounts receivable records, we were
unable to complete our review of accounts receivable totalling $ included in the interim
financial information. The entity is in the process of reconstructing these records and is uncertain as to
whether these records will support the amount shown above and the related allowance for uncollectible
accounts. Had we been able to complete our review of accounts receivable, matters might have come to
our attention indicating that adjustments might be necessary to the interim financial information.
Qualified Conclusion
Except for the adjustments to the interim financial information that we might have become aware of had
it not been for the situation described above, based on our review, nothing has come to our attention
that causes us to believe that the accompanying interim financial information does not give a true and
fair view of (or 'does not present fairly, in all material respects,') the financial position of the entity as
at March 31, 20X1, and of its financial performance and its cash flows for the three-month period then
ended in accordance with (indicate applicable financial reporting framework, including a reference to
the jurisdiction or country of origin of the financial reporting framework when the financial reporting
framework used is not International Financial Reporting Standards).
AUDITOR
Date
Address
3 Due diligence
Section overview
 Due diligence is a type of review engagement.
 There are a number of different types of due diligence report.
– Financial due diligence
– Commercial due diligence
– Operational due diligence
– Technical due diligence
– IT due diligence
– Legal due diligence
– Human resources due diligence
3.1 Introduction
Businesses need adequate, relevant and reliable information in order to take decisions. However,
problems may arise where one party to the transaction has more or better information than the other
party (this is sometimes called information asymmetry).
This problem is made worse by the fact that frequently there is an incentive to use this superior position
to gain an unfair advantage in a deal. The situation can be highlighted by the following illustration.

Worked example: The used car problem
In selling a used car the owner (the seller) has more information than the potential buyer, and has the
incentive to use this information to gain an advantage. Thus, if it is a good car the seller will say so, but if
it is a bad car the seller will probably still say it is good.
The buyer is at a disadvantage, as they have less information. They have difficulty in distinguishing a
good car from a bad car and may be reluctant to purchase.
There is thus a role for assurance here in the form of an AA or RAC survey to equalise information and
encourage trading. As a result, both parties may benefit.
The situation for many types of corporate transformation arrangement is similar to the used car example.
However, statutory audited financial statements may not be sufficient to narrow the information gap,
often because they are prepared for a different purpose.
A greater, and more specific, level of assurance may therefore be needed for acquisitions, mergers, joint
ventures and management buy-outs (MBOs). The most common type of assurance in this context is a
'report of due diligence'.
3.2 The nature of due diligence

A due diligence review is a specific type of review engagement.
While it can apply to many types of corporate transformation arrangement, this section discusses due
diligence in terms of an acquisition.
As noted above, an external party in a refinancing or acquisition scenario normally has to rely on the
information provided by the other party.
Due diligence is a means of attesting that information, normally on behalf of a prospective bidder. It
can take place at different stages in the negotiations, although the timing is likely to affect the nature of
the due diligence process. It may, for example, be pre-acquisition due diligence or it may be
retrospective.
There are several different forms of due diligence, some of which are carried out by accountants and
financial consultants, while other aspects require the expertise of other specialist skills.
Due diligence will thus attempt to achieve the following:
 Confirm the accuracy of the information and assumptions on which a bid is based
 Provide the bidder with an independent assessment and review of the target business
 Identify and quantify areas of commercial and financial risk
 Give assurance to providers of finance
 Place the bidder in a better position for determining the value of the target company
However, the precise aims will depend on the types of due diligence being carried out.
3.3 Potential liabilities and due diligence

If those involved in due diligence do not act properly there is significant potential for one of the parties
C
to suffer loss as a consequence and seek legal redress. H
A
As a general rule, the principle of caveat emptor (let the buyer beware) applies. The seller has no general
P
duty to disclose information to the purchaser (there may, however, be a specific contractual duty T
depending on the terms of the agreement). E
R
Thus auditors and other experts can be held liable for damages caused by their failure to uncover
potential or actual liabilities or other problems during the due diligence process.
Similarly, the requirements of corporate governance could render directors personally liable if adequate 25
due diligence has not been carried out.

3.4 Types of due diligence report
Financial due diligence
Financial due diligence is a review of the target company's financial position, financial risk and
projections. It is not the same as a statutory audit in a number of ways.
 Its nature, duties, powers and responsibilities are normally determined by contract or financial
regulation rather than by statute.
 Its purposes are more specific to an individual transaction and to particular user groups.
 There is normally a specific focus on risk and valuation.
 Its nature and scope is more variable from transaction to transaction, as circumstances dictate,
than a statutory audit.
 The information being reviewed is likely to be different and more future orientated.
 The timescale available is likely to be much tighter than for most statutory audits.
The information which is subject to financial due diligence is likely to include the following:
 Financial statements
 Management accounts
 Projections
 Assumptions underlying projections
 Detailed operating data
 Working capital analysis
 Major contracts by product line
 Actual and potential liabilities
 Detailed asset registers with current sale value/replacement cost
 Debt/lease agreements
 Current/recent litigation
 Property and other capital commitments
Commercial due diligence
Commercial due diligence work complements that of financial due diligence by considering the target
company's markets and external economic environment.
Information may come from the target company and its business contacts. Alternatively, it may come
from external information sources.
Evidence suggests that about half the financial and commercial due diligence for large companies is
carried out by accountants. It is important that those carrying out commercial due diligence have a
good understanding of the industry in which the target company operates.
The information which is relevant to commercial due diligence is likely to include the following:
 Analysis of main competitors
 Marketing history/tactics
 Competitive advantages
 Analysis of resources
 Strengths and weaknesses
 Integration issues
 Supplier analysis
 Market growth expectations
 Ability to achieve forecasts
 Critical success factors
 Key performance indicators
 Exit potential
 Management appraisal
 Strategic evaluation
Such information is useful not only for valuing a target company but also for advance planning of an
appropriate post-acquisition strategy.

Operational due diligence
Operational due diligence considers the operational risks and possible improvements which can be made
in a target company. In particular it will:
 validate vendor-assumed operational improvements in projections; and
 identify operational upsides that may increase the value of the deal.
The full scope of operations will normally be considered, including the supply chain, logistics and
manufacturing. The following areas will typically be considered:
 Procurement costs and cost synergies
 Growth drivers
 Potential risk areas
 Business relationships
 Supplier and distribution channels
 Balance of sales networks
 Inventory levels/flexibility
 Size of operational footprint
 Utilisation of business assets
 Effectiveness of back office functions
Technical due diligence
In many industries the potential for future profitability, and thus the value of the company, may be
largely dependent upon developing successful new technologies.
A judgement therefore needs to be made as to whether the promised technological benefits are likely to
be delivered. This is very common in a whole range of different industries, including electronics, IT,
pharmaceuticals, engineering, biotechnology and product development.
Such technological judgements are beyond the scope of accounting expertise, but nevertheless the
credibility of technological assumptions may be vital to the valuation process. Reliance will thus need to
be placed upon the work of relevant experts.
Information technology due diligence
IT due diligence assesses the suitability of and risks arising from IT factors in the target company. These
risks are likely to be relevant to most companies, but have particular significance where the target
company operates in the IT sector.
The functions which are relevant to IT due diligence are likely to include the following:
 A risk assessment of embedded systems
 IT security
 Evaluation of synergies, gaps and duplication
 Evaluation of IT compatibility post-acquisition
 IT skills audit
 Process management review
 Post-acquisition rationalisation strategy
Legal due diligence
Legal issues arising on an acquisition are likely to be relevant to the following: C
H
 Valuation of the target company – eg, hidden liabilities, uncertain rights, onerous contractual A
obligations P
T
 The acquisition process – eg, establishing the terms of the takeover (the investment agreement); E
contingent arrangements; financial restructuring; rights, duties and obligations of the various parties R
 The new group – eg, new articles of association, rights of finance providers, restructuring
Reliance will need to be placed on lawyers for this process. 25
Human resources due diligence

Protecting and developing the rights and interests of human resources may be key to a successful
acquisition. There may also be associated legal obligations.

The functions which are relevant to HR due diligence are likely to include the following:
 Human resource audit
 Employment contracts review
 Personnel files
 Obligations under the pension scheme
 Training
 Representation and communication policy
 Evaluation of synergies, gaps and duplications in numbers and skills
 Review of potential redundancies and cost savings post-acquisition
 Legal compliance
Tax due diligence
Information will need to be provided to allow the potential purchaser to form an assessment of the tax
risks and benefits associated with the company to be acquired. Purchasers will wish to assess the
robustness of tax assets, and gain comfort about the position re potential liabilities (including a possible
latent gain on disposal due to the low base cost).
 An explanation of the reason for the disposal structure, including an analysis of the base cost
position and a full technical analysis of the tax position (eg, degrouping charges, transfer of losses)
 Corporation tax reference details
 Copies of all previous tax computations, agreed and submitted
 Copies of HMRC correspondence on corporation tax and VAT
 Details and proof of pre-disposal VAT grouping position
 Details of corporation tax group payment arrangements
 Details of any transactions with connected parties outside the UK
 Details of payroll arrangements, plus copies of correspondence regarding PAYE and NICs
Information re tax warranties that the vendor might offer should also be made available with the due
diligence report as part of the 'marketing' information. This should generally not form a part of the due
diligence itself though.
3.5 Warranties
Due diligence may not be able to answer all the questions of the buyer. Warranties are therefore usually
given by the sellers of the company as a type of insurance. If the warranties are breached the buyer
may be able to claw back some of the sale proceeds. The specific nature of the warranties will depend on
the individual circumstances; however, they may include the following:
 All details regarding contracts of employment have been disclosed.
 Sales contracts exist and are current.
 All contingent liabilities have been disclosed.
 Tax has been paid or accrued for.
Interactive question 3: Due diligence

Hill Ltd is in the process of acquiring Lee Ltd a contract cleaning business. The accountants are
performing the due diligence and have identified the following issues:
(a) They have been unable to obtain the personnel files and employment contracts of two sales
managers.
(b) They have been unable to review the service contract with one of Lee Ltd's major customers.
(c) The finance director does not own any shares in Lee Ltd and has indicated that he is unwilling to
sign any warranties.
Requirement
Explain the implications of (a)–(c) above.

4 Reporting on prospective information
Section overview
 Prospective information includes forecasts and projections.
 It is difficult to give assurance about prospective information because it is highly subjective.
 Procedures could include:
– analytical procedures
– verification of projected expenditure to quotes or estimates
 An opinion may be given in the form of negative assurance.
4.1 Introduction
Prospective financial information means financial information based on assumptions about events that
may occur in future and possible actions by an entity.
Prospective financial information can be of two types (or a combination of both):
A forecast Prospective financial information based on assumptions as to future events which
management expects to take place and the actions management expects to take (best-
estimate assumptions).
A projection Prospective financial information based on hypothetical assumptions about future events
and management actions, or a mixture of best-estimate and hypothetical assumptions.
Increasingly, company directors are producing prospective financial information, either voluntarily or
because it is required by regulators, for example, in the case of a public offering of shares.
Markets and investors need prospective financial information that is understandable, relevant, reliable
and comparable. Some would say that prospective financial information is of more interest to users of
accounts than historical information which, of course, auditors do report on in the statutory audit. It is
highly subjective in nature and its preparation requires the exercise of judgement.
This is an area, therefore, in which the auditors can provide an alternative service to audit, in the form of
a review or assurance engagement.
Reporting on prospective financial information is covered by ISAE 3400 The Examination of Prospective
Financial Information.
4.2 Accepting an engagement

ISAE 3400 states that the auditor should agree the terms of the engagement with the directors, and
should withdraw from the engagement if the assumptions made to put together the prospective
financial information are unrealistic. It also lists the following factors which the auditor should consider:
 The intended use of the information
 Whether the information will be for general or limited distribution
 The nature of the assumptions; that is, whether they are best estimate or hypothetical assumptions
 The elements to be included in the information C
 The period covered by the information H
A
The auditor should have sufficient knowledge of the business to be able to evaluate the significant P
assumptions made. T
E
A firm must also consider practical matters, such as the time available to them, their experience of the R
staff member compiling the information, any limitations on their work and the degree of secrecy
required beyond the normal duty of confidentiality.
25

4.3 Procedures
When determining the nature, timing and extent of procedures, the auditor should consider the
following:
 The likelihood of material misstatement
 The knowledge obtained during any previous engagements
 Management's competence regarding the preparation of prospective financial information
 The extent to which prospective financial information is affected by the management's judgement
 The adequacy and reliability of the underlying data
The auditor should obtain sufficient appropriate evidence as to whether:
(a) management's best-estimate assumptions on which the prospective financial information is based
are not unreasonable and, in the case of hypothetical assumptions, such assumptions are
consistent with the purpose of the information;
(b) the prospective financial information is properly prepared on the basis of the assumptions;
(c) the prospective financial information is properly presented and all material assumptions are
adequately disclosed, including a clear indication as to whether they are best-estimate assumptions
or hypothetical assumptions; and
(d) the prospective financial information is prepared on a consistent basis with historical financial
statements, using appropriate accounting principles.
4.4 Specific procedures

The key issues which projections relate to are profits, capital expenditure and cash flows. The
following list of procedures provides examples of procedures which may also be relevant when assessing
prospective financial information. The auditor should undertake the review of procedures discussed
above in addition to these.
Profit forecasts
(a) Verify projected income figures to suitable evidence. This may involve:
(i) comparison of the basis of projected income to similar existing projects in the firm; or
(ii) review of current market prices for that product or service; that is, what competitors in the
market charge successfully.
(b) Verify projected expenditure figures to suitable evidence. There is likely to be more evidence
available about expenditure in the form of:
(i) quotations or estimates provided to the firm;
(ii) current bills for things such as services which can be used to reliably estimate market rate
prices, for example, for advertising;
(iii) interest rate assumptions can be compared to the bank's current rates; and
(iv) costs such as depreciation should correspond with relevant capital expenditure projections.
Capital expenditure
The auditor should check the capital expenditure for reasonableness. For example, if the projection
relates to buying land and developing it, it should include a sum for land.
(a) Projected costs should be verified to estimates and quotations, where possible.
(b) The projections can be reviewed for reasonableness, including a comparison of prevailing market
rates where such information is available (such as for property).
Cash forecasts
(a) The auditors should review cash forecasts to ensure the timings involved are reasonable (for
example, it is not reasonable to say the building will be bought on day 1, as property transactions
usually take longer than that).
(b) The auditor should check the cash forecast for consistency with any profit forecasts
(income/expenditure should be the same, just at different times).

(c) If there is no comparable profit forecast, the income and expenditure items should be verified as
they would have been on a profit forecast.
4.5 Expressing an opinion

It is clear that as prospective financial information is subjective information, it is impossible for an auditor
to give the same level of assurance regarding it, as he would on historical financial information. In this
instance, the limited assurance is expressed in a negative form.
The ISAE suggests that the auditor express an opinion including the following:
 A statement of negative assurance as to whether the assumptions provide a reasonable basis for the
prospective financial information
 An opinion as to whether the prospective financial information is properly prepared on the basis of
the assumptions and the relevant reporting framework
 Appropriate caveats as to the achievability of the forecasts
In accordance with ISAE 3400 the report by an auditor on an examination of prospective financial
information should contain the following:
 Title
 Addressee
 Identification of the prospective financial information
 A reference to the ISAE or relevant national standards or practices applicable to the examination of
 A statement that management is responsible for the prospective financial information including the
assumptions on which it is based
 When applicable, a reference to the purpose and/or restricted distribution of the prospective
financial information
 A statement of negative assurance as to whether the assumptions provide a reasonable basis for the
 An opinion as to whether the prospective financial information is properly prepared on the basis of
the assumptions and is presented in accordance with the relevant financial reporting framework
 Appropriate caveats concerning the achievability of the results indicated by the prospective financial
information
 Date of the report which should be the date procedures have been completed
 Auditor's address
 Signature
Example of an extract from an unmodified report on a forecast

We have examined the forecast in accordance with the International Standard on Assurance
Engagements applicable to the examination of prospective financial information. Management is
responsible for the forecast including the assumptions set out in note X on which it is based.
C
Based on our examination of the evidence supporting the assumptions, nothing has come to our H
attention which causes us to believe that these assumptions do not provide a reasonable basis for the A
forecast. Further, in our opinion the forecast is properly prepared on the basis of the assumptions and is P
T
presented in accordance with ….
E
Actual results are likely to be different from the forecast since anticipated events frequently do not occur R
as expected and the variation may be material.
When the auditor believes that the presentation and disclosure of the prospective financial information is 25
not adequate, the auditor should express a qualified or adverse opinion (or withdraw from the
engagement).

When the auditor believes that one or more significant assumptions do not provide a reasonable basis
for the prospective financial information, the auditor should express an adverse opinion (or withdraw
from the engagement).
When there is a scope limitation the auditor should either withdraw from the engagement or disclaim
the opinion.
Interactive question 4: Prospective financial information

A new client of your practice, Peter Lawrence, has recently been made redundant. He is considering
setting up a residential home for old people, as he is aware that there is an increasing need for this
service with an ageing population (more people are living to an older age). He has seen a large house,
which he plans to convert into an old people's home. Each resident will have a bedroom, there will be a
communal sitting room and all meals will be provided in a dining room. No long-term nursing care will
be provided, as people requiring this service will either be in hospital or in another type of
accommodation for old people.
The large house is in a poor state of repair, and will require considerable structural alterations (building
work), and repairs to make it suitable for an old people's home. The following will also be required:
 New furnishings (carpets, beds, wardrobes and so on for the resident's rooms; carpets and furniture
for the sitting room and dining room)
 Decoration of the whole house (painting the woodwork and covering the walls with wallpaper)
 Equipment (for the kitchen and for helping disabled residents)
Mr Lawrence and his wife propose to work full time in the business, which he expects to be available for
residents six months after the purchase of the house. Mr Lawrence has already obtained some estimates
of the conversion costs, and information on the income and expected running costs of the home.
Mr Lawrence has received about £50,000 from his redundancy. He expects to receive about £130,000
from the sale of his house (after repaying his mortgage). The owners of the house he proposes to buy
are asking £250,000 for it, and Mr Lawrence expects to spend £50,000 on conversion of the house
(building work, furnishing, decorations and equipment).
Mr Lawrence has prepared a draft capital expenditure forecast, a profit forecast and a cash flow forecast
which he has asked you to check before he submits them to the bank, in order to obtain finance for the
old people's home.
Requirements
Describe the procedures you would carry out on:
(a) The capital expenditure forecast
(b) The profit forecast
(c) The cash flow forecast
Section overview
 The terms of the engagement must be clearly defined.
 The procedures conducted will depend on the nature of the engagement.
 No assurance is given. The report identifies the auditor's factual findings.
5.1 Objective
Agreed-upon procedures assignments are dealt with by International Standard on Related Services (ISRS)
4400 Engagements to Perform Agreed-Upon Procedures Regarding Financial Information.

In an engagement to perform agreed-upon procedures, an auditor is engaged to carry out those
procedures of an audit nature to which the auditor and the entity and any appropriate third parties have
agreed and to report on factual findings. The recipients of the report must form their own conclusions
from the report by the auditor. The report is restricted to those parties that have agreed to the
procedures to be performed since others, unaware of the reasons for the procedures, may misinterpret
the results.
Note: ISRSs have not been adopted in the UK.
5.2 Defining the terms of the engagement

ISRS 4400 states that the auditor should ensure that there is a clear understanding regarding the
agreed procedures and conditions of the engagement. Matters to be agreed should include the
following:
 Nature of the agreement including the fact that the procedures performed will not constitute an
audit or review and therefore that no assurance will be expressed
 Stated purpose for the engagement
 Identification of the financial information to which the agreed-upon procedures will be applied
 Nature, timing and extent of the specific procedures to be applied
 Anticipated form of the report of factual findings
 Limitations on distribution of the report of factual findings
5.3 Procedures
The procedures performed will depend upon the terms of the engagement. The ISRS states that the
auditors should plan the assignment. They should carry out the agreed-upon procedures, documenting
their process and findings.
5.4 Reporting
The report of factual findings should contain the following:
 Title
 Addressee (ordinarily the client who engaged the auditor to perform the agreed-upon procedures)
 Identification of specific financial or non-financial information to which the agreed-upon procedures
have been applied
 A statement that the procedures performed were those agreed upon with the recipient
 A statement that the engagement was performed in accordance with the International Standard on
Related Services applicable to agreed-upon procedure engagements, or with relevant national
standards or practices
 When relevant, a statement that the auditor is not independent of the entity
 Identification of the purpose for which the agreed-upon procedures were performed C
 A listing of the specific procedures performed H
A
 A description of the auditor's factual findings including sufficient details of errors and exceptions P
found T
E
 Statement that the procedures performed do not constitute either an audit or a review and, as R
such, no assurance is expressed
 A statement that had the auditor performed additional procedures, an audit or a review, other
25
matters might have come to light that would have been reported
 A statement that the report is restricted to those parties that have agreed to the procedures to be
performed

 A statement (when applicable) that the report relates only to the elements, accounts, items or
financial and non-financial information specified and that it does not extend to the entity's financial
statements taken as a whole
 Date of the report
 Auditor's address
 Auditor's signature
Note: No assurance is expressed. The auditor reports the factual findings.
Appendix 2 of ISRS 4400 includes the following example of a report of factual findings:
Example of a Report of Factual Findings in Connection with Accounts Payable

Report of factual findings
To (those who engaged the auditor)
We have performed the procedures agreed with you and enumerated below with respect to the
accounts payable of ABC Company as at (date), set forth in the accompanying schedules (not shown in
this example). Our engagement was undertaken in accordance with the International Standard on
Related Services (or refer to relevant national standards or practices) applicable to agreed-upon
procedures engagements. The procedures were performed solely to help you to evaluate the validity of
the accounts payable and are summarised as follows:
(1) We obtained and checked the addition of the trial balance of accounts payable as at (date)
prepared by ABC Company, and we compared the total to the balance in the related general ledger
account.
(2) We compared the attached list (not shown in this example) of major suppliers and the amounts
owing at (date) to the related names and amounts in the trial balance.
(3) We obtained suppliers' statements or requested suppliers to confirm balances owing at (date).
(4) We compared such statements or confirmations to the amounts referred to in 2. For amounts which
did not agree, we obtained reconciliations from ABC Company. For reconciliations obtained, we
identified and listed outstanding invoices, credit notes and outstanding cheques, each of which was
greater than xxx. We located and examined such invoices and credit notes subsequently received
and cheques subsequently paid and we ascertained that they should in fact have been listed as
outstanding on the reconciliations.
We report our findings below:
(a) With respect to item 1 we found the addition to be correct and the total amount to be in
agreement.
(b) With respect to item 2 we found the amounts compared to be in agreement.
(c) With respect to item 3 we found there were supplier's statements for all such suppliers.
(d) With respect to item 4 we found the amounts agree, or with respect to amounts which did not
agree, we found ABC Company had prepared reconciliations and that the credit notes, invoices and
outstanding cheques over xxx were appropriately listed as reconciling items with the following
exceptions:
(Detail the exceptions)
Because the above procedures do not constitute either an audit or a review made in accordance with
International Standards on Auditing or International Standards on Review Engagements (or relevant
national standards or practices), we do not express any assurance on the accounts payable as of (date).
Had we performed additional procedures or had we performed an audit or review of the financial
statements in accordance with International Standards on Auditing or International Standards on Review
Engagements (or relevant national standards or practices), other matters might have come to our
attention that would have been reported to you.

Our report is solely for the purpose set forth in the first paragraph of this report and for your information
and is not to be used for any other purpose or to be distributed to any other parties. This report relates
only to the accounts and items specified above and does not extend to any financial statements of ABC
Company, taken as a whole.
AUDITOR
Date
Address
Section overview
 A compilation engagement is one in which the accountant compiles information.
 The information must contain a reference making it clear that it has not been audited.
 No assurance is expressed on the financial information.
6.1 Compilations
In a compilation engagement, the accountant is engaged to use accounting expertise, as opposed to
auditing expertise, to collect, classify and compile financial information.
Definition
Compilation engagement: An engagement in which a practitioner applies accounting and financial
reporting expertise to help management with the preparation and presentation of financial information
of an entity in accordance with an applicable financial reporting framework, and reports as required by
the relevant ISRS.
Examples include preparation of:

 historical financial information;
 pro forma financial information; and
 prospective financial information including financial budgets and forecasts.
The international guidance on compilation engagements is found in ISRS 4410 (Revised) Compilation
Engagements. The IAASB issued a revised ISRS in March 2012. This resulted from the growing demand
from small and medium-sized enterprises (SMEs) for services other than audit, particularly in jurisdictions
where exemptions for certain entities from the requirement to have an audit have been introduced.
Conforming amendments have been made to ISRS 4410 (Revised) resulting from the changes made to
ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements by the IAASB following
the conclusion of its NOCLAR (non-compliance with laws and regulations) project.
In particular these amendments provide guidance regarding the reporting of identified or suspected
non-compliance with laws and regulations to an appropriate authority outside the entity. C
H
This may be appropriate for reasons we discussed earlier. A
P
In some instances reporting to authorities outside the entity may give rise to confidentiality issues. The T
practitioner may consult internally, obtain legal advice or consult with a regulator or professional body in E
order to understand the implications of different courses of action. R
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6.2 Procedures
6.2.1 Engagement acceptance
In accordance with the revised ISRS, the work must be carried out in accordance with ethical and quality
control requirements. The practitioner must agree the terms of the engagement, in an engagement
letter or other suitable form of written agreement, with the management or the engaging party if
different including the following:
(a) The intended use and distribution of the financial information, and any restrictions on its use or
distribution
(b) Identification of the applicable financial reporting framework
(c) The objective and scope of the engagement
(d) The responsibilities of the practitioner, including the requirement to comply with relevant ethical
requirements
(e) The responsibilities of management for the financial information, the accuracy and completeness of
the records and documents provided by management for the compilation engagement and the
judgements needed in the preparation and presentation of the financial information
(f) The expected form and content of the practitioner's report
6.2.2 Performing the engagement

The practitioner is required to obtain an understanding of the entity's business and operations including
the accounting system and accounting records and the applicable financial reporting framework. The
practitioner then compiles the information using the records, documents, explanations and other
information provided by management. The specific nature of the work will depend on the nature of the
engagement. Before completion the practitioner must read the compiled information in the light of the
understanding obtained of the entity's business and operations and the applicable financial reporting
framework. If the practitioner becomes aware that the information provided by management is
incomplete, inaccurate or otherwise unsatisfactory the practitioner must bring this to the attention of
management and request additional or corrected information. If management fail to provide this
information and the engagement cannot be completed or management refuse to make amendments
proposed by the practitioner, the practitioner must withdraw from the engagement and inform
management and those charged with governance.
The practitioner must obtain an acknowledgement from management or those charged with
governance that they take responsibility for the final version of the information.
6.3 Reporting
The practitioner's report must clearly communicate the nature of the compilation engagement.
ISRS 4410 (Revised) stresses that the report is not a vehicle to express an opinion or conclusion on the
financial information in any form. The report on a compilation engagement must be in writing and must
contain the following:
 Title
 Addressee
 A statement that the practitioner has compiled the financial information based on information
provided by management
 A description of the responsibilities of management, or those charged with governance in relation
to the compilation engagement
 Identification of the applicable financial reporting framework and, if a special purpose financial
reporting framework is used, a description or reference to the description of that special purpose
financial reporting framework in the financial information
 Identification of the financial information, including the title of each element of the financial
information (if it comprises more than one element) and the date of the financial information

 A description of the practitioner's responsibilities in compiling the financial information, including
that the engagement was performed in accordance with ISRS 4410 (Revised) and that the
practitioner has complied with relevant ethical requirements
 A description of what a compilation engagement entails
 Explanation that as the compilation engagement is not an assurance engagement, the practitioner
is not required to verify the accuracy or completeness of the information provided by management
for the compilation
 Explanation that the practitioner does not express an audit opinion or a review conclusion on
whether the financial information is prepared in accordance with the applicable financial reporting
framework
 If the financial information is prepared using a special purpose framework an explanatory paragraph
that describes the purpose of the financial information and the intended users and draws the
readers' attention to the fact that the information may not be suitable for other purposes
 Date of the report
 Practitioner's address
 Practitioner's signature
Appendix 2 of ISRS 4410 (Revised) contains a number of examples of a compilation report. The
following extract is based on Illustration 1.
Example of a Report on an Engagement to Compile Financial Statements

PRACTITIONER'S COMPILATION REPORT
[To Management of ABC Company]
We have compiled the accompanying financial statements of ABC Company based on information you
have provided. These financial statements comprise the statement of financial position of ABC Company
as at December 31, 20X1, the statement of comprehensive income, statement of changes in equity and
statement of cash flows for the year then ended, and a summary of significant accounting policies and
other explanatory information.
We performed this compilation engagement in accordance with International Standard on Related
Services 4410 (Revised), Compilation Engagements.
We have applied our expertise in accounting and financial reporting to help you with the preparation
and presentation of these financial statements in accordance with International Financial Reporting
Standards for Small and Medium-sized Entities (IFRS for SMEs). We have complied with relevant ethical
requirements, including the principles of integrity, objectivity, professional competence and due care.
These financial statements and the accuracy and completeness of the information used to compile them
are your responsibility.
Since a compilation engagement is not an assurance engagement, we are not required to verify the
accuracy or completeness of the information you provided to us to compile these financial statements.
Accordingly, we do not express an audit opinion or a review conclusion on whether these financial
statements are prepared in accordance with IFRS for SMEs.
C
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A
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7 Forensic audit
Section overview
Forensic auditing can be applied to a wide variety of situations, including fraud and negligence
investigations.
7.1 Introduction
Definition
Forensic auditing: The process of gathering, analysing and reporting on data, in a predefined context,
for the purpose of finding facts and/or evidence in the context of financial or legal disputes and/or
irregularities and giving preventative advice in this area.
Forensic investigation: Undertaking a financial investigation in response to a particular event, where the
findings of the investigation may be used as evidence in court or to otherwise help resolve disputes.
Forensic investigations are carried out for civil or criminal cases. These can involve fraud or money
laundering.
Forensic audit and accounting is a rapidly growing area. The major accountancy firms all offer forensic
services, as do a number of specialist companies. The demand for these services arises partly from the
increased corporate governance focus on company directors' responsibilities for the prevention and
detection of fraud, and partly from government concerns about the criminal funding of terrorist groups.
The range of assignments in this area is vast, so to give specific definitions for each is not always
practicable. As a starting point, it's helpful to refer to the definition used by the Institute of Chartered
Accountants of Canada, in its publication Standard Practices for Investigative and Forensic Accounting
Engagements (November 2006):
Investigative and forensic accounting engagements are those that:
(a) require the application of professional accounting skills, investigative skills and an investigative
mindset; and
(b) involve disputes or anticipated disputes, or where there are risks, concerns or allegations of fraud or
other illegal or unethical conduct.
7.2 Applications of forensic auditing

7.2.1 Fraud
Forensic accountants can be engaged to investigate fraud. This could involve:
 quantifying losses from theft of cash or goods;
 identifying payments or receipts of bribes;
 identifying intentional misstatements in financial information, such as overstatement of revenue and

earnings and understatement of costs and expenses; or
 investigating intentional misrepresentations made to auditors.

Forensic accountants may also be engaged to act in an advisory capacity, to help directors with
developing more effective controls to reduce the risks from fraud.
7.2.2 Negligence
When an auditor or accountant is being sued for negligence, either or both parties to the case may
employ forensic accountants to investigate the work done to provide evidence as to whether it did in
fact meet the standards required. They may also be involved in establishing the amount of loss suffered
by the plaintiff.

7.2.3 Insurance claims
Insurance companies often employ forensic accountants to report on the validity of the amounts of
losses being claimed, as a means of resolving the disputes between the company and the claimant.
This could involve computing losses following an insured event such as a fire, flood or robbery. If a
criminal action arises over an allegation that an insured event was deliberately contrived to defraud the
insurance company, the forensic accountant may be called upon as an expert witness (see section 7.2.6
below).
7.2.4 Other disputes

Forensic accountants can be involved in the investigation of many other types of dispute:
 Shareholder disputes
 Partnership disputes
 Contract disputes
 Business sales and purchase disputes
 Matrimonial disputes, including:
– valuing the family business
– gathering financial evidence
– identifying 'hidden' assets
– advising in settlement negotiations
7.2.5 Terrorist financing

Governments are increasingly turning to forensic accountants as part of their counterterrorism strategy.
Gordon Brown, who was the UK Chancellor of the Exchequer at the time, said in a speech in October
2006:
'… forensic accounting of transaction trails across continents has been vital in identifying threats,
uncovering accomplices, piecing together company structures, and ultimately providing evidence
for prosecution. Most recently, forensic accounting techniques have tracked an alleged terrorist
bomb maker, using multiple identities, multiple bank accounts and third parties and third world
countries to purchase bomb making equipment and tracked him to and uncovered an overseas
bomb factory.'
7.2.6 The forensic accountant as expert witness

The preceding sections have identified a number of circumstances where the forensic accountant may be
involved as an expert witness in civil or criminal cases. For civil cases in England and Wales, the duties of
expert witnesses are set out in the Civil Procedure Rules.
(a) Experts always owe a duty to exercise reasonable skill and care to those instructing them, and to
comply with any relevant professional code of ethics.
However, as expert witnesses in civil proceedings, they have an overriding duty to help the court
on matters within their expertise.
(b) Experts should be aware of the overriding objective that courts deal with cases justly. Experts are
under an obligation to help the court so as to enable them to deal with cases in accordance with
the overriding objective.
C
However, experts have no obligations to act as mediators between the parties or require them to H
trespass on the role of the court in deciding facts. A
P
(c) Experts should provide opinions which are independent, regardless of the pressures of litigation. In T
this context, a useful test of 'independence' is that the expert would express the same opinion if E
given the same instructions by an opposing party. Experts should not take it upon themselves to R
promote the point of view of the party instructing them or engage in the role of advocates.
(d) Experts should confine their opinions to matters which are material to the disputes between the 25
parties and provide opinions only in relation to matters which lie within their expertise. Experts
should indicate without delay where particular questions or issues fall outside their expertise.

7.3 Procedures and evidence
7.3.1 Planning
The broad process of conducting a forensic audit bears some similarity to an audit of financial
statements, in that it will include a planning stage, a period when evidence is gathered, a review process,
and a report to the client. However, forensic investigations are not all of the same sort, and it is essential
that the investigation team considers carefully exactly what it is that they have been asked to achieve in
this particular investigation, and that they plan their work accordingly. Professional judgement will be
required to do the following:
 Identify the objectives of the engagement
 Obtain sufficient understanding of the circumstances and events surrounding the engagement
 Obtain sufficient understanding of the context within which the engagement is to be conducted
(eg, any relevant laws or regulations)
 Identify any limitation on the scope of the engagement (eg, where information is not available)
 Evaluate the resources necessary to complete the work, and identify a suitable engagement team
In order to meet these requirements, the engagement plan should include the following.
 Develop hypotheses to address the circumstances and context of the engagement
 Decide on the best approach to meet the engagement objectives within constraints such as cost
and time
 Identify the financial (and other) information needed, and develop a strategy to acquire it
 Determine the impact of the nature and timing of any reporting requirements
One key difference in emphasis from an audit of financial statements is that the forensic accountant is
stepping into an arena that is defined by conflict. It is thus essential that the investigator obtains an
understanding of the background and context to the engagement as well as of any limitations on its
scope, as these will affect the extent of the conclusions that can be drawn. In the case of a matrimonial
dispute, for example, the investigator would need to take a sceptical attitude towards all the information
they are provided with, as it may be biased, false or incomplete.
Many forensic investigations involve investigating potential frauds. The objectives of a fraud investigation
would include the following:
 Identifying the type of fraud that has been operating, how long it has been operating for, and how
the fraud has been concealed
 Identifying the fraudster(s) involved
 Quantifying the financial loss suffered by the client
 Gathering evidence to be used in court proceedings
 Providing advice to prevent the recurrence of the fraud

The investigators should then consider the best way to gather evidence in the light of these objectives.
7.3.2 Audit procedures

The specific procedures which would be performed as part of a forensic audit will depend on the specific
nature of the investigation. However, using a fraud investigation as an example, the following would
normally apply.
 Develop a profile of the entity under investigation including its personnel
 Identify weaknesses in internal control procedures and basic recordkeeping eg, bank reconciliations
not performed
 Perform trend analysis and analytical procedures to identify significant transactions and significant
variations from the norm

 Identify changes in patterns of purchases/sales, particularly where a limited number of
suppliers/customers are involved
 Identify significant variations in consumption of raw materials and consumables, particularly where
consumption appears excessive
 Identify unusual accounts and account balances eg, closing credit balances on debit accounts and
vice versa
 Review accounting records for unusual transactions and entries, eg, large numbers of accounting
entries between accounts, transactions not executed at normal commercial rates
 Review transaction documentation (eg, invoices) for discrepancies and inconsistencies
 Once identified trace the individual responsible for fraudulent transactions
 Obtain information regarding all responsibilities of the individual involved
 Inspect and review all other transactions of a similar nature conducted by the individual
 Consider all other aspects of the business which the individual is involved with and perform further
analytical procedures targeting these areas to identify any additional discrepancies
Interactive question 5: Forensic auditing

You are a manager in the forensic investigation department of an audit firm. The financial director of
Benji Co approached you with a request to investigate a fraud. He has identified a number of
discrepancies between inventory records and the half-year physical inventory counts which are
performed. Furthermore, the discrepancy always relates to the same product line and approximately the
same number of items appear to be missing each time.
Requirement
Explain the procedures you would perform to determine whether a fraud has taken place and to quantify
the loss suffered by the company.
7.3.3 A different approach

While many of the techniques used in a forensic investigation will be similar to those used in an audit,
the different objectives and risks involved will require some differences in approach.
Materiality There may be no materiality threshold.
Timing Less predictable than audit – often by necessity.
Documentation Needs to be reviewed more critically than on an audit.
Interviews It may be appropriate to interview a suspected fraudster. Doing so

requires a high level of experience and skill, and awareness of legal
issues (including risk of prosecution for defamation).
C
Computer-assisted techniques Data mining is key to many investigation processes, allowing the H
accountant to access and analyse large numbers of transactions. A
P
Specific characteristics can be checked ie, date, time, amount, T
approval, payee. E
R
If possible, data should be gathered before the initial field visit to
reduce the risk of the data being compromised.
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Summary
Common elements of
Prior knowledge Assurance assurance engagements
Concept of assurance Types of assurance

engagement
and related services
statements
financial information
Types of due diligence

Self-test
1 Travis plc
Travis plc is an international hotel company which is looking to expand and diversify via acquisition.
Two potential target companies have been identified.
(i) Bandic AB operates over 100 hotels throughout Scandinavia, an area where Travis plc currently
has no hotel. This acquisition would give it a fast entry into this new geographical market.
Approximately half of Bandic AB's hotels target the luxury/business end of the market, where
Travis plc currently focuses; the remainder are more downmarket.
(ii) Macis plc has several hotels throughout the British Isles with a high proportion in Scotland,
where Travis plc currently has only limited coverage.
So far Travis plc has acquired 4% of the share capital of Macis plc in several relatively small
purchases.
Requirements
(a) If the acquisition of Bandic AB is to go ahead, explain four key business risks the directors
should consider.
(b) Explain the purpose of a due diligence exercise if one of these purchases were to go ahead.
2 Upstarts Ltd
You are a senior in the corporate services department of your firm which has been approached by
GP Sidney Wittenburg Global Fund Managers (GPSWGFM), the venture capital arm of a leading
investment bank. GPSWGFM is investigating a management buy-out (MBO) of Upstarts Ltd
(Upstarts).
Upstarts was formed as a start-up three years ago, as a wholly owned subsidiary of an IT hardware
supplier, DatLinks plc (DatLinks). DatLinks and Upstarts both operate entirely within the UK. The
group's accounting year end is 30 September. Upstarts provides a 'one stop service' for client
extranets to the financial services industry (ie, intranets which can be securely accessed by
customers to obtain information, pay bills etc). Upstarts provides hardware, which is sourced
exclusively from its parent company DatLinks, plus software, support, web design and security
services.
It was initially successful, but some highly publicised problems surrounding security breaches in
similar products, together with cash flow problems, have resulted in a severe breakdown in the
relationship between Upstarts's management team and the directors of DatLinks. DatLinks is
therefore keen to divest itself of its interest in Upstarts.
The proposed deal would involve GPSWGFM providing the funding for the MBO. Its exit route will
be via a planned flotation of Upstarts in two to four years' time. GPSWGFM has worked with
Upstarts's management to produce a detailed business plan and financial projections up to the date
of the flotation under a variety of scenarios.
Your firm has been asked to quote for the full range of advisory services, including the following:
 Due diligence on the MBO C
 Review of the business plan and the financial projections H
 Tax structuring advice on the acquisition A
P
 Upstarts's audit and advisory work on an ongoing basis T
 Advisory work on the planned flotation of Upstarts E
R
Performance management
The gross assets of Upstarts are £9.5 million. The acquisition price is estimated at this stage to be in
the region of £45 million, although this will depend on the outcome of the due diligence work and 25
the review of the financial projections.
GPSWGFM informs you that the price looks very attractive, since it is based upon historical earnings
levels which have been depressed by DatLinks's group accounting policies. Discussions with

Upstarts's management team have revealed that the vendor group's transfer pricing policies had the
effect of reducing the results of its subsidiaries and inflating the results of the parent. Upstarts's
finance director has provided GPSWGFM with revised financial statements, together with detailed
reconciliations which reverse the effects of these policies and restate Upstarts's historical results on a
'standalone' basis. These would indicate a true market value in the region of £60 million.
GPSWGFM believes that, in addition to an early cash injection, the success of Upstarts depends
upon the retention of its key asset – the design team. The deal depends upon the retention of up to
25 identified individuals, at least until GPSWGFM's exit on flotation. To this end, and to protect its
investment, GPSWGFM wishes to grant share options, with current values per employee ranging
from £50,000 to £100,000, to be exercisable in two to four years' time – depending on how quickly
the flotation takes place. The poor relationship between the management teams of Upstarts and
DatLinks means that access to DatLinks's management team during the due diligence process will
be restricted. A data room containing detailed financial, legal and commercial information will be
provided at the premises of DatLinks's lawyers. Upstarts's management team will, however, be
freely available to answer questions and provide any information that might be requested. DatLinks
has indicated that it will not provide any warranties in respect of the acquisition.
The engagement partner from your firm is meeting GPSWGFM shortly to discuss the potential
assignment. He has asked you to provide him with a briefing note that will assess the risks
associated with the assignment including the due diligence, the business plan review and the
ongoing audit.
Requirement
Prepare the briefing note for the engagement partner.

Technical reference
1 Assurance engagements
 Planning ISAE 3000.40–45
 Obtaining evidence ISAE 3000.48–51
 Reporting ISAE 3000.64–77
2 Assurance reports at service organisations

 Objectives ISAE 3402.8
3 Assurance engagements on greenhouse gas statements

 Objectives ISAE 3410.13
 Reporting ISAE 3410.76 & Appendix 2
4 Review of historical financial information

 Nature ISRE 2400.5–8
 Quality control ISRE 2400.24–25
 Agreeing terms ISRE 2400.37
 Procedures ISRE 2400.43–57
 Reporting ISRE 2400.86-92 & Illustrations
5 Review of interim financial information

 Assurance provided – negative ISRE 2410 .7
 Procedures ISRE 2410.12–29
 Reporting ISRE 2410.43-63 & Appendix
6 Prospective financial information

 Acceptance ISAE 3400.10–12
 Procedures ISAE 3400.17–25
 Defining the terms ISRS 4400.9
 Procedures ISRS 4400.15
 Reporting ISRS 4400.17–18 & Appendix
 Defining terms ISRS 4410.17
C
 Procedures ISRS 4410.28–37
H
 Reporting ISRS 4410.39–41 & Appendix A
P
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(a) Investors will be concerned about risk management, as the risk that the company enters into has a
direct impact on the risk of the investment. Stakeholders need assurance that the risk taken by the
company is acceptable to them and that the returns that they receive are in accordance with that
level of risk.
(b) An assurance engagement normally exhibits the following elements:
(i) A three-party relationship:
(1) A practitioner, in this case the auditor
(2) A responsible party, in this case Knoll plc
(3) An intended user, in this case the directors and shareholders of Knoll plc
(ii) Subject matter, in this case the risk management procedures
(iii) Suitable criteria, which in this case will depend on the specific needs of the company
(iv) Evidence gathered
(v) An assurance report
(c) The matters to be considered would be as follows:
(i) Whether there is any conflict of interest as a result of performing the statutory audit as well as
this assignment and whether the firm would be able to perform the engagement in
accordance with the FRC Ethical Standard (Revised June 2016)
(ii) The level of assurance required by the client and the form of the report to be issued
(iii) The specific recipients of any report and the use which will be made of the report
(iv) The terms of the engagement and in particular the criteria by which the risk management
procedures are to be measured. These could include UK Corporate Governance Code and/or
the management's policy on risk management. As there are no universally recognised criteria
for evaluating the effectiveness of an entity's risk evaluation, assurance is likely to be limited to
whether evaluation is properly carried out
(v) The risk to the audit firm of performing the assurance engagement and whether this can be
reflected adequately in the fee chargeable

(a) As the report is to be sent directly to the bank, the engagement is with the bank and not Kelly plc.
Therefore the engagement letter should be addressed to the bank.
(b) The matters to be addressed in the letter of engagement include the following:
 The nature of the work which is being conducted ie, in accordance with the terms of the
lending agreement
 The respective responsibilities. The directors are responsible for ensuring that the company
complies with the terms of the loan agreement, both in terms of the covenants and the
preparation of the statement of compliance. The auditors are responsible for reporting to the
bank on the statement of compliance
 The basis of the report. This would include:
– the quality standards to which the work is performed eg, ISAE 3000;
– the extent of the procedures to be performed;
– any limitations in the work to be performed ie, what the work will not cover; and
– restrictions on the use of the report ie, for use by the bank in respect of the loan
agreement and not for use by other third parties.

(c) Procedures would include:
 reading the statement of compliance and obtaining an understanding of the way in which it
was compiled through inquiry of management;
 comparison of the financial information in the statement and the source information from
which it has been taken; and
 recomputation of the calculations and comparison of the results with those of the client and
the requirements of the loan agreement.
Tutorial note
Depending on the precise nature of the engagement and the terms set out in the engagement letter the
auditor may also be required to review or verify the financial information which has provided the source
for the calculations in the statement.

(a) The ongoing costs and liabilities of the target company may be understated if the terms of the sales
managers' contracts have not been correctly reflected in the information provided to the
accountants. For example, the sales managers may have been promised bonuses which have not
been accrued for. Without a proper review of the terms of their employment the accountants are
not able to establish whether this is the case or not. If the documentation cannot be provided the
shareholders may be required to provide a warranty on this issue.
(b) The ability of the target company to generate profits in future will have an impact on the valuation
of the business. As the accountants have not been able to review a major sales contract they will
not be able to confirm:
 the number of years remaining on the contract before it may go out to tender;
 whether the contract is transferable; or
 whether there are any liabilities associated with the contract which have not been disclosed.
Again, warranties may need to be sought on this issue.
(c) Warranties may be provided by the sellers of a business as a 'guarantee' that they have disclosed all
the relevant information about the target company. As the finance director does not own any
shares and apparently therefore will not benefit from the sale of Lee Ltd, it is understandable that
he does not wish to warrant the transaction. However, as he is in the position of finance director,
this fact may undermine the confidence of Hill Ltd in the sale process and affect the share price. A
potential solution would be to incentivise the finance director by offering him a bonus on
completion of the sale in exchange for the warranties.

All three of the forecasts to be reviewed should be prepared on a monthly basis and the following work
would be required in order to consider their reasonableness.
(a) Capital expenditure forecast
(i) Read estate agent's details and solicitors' correspondence and compare to the capital
expenditure forecast to ensure that all expenditure (including sale price, surveyors' fees, legal C
costs, taxes on purchase) is included. H
A
(ii) Confirm the estimated cost of new furnishings by agreeing them to supplier price lists or P
quotations. T
E
(iii) Verify any discounts assumed in the forecast are correct by asking the suppliers if they will R
apply to this transaction.
(iv) Confirm projected building and decoration costs to the relevant suppliers' quotation.
25
(v) Confirm the projected cost of specialist equipment (and relevant bulk discounts) to suppliers'
price lists or websites.
(vi) In the light of experience of other such ventures, consider whether the forecast includes all
relevant costs.

(b) Profit forecast
As a first step it will be necessary to recognise that the residential home will not be able to generate
any income until the bulk of the capital expenditure has been incurred in order to make the home
'habitable'. However, while no income can be anticipated, the business will have started to incur
expenditure in the form of loan interest, rates and insurance.
The only income from the new building will be rent receivable from residents. The rentals which Mr
Lawrence is proposing to charge should be assessed for reasonableness in the light of rental
charged to similar homes in the same area. In projecting income it would be necessary to anticipate
that it is likely to take some time before the home could anticipate full occupancy and also it would
perhaps be prudent to allow for some periods where vacancies arise because of the 'loss' of some of
the established residents.
The expenditure of the business is likely to include the following.
(i) Wages and salaries. Although Mr and Mrs Lawrence intend to work full time in the business,
they will undoubtedly need to employ additional staff to care for residents, cook, clean and
tend to the gardens. The numbers of staff and the rates of pay should be compared to similar
local businesses of which the firm has knowledge.
(ii) Rates and water rates. The estimate of the likely cost of these confirmed by asking the local
council and/or the estate agents dealing with the sale of property.
(iii) Food. The estimate of the expenditure for food should be based on the projected levels of staff
and residents, with some provision for wastage.
(iv) Heat and light. The estimates for heat, light and cooking facilities should be compared to
similar clients' actual bills.
(v) Insurance. This cost should be verified to quotes from the insurance broker.
(vi) Advertising. The costs of newspaper and brochure advertising costs should be checked
against quotes obtained by Mr Lawrence.
(vii) Repairs and renewals. Adequate provision should be made for replacement of linen, crockery
and such like and maintenance of the property.
(viii) Depreciation. The depreciation charge should be recalculated with reference to the capital
costs involved being charged to the capital expenditure forecast.
(ix) Loan interest and bank charges. These should be checked against the bank's current rates
and the amount of the principal agreed to the cash forecast.
(c) Cash flow forecast
(i) Check that the timing of the capital expenditure agrees to the cash flow forecast by
comparing the two.
(ii) Compare the cash flow forecast to the details within the profit forecast to ensure they tie up,
for example:
 Income from residents would normally be receivable weekly/monthly in advance.
 The majority of expenditure for wages etc, would be payable in the month in which it is
incurred.
 Payments to the major utilities (gas, electricity, telephone) will normally be payable
quarterly, as will the bank charges.
 Rates and taxes are normally paid half-yearly.
 Insurance premiums will normally be paid annually in advance.
(iii) Redo the additions on the cash forecast and check that figures that appear on other forecasts
are carried over correctly.

Procedures would involve the following:
To establish whether a fraud has taken place
 Obtain an understanding of the business and in particular the roles and responsibilities of those
involved in processing inventory transactions and those in the warehouse.
 Discuss with management the method adopted for conducting the quarterly inventory count and
review the detail of the count instructions. Any weaknesses in the controls should be identified and
considered as a possible explanation for the discrepancies eg, double counting of this particular line
of inventory.
 Obtain confirmation of whether inventory is held at more than one location. If so confirm that this
has been included in the physical inventory counts.
 Review procedures for the identification of obsolete and damaged items and in particular the
disposal of such items. Determine who is responsible for making the decision and the procedures
for updating records for these adjustments. If items have been disposed of but records not
maintained this could explain the discrepancy.
 Obtain an understanding of the system for the processing and recording of despatches and in
particular consider the effectiveness of controls regarding completeness of despatches. Trace
transactions from order to despatch in respect of the inventory line in question to confirm that all
goods out have been recorded.
 Obtain an understanding of the system for the processing and recording of goods received for this
inventory line. Controls over the initial booking in of inventory should be reviewed. If inventory is
double counted at this stage this could account for the discrepancy.
 Review the system for subsequent processing of goods received, in particular the controls and
procedures regarding the accuracy of input. If goods in are processed more than once this would
give rise to a discrepancy between the book records and actual inventory.
 Assess the existence of general controls affecting access to the warehouse and inventory.
To quantify the loss
The evidence obtained above should enable the auditor to determine the accuracy of the book records
and the accuracy of the physical inventory records. A reconciliation of the two figures should provide the
number of units missing. The cost of each unit should be agreed to recent purchase invoices.
Tutorial note
In this particular case, the approach taken is likely to involve elimination of legitimate reasons why the
discrepancies may have arisen.
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1 Travis plc
(a) Key business risks (only four required)
Risk with diversification
Scandinavia would be a new geographical area to the directors of Travis.
The culture and expectations of a Scandinavian workforce and Scandinavian business/holiday
travellers may be very different to that in other areas where Travis operates.
Regulatory environment
The directors of Travis will need to ensure that the company quickly gains knowledge of
regulations in the Scandinavian countries to ensure that local laws are not breached by future
decisions eg, local health and safety rules, local employment legislation.
Change management
The takeover of Bandic will be potentially unsettling for the Bandic workforce.
 Head office staff may think their jobs are at risk, as control may be subsumed within the
head office function of Travis.
 Hotel staff may be concerned about the future of the hotel in which they work.
This uncertainty is demotivating and can have serious performance consequences if decisions
are not made quickly and communicated effectively.
Financing
Travis must ensure that it does not overstretch itself when making an acquisition. A balance
must be struck between using existing resources and raising new finance via debt and/or
equity that the new entity is comfortably able to service.
Systems
Computer systems in Bandic will need to be integrated so that:
 reporting to the Travis board can be carried out, especially when integrating results for
overall control; and
 if the group wants standard booking/check-in procedures etc, Bandic's systems will need
more thorough integration.
(b) Due diligence
When bidding for the shares in its chosen company, Travis and its advisers will have only
limited access to financial information on that company.
A due diligence exercise is carried out by Travis once it has identified the target company. This
would usually be performed by the purchasing company together with its external advisers,
and would give a much more detailed review of the assets, liabilities, contracts in progress,
risks, etc, of the acquired company, to confirm that the original information relied on by Travis
was accurate.
An acquisition deal will not become unconditional until after satisfactory completion of a due
diligence exercise.

2 Upstarts Ltd
Briefing note
To: The engagement partner
From: Senior in corporate services
Date: Today
Re: Potential assignment at GPSWGFM
Associated risks
The most important issue here is that our client, GPSWGFM, seems to have a somewhat naïve
approach to this assignment. The buy-out is in a generally high risk area (see below), but the
information we have indicates that the client is placing reliance upon the management team of
Upstarts, without reference to the vendor.
This is exacerbated by the fact that the directors of Upstarts claim that its previous audited, filed
accounts significantly understate its profits, and further still by the limits upon our due diligence
work and by the vendor's refusal to provide any warranties.
A list of the risk factors associated with the transaction is set out below.
 The previous filed accounts are being restated, beneficially, by Upstarts, apparently without
any means to verify this with the vendor
 Previous problems within Upstarts, in particular the breakdown in relations with DatLinks and
its cash flow problems
 The overwhelming reliance upon management, who have a vested interest in overstating
results – particularly in view of the share options which are being proposed
 The lack of warranties from the vendor
 The fact that the company is in a high technology sector which carries a high level of
(inherent) risk
 Industry-wide problems (eg, the publicised security breach)
 The dependence upon key individuals remaining with the business – how likely is this?
 The potential adjustments to the accounts might well increase the company's statement of
financial position, such that the EMI scheme no longer applies
 The planned Initial Public Offering will exacerbate the incentive to overstate results, as will the
proposed share option scheme
Performance management
 The main supplier of hardware to Upstarts is the parent company DatLinks. Therefore new
suppliers may need to be sourced, thereby increasing the risk of stock-outs and interruptions
in supply and quality of supply.
Additionally, the following factors will affect our firm's own risk profile.
 The reliance by GPSWGFM on our due diligence work C
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 The potential conflict of interest – it might be perceived that the availability of ongoing work
A
might prejudice our approach to the due diligence exercise (ie, it may be perceived that we P
have a vested interest in seeing the deal go through). T
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 The Initial Public Offering will increase our exposure still further, since the public will rely upon R
our work.
25

Many of the above-mentioned risks are pervasive across the whole range of advisory services we are
considering offering. A summary of the key risks associated with each work stream is as follows.
 Due diligence – Reliance upon management; lack of management information; lack of
warranties; previous financial difficulties; reliance upon our work by GPSWGFM; incentives to
optimism by managers.
 Business plan review – The business plan and financial projections are an extension of the
due diligence work ie, projecting forwards to calculate profitability. The risks will be as above,
but with added risk because the integrity of projections in a relatively volatile market will need
to be tested.
 Tax structuring – This relies upon the numbers in the financial projections. As Upstarts has
suffered from cash flow problems recently, it will be important to determine the amount of
any unpaid tax liabilities, as these could impact the company's valuation. If any losses have
been incurred, how these unused losses can be preserved for offset against future profits needs
to be considered. This is especially important in the light of the group's transfer pricing policies
– there may be a risk of HMRC requiring transfer pricing adjustments, therefore increasing
previous years' tax liabilities. How to structure the share option scheme, and the amount of
any degrouping charges arising in Upstarts, also must be considered.
 Audit – Audit risk should be regarded as high: this is a new client to the firm, in an inherently
risky market sector, with a history of financial problems. The reliance upon key staff will also
affect audit risk, since the ability of Upstarts to continue as a going concern is dependent upon
the retention of key personnel. Depending on the nature of the future listing ethical
restrictions may apply in respect of the provision of both audit and other services.
 Flotation – This will extend the audit risk, since levels of reliance upon our work will be
increased throughout the general public. The proposed share options will potentially motivate
management to overstate results.
Overall, the deal should at this stage be regarded as very high risk – both for our client and for
ourselves. There may be significant ethical issues in future.
For ourselves, we should seriously consider not quoting for any of these services, or quoting for only
some parts of the work to avoid the potential conflict of interest noted above.

CHAPTER 26
Environmental and
social considerations
Introduction
Topic List
1 Introduction
2 Social responsibility reporting
3 Implications for the statutory audit
4 Social and environmental audits
5 Implications for assurance services
6 Integrated reporting
1419
Introduction
Learning objective Tick off
 Identify and explain corporate reporting and assurance issues in respect of social
responsibility, sustainability and environmental matters for a range of stakeholders
Specific syllabus references for this chapter are: 18(a)

1 Introduction C
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Section overview P
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Many corporations are now compiling and issuing annual reports that provide details about their E
environmental and social behaviour. R
1.1 Corporate responsibility 26
Traditionally management (and auditors) have been primarily concerned with one set of stakeholders,
the shareholders on whose behalf they operate the business and to whom they report.
However, in recent years pressure on organisations to widen the scope of their corporate public
accountability has come from the increasing expectations of other stakeholders, in particular
concerning the environment, society and employees.
The The environment is directly impacted by many corporate activities today. For
environment example a company can cause harm to natural resources in various ways, including:
 exhausting natural resources such as coal and gas; and
 emitting harmful toxins which damage the atmosphere.
This impact is regulated by environmental legislation and consumer opinion.
Society Society, from the point of view of the company, is made up of consumers or
potential consumers. As recognised above, consumers increasingly have opinions
about 'green', environmentally friendly products and will direct their purchasing
accordingly. They are concerned with harm to natural resources as they and their
children have to live on the planet and may suffer direct or indirect effects of
pollution or waste.
Society will also, through lobby groups, often speak out on behalf of the
environment as it cannot speak out itself.
Employees Employees have a relationship with the company in their own right, in terms of
their livelihood and also their personal safety when they are at work.
However, from the company's perspective, they are also a small portion of society at
large, as they may purchase the products of the company or influence others to do so.
Corporate responsibility is a field which is still developing. As a result, what constitutes corporate
responsibility is part of an ongoing debate. ICAEW (in An Overview of Corporate Responsibility) defines it
as the 'actions, activities and obligations of business in achieving sustainability'. If a business is to be
sustainable in the long run then the resources it uses must be sustainable. This includes raw materials
and energy and so on but also includes less tangible resources including:
 human and intellectual capital; and
 relationships with communities, governments, consumers and other stakeholders.
The business argument is that companies that are responsible will in the long term be more successful.
This gives rise to both:
 risk eg, reputational risk as a result of poor behaviour; and
 opportunity eg, companies that use energy efficiently will reduce cost.
1.2 Reputation
For a company, however, there is one simple need. Companies desire above all else to keep making
their products and to keep making sales. Increasingly to achieve this a business must have the
reputation of being a responsible business that enhances long-term shareholder value by addressing
the needs of its stakeholders. Where this is not seen to be the case, evidence indicates that consumers
will take action. For example, consumer campaigns have targeted Nike for alleged exploitation of
overseas garment-trade workers and McDonald's for alleged contribution to obesity and related illness.
Environmental and social considerations 1421

Therefore it is important for companies to have policies in order to appease stakeholders and to
communicate the policies to them.
As a result, many companies have developed specific policies to address social and environmental
concerns.
Examples
The following illustrate the wide-ranging nature of these policies:
 Johnson & Johnson generates 30% of its total US energy from green power sources such as wind
power, on-site solar, low impact hydro, renewable energy sources.
 IBM have installed energy saving devices including installing motion detectors for lighting in
bathrooms and copier rooms and rebalancing heating and lighting systems.
 Polaroid requires each employee to identify energy-saving projects as part of their performance
evaluation.
 Banks have introduced a 'green' credit card which donates a proportion of profits to environmental
causes and charges a lower interest rate on 'green purchases'.
This puts governance into a wider context (see Chapter 4).
Worked example: BP oil spill 2010

On 20 April 2010 a BP drilling rig exploded in the Gulf of Mexico resulting in the death of a number of
employees and the largest offshore oil spill in US history. This proved to be not only a catastrophic
environmental disaster but also severely damaged the reputation of the company. Before the accident
BP was the UK's biggest company, with a stock market value of £122 billion. By early June 2010
£49 billion had been wiped off the company's value and relations with the US Government were
strained. Dividend payments were suspended until the fourth quarter of 2010 and the financial
statements for 2010 showed a pre-tax charge of $40.9 billion relating to the accident and spill.
The oil spill has continued to have a significant impact on the company with compensation payments
being made to individuals and businesses from a disaster fund which was paid for by selling a number of
oil fields, thus affecting profitability.
2 Social responsibility reporting
Section overview
 Many companies are adopting 'triple bottom line' reporting.
 There is no mandatory guidance in the UK as to the format of sustainability reports.
 Companies may also produce employee and employment reports.
2.1 Sustainability reporting

The ICAEW website defines sustainability as 'maintaining the world's resources rather than depleting or
destroying them. This will ensure they support human activity now and in the future. Sustainable
business is the actions, activities and obligations of business in achieving sustainability. It involves
reconnecting business, society and the environment and recognising their interdependence.' In its paper
Sustainability: the Role of the Accountant, ICAEW suggests that there are a number of mechanisms which
can be used by individuals, societies and governments to enhance sustainability supported by reliable
information on which assurance has been provided by the accountant.
The paper summarises this as follows:

A market-based approach to sustainability
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MECHANISMS H
SUSTAINABILITY A
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Corporate Supply chain Stakeholder Voluntary Environmental E
policies pressure engagement codes performance R
Social 26
Market activity performance
Rating and Taxes and Tradable Requirements Economic

benchmarking subsidies permits and performance
prohibitions
SUPPORTING ACTIVITIES
Information and reporting
Assurance processes
Figure 26.1: A Market-Based Approach to Sustainability

As shown in the diagram above, sustainability can be seen to have three key aspects:
Economic Information provided goes beyond that required by law. It should demonstrate
how a company generates value in a wider sense eg, by creating human capital
Environmental This may provide information about the impact of products on the environment
eg, emissions, waste
Social Information may be provided on a range of social issues, including ethnic and
gender diversity, child labour, working hours and wages
As well as adopting social and environmental policies it is important that companies communicate
these policies to stakeholders. Increasingly companies are providing information on sustainability. This
type of report typically includes information about these three aspects of performance and is often
referred to as 'triple bottom line' reporting.
2.2 Regulation
There is currently no consensus on the type of information that should be disclosed in a sustainability
report. Historically companies whose activities have the greatest social and environmental impact have
been the most active in developing this type of reporting, for example companies within the oil and gas
industry like Shell. In more recent years sustainability reporting has become more common but
guidance is still at an early stage of development.
An increasing number of companies including BT, Vauxhall Motors and British Airways are following
guidance issued by the Global Reporting Initiative (GRI). The GRI aims to develop transparency,
accountability, reporting and sustainable development. Its vision is that reporting on economic,
environmental and social impact should become as routine and comparable as financial reporting.
In October 2016 GRI launched the GRI Sustainability Reporting Standards. These replace the previous
G4 Guidelines, although the new Standards are based on these. The Standards are made up of a set of
36 modular standards. This includes three universal standards which are to be used by every
organisation that prepares a sustainability report:
 GRI 101: Foundation
This sets out the Reporting Principles.

 GRI 102: General disclosures
This is used to report contextual information about an organisation and its sustainability reporting
practices. This includes information about an organisation's profile, strategy, ethics and integrity,
governance, stakeholder engagement practices and reporting processes.
 GRI 103: Management approach
This is used to report information about how an organisation manages a material topic.
The Reporting Principles as set out in GRI 101 are as follows:
Reporting principles for defining report content
 Stakeholder inclusiveness: The organisation should identify its stakeholders and explain how it has
responded to their reasonable expectations and interests.
 Sustainability context: The report should present the organisation's performance in the wider
context of sustainability.
 Materiality: The report should cover aspects that reflect the organisation's significant economic,
environmental and social impacts or substantively influence the assessments and decisions of
stakeholders.
 Completeness: The report should include coverage of material aspects and their boundaries
sufficient to reflect economic, environmental and social impacts, and to enable stakeholders to
assess the organisation's performance in the reporting period.
Reporting principles for defining report quality
 Balance: The report should reflect positive and negative aspects of the organisation's performance
to enable a reasoned assessment of overall performance.
 Comparability: The organisation should select, compile and report information consistently. The
reported information should be presented in a manner that enables stakeholders to analyse
changes in the organisation's performance over time and that could support analysis relative to
other organisations.
 Accuracy: The reported information should be sufficiently accurate and detailed for stakeholders to
assess the organisation's performance.
 Timeliness: The organisation should report on a regular schedule so that information is available in
time for stakeholders to make informed decisions.
 Clarity: The organisation should make information available in a manner that is understandable
and accessible to stakeholders using the report.
 Reliability: The organisation should gather, record, compile, analyse and disclose information and
processes used in the preparation of a report in a way that can be subject to examination and that
establishes the quality and materiality of the information.
(Source: https://www.globalreporting.org/standards/ [Accessed 21 March 2017])
2.2.1 Companies Act 2006

The Companies Act 2006 requires information on the environment, employees, social, community and
human rights issues, including details of company policies and their effectiveness to be included in the
strategic report. There is also a requirement to include disclosures on gender diversity. The requirements
also state that the analysis should include both financial and, where appropriate, other key performance
indicators relevant to the particular business, including information relating to environmental and
employee matters.
Note: From 1 October 2013 the Companies Act 2006 requires all UK quoted companies to report on
their greenhouse gas emissions as part of their annual Directors' Report. All other companies are
encouraged to report this information but it remains voluntary.

2.2.2 DEFRA Guidelines
C
In January 2006 DEFRA (the UK government department responsible for policy and regulation on the H
environment, food and rural affairs) published a set of environmental reporting guidelines for UK A
companies to help them identify and address their most significant environmental impacts. These were P
updated in June 2013. The guidelines are particularly useful for: T
E
 companies that do not currently report environmental performance; R
 companies required to prepare a Strategic Report;

 companies required to make mandatory greenhouse gas emissions statements; and 26
 small and Medium-Sized Enterprises (SMEs) that can benefit from improving and reporting on their
environmental performance, for example, if they are part of the supply chain of a larger company
that expects its suppliers to behave responsibly (eg, under BSI's ISO 14001 or the European
equivalent, EMAS (Eco-management and Audit Scheme)).
2.2.3 Accounting for Sustainability

The Accounting for Sustainability project was launched in the UK in 2006 by Prince Charles with an
overall aim 'to help ensure that sustainability … is not just talked and worried about, but becomes
embedded in organisations' "DNA"'. The Connected Reporting Framework that was produced as a result
of this project was not designed as a new reporting standard, but rather to build upon and improve the
frameworks already issued by the GRI and DEFRA and other organisations. Since then Accounting For
Sustainability (A4S) has continued to work to inspire action by finance leaders to drive a fundamental
shift towards resilient business models and a sustainable economy. To do this A4S has three core aims:
(1) Inspire finance leaders to adopt sustainable and resilient business models.
(2) Transform financial decision making to enable an integrated approach, reflective of the
opportunities and risks posed by environmental and social issues.
(3) Scale up actions across the global finance and accounting community.
A4S currently has a number of ongoing projects which are split into four main themes:
(1) Lead the way: Developing a strategic response to macro sustainability trends
(2) Transform your decisions: Integrating material sustainability factors into decision making
(3) Measure what matters: Developing measurement and valuation tools
(4) Access finance: Engaging with finance providers on the drivers of sustainable value
A series of guides has also been produced which are designed to inspire action by the financial
community.

Worked example: Sustainability report
The following is an extract from BT's sustainability report for 2014/5:

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(Source:
https://www.btplc.com/Sharesandperformance/Annualreportandreview/pdf/2015_BT_Annual_Report.pdf)

2.3 Advantages and disadvantages of sustainability reporting
The advantages are as follows:
 Employee satisfaction leads to improved customer service.
 Improved stakeholder satisfaction leads to increased financial performance.
 Investors want to see a company adopt practices that are more environmentally sustainable.
 Abuses of environment/human rights can damage reputations and hence share prices.
 Using resources efficiently can save money.
The disadvantages are as follows:
 Focus should be strictly on satisfying shareholders' desire for financial return.
 Shareholders' value may be reduced if profits are lost.
 Initially costs are incurred to become 'green'.
Interactive question 1: Social/environmental reporting

Westwitch plc is a multinational energy group, recently quoted on the London Stock Exchange. Among
its many activities the group operates an oil refinery in Nigeria, a nuclear waste disposal facility in South
Africa, and coal extraction in South America.
Requirement
How might the publication of a social/environmental report benefit Westwitch plc?
2.4 Employee and employment reports

Continuing the theme of increased information to stakeholders, the use of employee and employment
reports has been much debated.
Companies employ large numbers of individuals and thus have certain responsibilities, both to the
employees themselves and to society at large, to behave appropriately to them.
An employee report is an annual report for use by the employees to help simplify the information. It
uses non-technical language with charts, diagrams, etc. It aims to give these particular stakeholders the
opportunity to understand fully the assurances they require over the business.
It is recommended that an employment report be added to the annual report to include details of a
company's employees, eg, numbers employed, age, geographical location, hours worked, pension
schemes, staff training, and health and safety. This would furnish stakeholders with more information
than that required by law.
3 Implications for the statutory audit
Section overview
 The auditor will need to consider the implications of social and environmental matters on the
audit of the financial statements particularly at the following stages of the audit:
– Planning
– Substantive procedures
– Audit review
3.1 Introduction
As we have seen above, social and environmental matters are becoming significant to an increasing
number of entities and may, in certain circumstances, have a material impact on their financial
statements.

When these matters are significant to an entity, there may be a risk of material misstatement (including
inadequate disclosure) in the financial statements. In these circumstances the auditor needs to give C
consideration to these issues in the audit of the financial statements. H
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3.2 The consideration of environmental matters in the audit of financial E
statements R
Examples of environmental matters affecting the financial statements could include the following:
 The introduction of environmental laws and regulations may involve an impairment of assets and 26
consequently a need to write down their carrying value.
 Failure to comply with legal requirements concerning environmental matters, such as emissions
and waste disposal, or changes to legislation with retrospective effect, may require accrual of
remediation, compensation or legal costs.
 Some entities, for example in the extraction industries (oil and gas exploration or mining),
chemical manufacturers or waste management companies may incur environmental obligation as
a direct by-product of their core businesses.
 Constructive obligations that stem from a voluntary initiative, for example an entity may have
identified contamination of land and, although under no legal obligation, it may have decided to
remedy the contamination, because of its concern for its long-term reputation and its relationship
with the community.
 An entity may need to disclose in the notes the existence of a contingent liability where the
expense relating to environmental matters cannot be reasonably estimated.
 In extreme situations, non-compliance with certain environmental laws and regulations may affect
the continuance of an entity as a going concern and consequently may affect the disclosures and
the basis of preparation of the financial statements.
3.3 Planning the audit

Social and environmental issues impact on the planning of the audit in two ways:
 Understanding the entity
 Inherent risk assessment
As part of his knowledge of the business, the auditor should have an awareness of any environmental
regulations the business is subject to, and any key social issues arising in the course of the business.
Questions which the auditor may need to ask include the following:
 Does the entity operate in an industry that is exposed to significant environmental risk that may
adversely affect the financial statements of the entity?
 What are the environmental issues in the entity's industry in general?
 Which environmental laws and regulations are applicable to the entity?
 Have any regulatory actions been taken or reports been issued by enforcement agencies that may
have a material impact on the entity and its financial statements?
 Is there a history of penalties and legal proceedings against the entity or its directors in connection
with environmental matters? If so, what were the reasons for such actions?
The auditor may also be able to obtain knowledge of this aspect of the business by reading the entity's
procedures manual or reviewing any quality control documentation they have relating to standards. The
auditor may be able to review the results of any environmental audits undertaken by the company.
This information will then form part of the assessment of inherent risk.

3.4 Substantive procedures
Social and environmental issues, particularly environmental issues, may impact on the financial
statements in a number of ways. Some examples are given below.
 Provisions (for example, for site restoration, fines/compensation payments)
 Contingent liabilities (for example, in relation to pending legal action)
 Asset values (issues may impact on impairment or purchased goodwill/products)
 Capital/revenue expenditure (costs of clean up or meeting legal standards)
 Development costs (new products)
 Going concern issues (considered below under audit reviews)
The auditor will have to bear in mind the effects of social or environmental issues on the financial
statements when designing audit procedures. We will now look at some potential audit procedures
that would be relevant in three of the key areas above.
3.4.1 Asset values

The key risk that arises with regard to valuation is that assets might be impaired. IAS 36 Impairment of
Assets, which you have covered in your Financial Reporting studies, requires an impairment review to be
undertaken with regard to non-current assets if certain indicators of impairment exist. IAS 36 gives a list
of indicators that an impairment review is required. The indicator relevant in this instance is a
significant change in the technological market, legal or economic environment of the business in
which the assets are employed.
The following procedures to identify asset impairments may be used:
 Inquire about any planned changes in capital assets, for example, in response to changes in
environmental legislation or changes in business strategy, assess their influences on the valuation of
these assets or the company as a whole.
 Inquire about policies and procedures to assess the need to write-down the carrying amount of
an asset in situations where an asset impairment has occurred due to environmental matters.
 Inquire about data gathered on which to base estimates and assumptions developed about the
most likely outcome to determine the write-down due to the asset impairment.
 Inspect documentation supporting the amount of the possible asset impairment and discuss such
documentation with management.
 For any asset impairments related to environmental matters that existed in previous periods,
consider whether the assumptions underlying a write-down of related carrying values continue to
be appropriate.
Other procedures might also include the following:
 Review of the board minutes for indications that the environmental regulatory environment has
changed
 Review of relevant trade magazines or newspapers to assess whether any significant adverse
changes have taken place
If an impairment review has been undertaken, and the valuation of the asset has been adjusted
accordingly, the auditor should audit the impairment review.
3.4.2 Provisions and contingencies

Guidance on accounting for provisions and contingencies is provided in IAS 37 Provisions, Contingent
Liabilities and Contingent Assets which you have studied in Financial Reporting.
The IAS provides some helpful examples of environmental issues that result in provisions being
required. These include circumstances where the company has:
 an environmental policy such that the parties would expect the company to clean up
contamination; or
 broken current environmental legislation.

The auditor needs to be aware of any circumstances that might give rise to a provision being required,
and then apply the recognition criteria to it. C
H
Social and environmental issues may also give rise to contingencies. In fact, a contingent liability is A
likely to arise as part of a provisions review, where items highlighted do not meet the recognition criteria P
for a provision. T
E
The following procedures may be performed to assess the completeness of liabilities, provisions and R
contingencies arising from environmental matters:
 Inquire about policies and procedures implemented to help identify liabilities, provisions and 26
contingencies.
 Inquire about events or conditions that may give rise to liabilities, provisions or contingencies, for
example:
– violation of environmental laws and regulations;
– penalties arising from violations of environmental laws and regulations; and
– claims and possible claims for environmental damage.
 If site clean-up costs, future removal or site restoration costs or penalties have been identified,
inquire about any related claims or possible claims.
 Inquire about, read and evaluate correspondence from regulatory authorities.
 For property abandoned, purchased or closed during the period, inquire about requirements for
site clean-up or intentions for future removal and site restoration.
 Perform analytical procedures and consider the relationships between financial information and
quantitative information included in the entity's environmental records (for example the
relationship between raw material consumed or energy used, and waste production or emissions,
taking into account the entity's liabilities for proper waste disposal or maximum emission levels).
Interactive question 2: Provisions

Mole Mining Company Ltd carries out quarrying activities. It has recently obtained planning permission
to mine at a new location. A condition of the planning consent is that environmental damage caused by
the opening of the mine must be remedied on completion of quarrying. The company must also
remedy any damage caused by the subsequent mineral extraction.
At the year end the mine has been opened but no mining has taken place.
Requirement
What are the factors which the auditor needs to consider in respect of any possible provision for
environmental damage?
3.5 Audit reviews

Key issues include:
 going concern
 non-compliance with laws and regulations
Environmental and social issues can impact on the ability of the company to continue as a going
concern. ISA (UK) 570 (Revised June 2016) Going Concern is covered in Chapter 8.
The auditors' responsibility with regard to laws and regulations
is set out in ISA (UK) 250A (Revised June 2016) Section A – Consideration of Laws and Regulations in an
Audit of Financial Statements. You have studied this topic in Audit and Assurance at Professional Level.
In the context of environmental and social auditing, environmental obligations would be core in some
businesses (for example, oil and chemical companies); in others they would not. ISA 250 talks of laws
that are 'central' to the entity's ability to carry on business.

Clearly, in the case of a company which stands to lose its operating licence to carry on business in the
event of non-compliance, environmental legislation is central to the business.
In the case of social legislation, this will be a matter of judgement for the auditor. It might involve
matters of employment legislation, health and safety regulation, human rights law and such matters
which may not seem core to the objects of the company, but which permeate the business due to the
needs of employees.
Note: A number of points in section 3 are based on the IAASB's IAPS 1010 The Consideration of
Environmental Matters in the Audit of Financial Statements. Although IAPS 1010 has now been withdrawn,
these points offer useful guidance.
4 Social and environmental audits
Section overview
 Social audits determine whether the company is acting in a socially responsible manner and in
accordance with objectives set by management.
 Environmental audits assess the extent to which a company protects the environment from the
effects of its activities in accordance with the objectives set by management.
4.1 Social audits

The process of checking whether a company has achieved set targets may fall within a social audit that a
company carries out.
Social audits involve the following:
 Establishing whether the firm has a rationale for engaging in socially responsible activity
 Identifying that all current environment programmes are congruent with the mission of the
company
 Assessing the objectives and priorities related to these programmes
 Evaluating company involvement in such programmes past, present and future
Whether or not a social audit is used depends on the degree to which social responsibility is part of the
corporate philosophy. A cultural awareness must be achieved within an organisation in order to
implement environmental policy, which requires board and staff support.
In the US, social audits on environmental issues have increased since the Exxon Valdez catastrophe (in
which millions of gallons of crude oil were released into Alaskan waters) and the BP Gulf of Mexico
disaster (covered earlier).
4.2 Environmental audits

Environmental audits seek to assess how well the organisation performs in safeguarding the
environment in which it operates, and whether the company complies with its environmental policies.
The auditor will carry out the following steps:
 Obtain a copy of the company's environmental policy
 Assess whether the policy is likely to achieve objectives:
– Meet legal requirements
– Meet British Standards
– Satisfy key customers/suppliers' criteria
 Test implementation and adherence to the policy by:
– discussion
– observation
– 'walk-through tests' where possible

5 Implications for assurance services C
H
A
Section overview P
T
Environmental and social issues provide an opportunity for the auditor to provide other assurance E
services. R
5.1 Types of service 26
5.1.1 Assurance on sustainability reporting

Auditors can provide a variety of assurance services in respect of environmental and social issues. We
have looked at assurance engagements in detail in Chapter 25, therefore in this chapter we will consider
engagements specifically related to sustainability issues.
If directors issue an environmental and social report, it may contain figures and statements that are
verifiable.
The earlier sections of this chapter have highlighted the growing importance of environmental and
sustainability reporting. The credibility of this information can be enhanced by an assurance process. In
the same way that there is no one generally accepted set of rules for environmental and sustainability
reporting, there is currently no specific standard that applies to the related assurance assignments.
However, ISAE 3000 (Revised) Assurance Engagements Other than Audits or Reviews of Historical Financial
Information is relevant and firms may also make use of the assurance standard AA1000AS (Assurance
Standard), issued by AccountAbility.
AccountAbility is a global non-profit network that works with businesses and governments to promote
accountability innovations that advance sustainable development. It has issued a reporting standard,
AA1000 Accountability Principles, which establishes three principles for sustainability reporting.
Inclusivity For an organisation that accepts its accountability to those on whom it has an
impact and who have an impact on it, inclusivity is the participation of
stakeholders in developing and achieving an accountable and strategic
response to sustainability.
Materiality Materiality is determining the relevance and significance of an issue to an
organisation and its stakeholders. A material issue is an issue that will influence
the decisions, actions and performance of an organisation or its stakeholders.
Responsiveness Responsiveness is an organisation's response to stakeholder issues that affect its
sustainability performance and is realised through decisions, actions and
performance, as well as communication with stakeholders.
Much of the guidance in this standard is very similar to ISAE 3000 (Revised), but there are areas where it
gives more specific guidance:
 The objective of the engagement is to evaluate and provide conclusions on:
– the nature and extent of adherence to the AA1000 principles and, if within the scope agreed
with the reporting company; and
– the quality of publicly disclosed information on sustainability performance.
 Any limitation in the scope of the disclosures on sustainability, the assurance engagement or the
evidence gathering shall be addressed in the assurance statement and reflected in the report to
management if one is prepared.
 There is no set wording for the assurance statement but the following is listed as the minimum
information required:
– Intended users of the assurance statement
– The responsibility of the reporting organisation and of the assurance provider
– Assurance standard(s) used, including reference to AA1000AS (2008)

– Description of the scope, including the type of assurance provided
– Description of disclosures covered
– Description of methodology
– Any limitations
– Reference to criteria used
– Statement of level of assurance
– Findings and conclusions concerning adherence to the AA1000 Accountability Principles of
Inclusivity, Materiality and Responsiveness (in all instances)
– Findings and conclusions concerning the reliability of specified performance information (for
Type 2 assurance only)
– Observations and/or recommendations
– Notes on competencies and independence of the assurance provider
– Name of the assurance provider
– Date and place
This Standard is currently in revision and it is expected that the revised Standard will be launched by
late-2017.
Worked example: Assurance services

The following extract from the assurance statement prepared by Ernst & Young on BP's 2015
Sustainability Report reflects an assignment carried out in accordance with ISAE 3000 (Revised).
Ernst & Young Independent assurance statement (extract)

We have performed a limited assurance engagement on selected performance data and statements
presented in the BP plc (BP) Sustainability Report 2015 (the Report).
Respective responsibilities
BP management are responsible for the collection and presentation of the information within the
Report. BP management are also responsible for the design, implementation and maintenance of
internal controls relevant to the preparation of the Report, so that it is free from material misstatement,
whether due to fraud or error.
Our responsibility, in accordance with BP management's instructions, is to carry out a 'limited level'
assurance engagement on selected data and performance claims in the Report (the subject matter
information). We do not accept or assume any responsibility for any other purpose or to any other
person or organisation. Any reliance any such third party may place on the Report is entirely at its own
risk.
What we did to form our conclusions
Our assurance engagement has been planned and performed in accordance with ISAE 3000 (Revised).
The Report has been evaluated against the following criteria:
Whether the Report covers the key sustainability issues relevant to BP in 2015 which were raised in the
media, BP's own review of material sustainability issues, and selected internal documentation.
Whether the health, safety and environment (HSE) data presented in the Report are consistent with BP's
Environmental Performance Group Reporting Requirements and HSE Reporting Definitions.
Whether sustainability claims made in the Report are consistent with the explanation and evidence
provided by relevant BP managers.
Summary of work performed

The procedures we performed were based on our professional judgement and included the steps
outlined below: C
H
1 Interviewed a selection of BP's senior managers to understand the current status of safety, social, A
ethical and environmental activities and progress made during the reporting period. P
T
2 Reviewed selected group level documents relating to safety, social, ethical and environmental E
aspects of BP's performance to understand progress made across the organisation and test the R
coverage of topics within the Report.
3 Carried out the following activities to review health, safety and environment (HSE) data samples
26
and processes:
(a) Reviewed disaggregated HSE data reported by a sample of 19 businesses to assess whether
the data had been collected, consolidated and reported accurately
(b) Reviewed and challenged supporting evidence from the sample of businesses
(c) Tested whether HSE data had been collected, consolidated and reported appropriately at
group level
4 Reviewed the coverage of material issues within the Report against the key sustainability issues
raised in external media reports and the outputs from BP's processes for determining material
sustainability issues.
5 Reviewed information or explanations about selected data, statements and assertions within the
Report regarding BP's sustainability performance.
The limitations of our review
Our evidence-gathering procedures were designed to obtain a limited level of assurance (as set out in
ISAE 3000 (Revised) on which to base our conclusions. The extent of evidence-gathering procedures
performed is less than that of a reasonable assurance engagement (such as a financial audit) and
therefore a lower level of assurance is provided.
Our work did not include physical inspections of any of BP's operating assets.
Completion of our testing activities has involved placing reliance on BP's controls for managing and
reporting HSE information, with the degree of reliance informed by the results of our review of the
effectiveness of these controls. We have not sought to review systems and controls at BP beyond those
used for HSE data.
Our conclusions
Based on the scope of our review our conclusions are outlined below:
Materiality
Has BP provided a balanced representation of material issues concerning BP's sustainability
performance?
 We are not aware of any material aspects concerning BP's sustainability performance which have
been excluded from the Report.
 Nothing has come to our attention that causes us to believe that BP management has not applied
its processes for determining material issues to be included in the Report.
Completeness and accuracy of performance information
How complete and accurate is the HSE data in the Report?
 With the exception of the limitations identified in the Report on pages 8–9, we are not aware of
any material reporting units that have been excluded from the group-wide HSE data.
 Nothing has come to our attention that causes us to believe that the data relating to the above
topics has not been collated properly from group-wide systems.
 We are not aware of any errors that would materially affect the data as presented in the Report.

How plausible are the statements and claims within the Report?
 We have reviewed information or explanation on selected statements on BP's sustainability
activities presented in the Report and we are not aware of any misstatements in the assertions
made.
(Source: https://www.bp.com/content/dam/bp/pdf/sustainability/group-reports/bp-sustainability-
report-2015.pdf)
Interactive question 3: Assurance services

Your audit client, Naturascope Ltd, is a health food and homeopathic remedies retailer, with a strong
marketing emphasis on the 'natural' elements of the products and the fact that they do not contain
artificial preservatives.
The directors have decided that it would benefit the company's public image to produce a social and
environmental report as part of their annual report. There are three key assertions which they wish to
make as part of this report:
(1) Goods/ingredients of products for sale in Naturascope have not been tested on animals.
(2) None of Naturascope's overseas suppliers use child labour (regardless of local laws).
(3) All Naturascope's packaging uses recycled materials.
The directors have asked the audit engagement partner whether the firm would be able to produce a
verification report in relation to the social and environmental report.
Requirements
(a) Identify and explain the matters the audit engagement partner should consider in relation to
whether the firm can accept the engagement to report on the social and environmental report.
(b) Comment on the matters to consider and the evidence to seek in relation to the three assertions.
5.2 Due diligence and sustainability

Due diligence engagements were covered earlier but this is another area where there is an increasing
emphasis on environmental and other corporate responsibility issues.
The following is a quotation from Eric Collard of KPMG Luxembourg, taken from a press release issued
in October 2008:
'In all aspects of business, fads and trends come and go. Those that remain will have struggled long
and hard to make it into the mainstream business consciousness. But how can we judge when
something has made the transition from flavour of the month to inescapable fact?
Well, I would suggest that being accepted by tough-talking M&A executives and investment
bankers – a group not known to suffer fools lightly – is a sure indication that something is no
longer a fad; it's here to stay.
That's what I believe has now happened with the sustainability agenda – and all of its component
environmental, social, economic and ethical parts. In fact, it has now become a key factor against
which a target business is assessed in the pre-deal due diligence process.
It has been a fairly startling rise for the new 'new kid on the block' but sustainability concerns now
sit comfortably alongside financial, strategic, operational and reputational concerns at the top of
the dealmaker's checklist. In fact, any business which fails to investigate a target business with
regards to its sustainability profile is not just missing out on potential benefits; it could actually be
putting itself at risk.'
Environmental due diligence (EDD) has been carried out for some years in relation to corporate
acquisitions and mergers and property transfers, with the traditional risks relating to contaminated land
and regulatory compliance being considered.

The scope of this due diligence has widened in recent years to consider a greater range of risks that
could have a material impact on the transaction, such as the following: C
H
 Investigation of monitoring and reporting procedures in respect of environmental liabilities and A
risks P
T
 Waste disposal issues E
R
 Environmental search reports (Dun & Bradstreet have developed a new service to help users screen
for environmental risks)
 Examination of environmental consents and licences 26
 Review of insurance
6 Integrated reporting
Section overview
Integrated reporting is borne out of an increasing demand for companies to disclose a more holistic
view of how a company creates value. The Integrated Reporting Framework seeks to evaluate value
creation through the communication of qualitative and quantitative performance measures.
6.1 Rise of integrated reporting

In recent years there has been increasing demand for the senior management in large organisations to
provide greater detail on how they use the resources at their disposal to create value. Traditional
corporate reporting which focuses on financial performance is said to tell only part of the story.
Integrated reporting is concerned with conveying a wider message on an entity's performance. It is not
solely centred on profit or the organisation's financial position but details how its activities interact to
create value over the short, medium and long term.
The report by Deloitte, A clear vision: Annual report insights 2016, which is based on a survey of the
annual reports of 100 UK listed companies indicates that 12 companies specifically referred to
Integrated Reporting in their annual reports in 2016 (2015: 7). Four companies (2015: 2) indicated that
their annual reports were prepared in line with the Principles of the Integrated Reporting Framework.
(Deloitte (2016) A Clear Vision: Annual Report Insights [Online] Available from:
https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/audit/deloitte-uk-ari-16-full-
details.pdf [Accessed 21 March 2017])
In 2013, the International Integrated Reporting Council (IIRC) introduced the integrated reporting
framework. The framework refers to an organisation's resources as 'capitals'. Capitals are used to assess
value creation. Increases or decreases in these capitals indicate the level of value created or lost over a
period. Capitals cover various types of resources found in a standard organisation. These may include
financial capitals, such as the entity's financial reserves, through to its intellectual capital which is
concerned with intellectual property and staff knowledge.
6.2 Types of capital

The integrated reporting framework classifies the capitals as:
Capital Comment
Financial capital The pool of funds that is:

• available to an organisation for use in the production of goods or the
provision of services; and
• obtained through financing, such as debt, equity or grants, or
generated through operations or investments.

Capital Comment
Manufactured capital Manufactured physical objects (as distinct from natural physical objects) that
are available to an organisation for use in the production of goods or the
provision of services. Manufactured capital is often created by other
organisations, but includes assets manufactured by the reporting
organisation for sale or when they are retained for its own use
Intellectual capital Organisational knowledge-based intangibles
Human capital People's competencies, capabilities and experience, and their motivations to
innovate
Natural capital All environment resources and processes that support the prosperity of an
organisation
Social and relationship The institutions and the relationships within and between communities,
capital groups of stakeholders and other networks, and the ability to share
information to enhance individual and collective wellbeing
(Source: The International Integrated Reporting Framework, www.theiirc.org)
6.3 Interaction of capitals

Capitals continually interact with one another, and an increase in one may result in a decrease in
another. For example, a decision to purchase a new IT system would improve an entity's 'manufactured'
capital while decreasing its financial capital in the form of its cash reserves.
6.4 Short term vs long term

Integrated reporting forces management to balance the organisation's short-term objectives against its
longer-term plans. Business decisions which are solely dedicated to the pursuit of increasing profit
(financial capital) at the expense of building good relations with key stakeholders such as customers
(social capital) are likely to hinder value creation in the longer term.
6.5 Monetary values

Integrated reporting is not aimed at attaching a monetary value to every aspect of the organisation's
operations. It is fundamentally concerned with evaluating value creation through the communication of
qualitative and quantitative performance measures. Key performance indicators are effective in
communicating performance.
6.6 Materiality
When preparing an integrated report, management should disclose matters which are likely to impact
on an organisation's ability to create value. Both internal and external threats regarded as being
materially important are evaluated and quantified. This provides users with an indication of how
management intend to combat risks should they materialise.
6.7 Implications of introducing integrated reporting

Implications Comment
IT costs The introduction of integrated reporting will most likely require significant
upgrades to be made to the organisation's IT and information system
infrastructure. Such developments will be needed to capture KPI data. Due
to the broad range of business activities reported on using integrated
reporting (customer, supplier relations, finance and human resources) it is
highly likely the costs of improving the infrastructure will be significant.

Implications Comment
C
Time/staff costs The process of gathering and collating the data for inclusion in the report H
A
is likely to require a significant amount of staff time. This may serve to P
decrease staff morale if they are expected to undertake this work in T
addition to existing duties. E
R
This may require additional staff to be employed.
Consultancy costs Organisations producing their first integrated report may seek external
guidance from an organisation which provides specialist consultancy on 26
integrated reporting. Consultancy fees are likely to be significant.
Disclosure There is a danger that organisations may volunteer more information
about their operational performance than intended. Disclosure of planned
strategies and key performance measures are likely to be picked up by
competitors.
Worked example: Integrated report 1

ICAEW produced its first integrated report in 2012/13.
In an article published in Economia in April 2013, ICAEW's CFO, Robin Fieth, discussed the challenges
that ICAEW has faced in adopting integrated reporting:
'First, we followed the principle of defining ICAEW in terms of six capitals – financial, manufactured,
intellectual, human, social and relationship, and natural. We don't usually think of our institute in
these terms or about how we create 'value' in the abstract. We also looked at and defined our
stakeholders in a quite simple diagram. I think that the conversations that this exercise started will
ripple out this year into looking at how we serve the public interest and will be seen in some of our
corporate governance work that is to be released next week, which looks at what business is
responsible for.
Second, we had to look at reporting against key performance indicators (KPIs), and disclosing both
our KPIs for this year and for next – something we have never done before. This level of disclosure
prompted a lot of debate, with some expressing concern that we were disclosing too much, and
others that this level of public accountability could lead to the temptation to moderate future years'
key targets because of the fear of publicly failing to meet them. In the final analysis, however, we
felt that these KPIs would help us report in a more transparent way and let our members hold us to
account more effectively. In short, it was the right thing to do. It also means that we align our
internal planning with the external reporting more effectively.
At the same time, we were very aware of the growing length of annual reports, and that a longer
report does not necessarily make for a better report. We wanted to tell our members the whole
story, but in fewer words.'
(Source: Economia, http://economia.icaew.com/business/integrated-reporting-in-action)
Below, we include some excerpts from ICAEW's integrated report 2012/13, which relate to the challenges
described above. The full integrated annual review can be accessed at: http://review.icaew.com/.

Key elements from ICAEW's integrated report
Organisational overview
ICAEW: Helping people do business with confidence, creating leaders in business and finance
ICAEW is a professional membership organisation, with a Royal Charter that commits us to working in
the public interest.
People and relationships that matter
As a not-for-profit organisation, we create value for society principally in terms of human, social and
relationship and intellectual capital, that is to say: People, Relationships that Make a Difference, and Our
Thinking.
What we do How we create value
People We translate technical financial and We provide members with life-long

ethical concepts into practical guidance learning and membership helping them
and advice for members and other make a living. Our CPD is mandatory.
stakeholders. The continuing advancement of
personal and technical standards is the
backbone of professionalism.
Relationships The importance of the relationship Our technical thought leadership
between the profession and society is captures and applies the collective
reflected in our Royal Charter, and its business and financial knowledge and
emphasis on the public interest. The experience of our members to advance
profession came into being because collective well-being.
people needed to be able to trust the
businesses in which they were investing.
That trust was, and still is, built on
reliable, high quality financial
information and business advice, both
provided by ICAEW Chartered
Accountants.
Thinking We are proud of the practical outputs We create and enhance intellectual
from our wide-ranging thought capital through our research, policy and
leadership. Our thinking sparks guidance on technical and public
discussion, supports members and interest issues relating to business,
businesses and inspires public practice and the public sector.
confidence by influencing the policy
decisions of regulators and politicians.

Our members engage with 1.5m businesses in the UK alone, and offer
ICAEW Chartered Accountants have the knowledge, skills and
experience to operate at the highest professional, technical and free advice through our Business Advice Service. They contribute to C
ethical standards. ICAEW society advising businesses, the public sector and charities. We promote H
the highest technical and ethical standards in business and in the public
Chartered interest. A
Accountants P
T
We are making the profession E
accessible to a more diverse range of We provided assessment, syllabus and the
ethical framework for employers to develop
R
students while maintaining the
quality and prestige of our Students Employers people, combined with experience in the
qualifications. workplace, but we also help to build
institutions and standards that then contribute
to the wider economy and to society.
26
ICAEW
acting in the
public interest
Our ideas influence policy, for

example those set out in our 2013 We work schools, universities, tuition
paper ‘The CFO at the Cabinet Table’. Policy Educators providers and firms that train chartered
Our members and stakeholders Makers accountants to ensure that the skills and
share their expertise and knowledge competencies that modern professionals
through ICAEW’s research and need are built into the ACA curriculum and
policy work evidenced by experience and practical
learning.
Regulators
and Global
Our standard-setting expertise is shared internationally through Bodies We create social value by raising standards, always acting in the public
capacity-building projects. interest, helping build strong national bodies around the world and
allowing people to do business with confidence.
Performance
Students
Commentary 2012 2013 2013 2014 Commentary

on 2013 Actual Budget Actual Budget on 2014
Total ICAEW Evolved ACA 20,037 20,095 20,121 21,142 Continue to

Chartered launched in develop
Accountants 2013 to student base
(ACA) good internationally
students feedback
ACA student Below target 6,201 6,535 5,656 6,170 Growth
intake as economy anticipated in
continued to key
see only international
partial markets,
recovery in supported by
UK and key direct and
international partnership
markets approaches to
recruitment
CFAB intake Doubled 903 1,992 1,822 2,190 Growth based
(our entry previous on
qualification) year to take investment in
total ICAEW key markets
students to
record level

Membership

Total Stronger 140,573 142,093 142,334 144,080 We anticipate

membership admissions steady
and growth
retention,
1.3%
growth
New Above 3,928 3,535 3,660 3,910 We expect
members target with growth based
admitted strong on higher
admissions student base
performance coming into
membership
Operations

Operating A strong (1.2) 0.5 2.2 1.0 We target a

result (£m) result in modest
delivering surplus to
our strategy contribute to
despite strategic
additional development.
FRC case cost The outcome
requirements will be
dependent
on FRC case
outcomes.
Special Significant 13,642 13,643 14,766 15,695 New groups
Interest growth and continue
Group across the to develop
membership groups content and
offerings
Faculty Growth 31,296 30,751 31,756 31,975 Continued
membership achieved growth partly
across new from new
services services
We delivered a strong performance across most of our key measures of success. Our student intake was
below the ambitious target set as the economic situation continued to weigh on recruitment in a
number of significant markets. A number of developments in 2013, outlined in the Access section
below, will provide us with tools to address this, together with a greater focus on developing
recruitment to ICAEW qualifications. Despite this shortfall, the total number of students pursuing ICAEW
qualifications reached an all-time high.
(Source: ICAEW Annual Review 2013. The complete integrated annual review can be accessed at:
http://review.icaew.com/)

Worked example: Integrated report 2
C
The following extract from the Integrated Report and Accounts 2015 for G4S plc clearly show links H
between strategic priorities with key risks and KPIs. A
P
Competitive Advantage Key Risks* Progress, Performance T
E
Measures & KPIs**
R
 Brand  Our trained and skilled  130 new senior
people are hired by appointments
 Scale and breadth of business 26
competitors or other
 New leadership, operations
 Investment in selection, training, businesses (see Principal
and sales training
support and development risks: People page 50)
programmes
 Recognition, incentives and
 Recruitment and retention
rewards
 Sector expertise  Failure to understand  Customer retention 90%+
customers changing needs
 Skilled account managers  Contract retention 90%+
 Loss of customers
 Account and relationship
(see Principal risks: Growth
management
strategy page 52)
 Sector expertise  Our service design fails to  Growing, diversified
create adequate value for pipeline
 Investment in service innovation
our customers
 Won new work of £1.3
 Technology centres of excellence
 Failure to market or deliver billion annual contract
 Investment in sales and business services effectively value (£2.4 billion total
development (see Principal risks: Delivery contract value) in 2015
of core service lines
 Scale and breadth of market and  New services and solutions
page 51 and Growth
service coverage launched
strategy page 52)
 Integrated service offering
 Global account
wins/growth
 Underlying revenue growth
of 4.0%
 Investment in training,  Our service falls short of  Established customer

supervision and development customer expectations satisfaction programmes
(see Principal risks: Delivery
 Investment in systems and  Effective account
of core service lines
technology management
page 51 and Major
 Skilled account managers contracts page 51)  Improving Net Promoter
Score
 Investment in account and
relationship management  Retention 90%+
 Investing in best in class  Failure to comply with  Strengthened safety

operating and safety standards standards policies and resources
 Subject matter experts in  Loss of expertise  Successful implementation
operations, security and safety of major restructuring
 Investment fails to deliver
programmes
 Investment in systems and benefits
technology  Lost time incidents
 Investment in global procurement  Zero harm
 Investment in restructuring and
lean process design

Competitive Advantage Key Risks* Progress, Performance
Measures & KPIs**
 Standardised risk and contract  Failure to comply with  Group-wide capital

assessment group standards allocation and efficiency
 Investment in skills and expertise  Inefficient capital  Focused working capital
management management
 Investment in contract
management capability  Failure to realise expected  Major, accretive portfolio
value for disposals changes
 Investment in systems and
technology  See Principal risks: Major  Earnings per share
contracts page 51 (see page 37)
 Operating cash flow
(see page 37)
6.8 Auditing integrated reports

One central problem faces auditors auditing integrated reports: how to measure the effect of one
variable on another, when no independent variable can be isolated? This is the problem of the
complexity of the social world. One might, for instance, decide to measure the performance of a school
in terms of the examination performances of its students. The immediate difficulty is that a student's
performance is not simply the result of one variable (the school) but results from a large number of
different factors, such as the student's level of education on entering the school, the educational
environment in the student's home life, the amount of time available to the student for study rather
than paid work (the list goes on).
It is thus necessary to take great care when designing performance measures to take into account the
effect of other factors on the reported metric. In practice the auditor will often adjust figures to take
into account the effect of other variables.
Interactive question 4: Auditing performance information

Two hospitals, North Hospital and South Hospital, are required to report information in relation to the
mortality of patients undergoing cardiothoracic (heart) surgery. The following information was reported.
Number of planned
Hospital Number of patients procedures Number of deaths
North 763 610 23

South 549 494 19
Of the deaths experienced in North Hospital, 12 were patients who died during planned procedures
(the rest were emergency procedures). At South Hospital 7 patients died during planned procedures.
Requirement
Analyse the performance of the two hospitals and identify the better performing hospital.
6.8.1 Incentives and manipulation

An important difficulty in the use of performance information is that of manipulation of the reported
figures (indeed, this is part of the reason for this information being subject to audit in the first place).
This could take the form of straightforwardly doctoring the report figures, but perhaps more damaging
is the risk that those being measured change their behaviour in order to improve the reported figures,
without actually improving performance. This is the problem of perverse incentives.
A simple example of a perverse incentive is a measure of the speed in answering letters, which is not
balanced by a measure of the quality of responses. This might encourage people to answer letters

quickly, but badly. Extending the theme, a publishing company might set deadlines for books going to
print or for drafts being completed, irrespective of their quality. C
H
A
Worked example: Healthcare targets P
T
A public sector healthcare provider was set a target for the maximum length of time a patient would E
have to wait in emergency departments before being seen by a doctor. The target was for patients to be R
seen within four hours of being admitted.
The response in some departments was simply to leave non-urgent patients to wait outside in
26
ambulances. Patients still in the ambulance were not yet technically 'admitted' to the department, so the
time in the ambulance did not count towards the four-hour target even though it was clearly
detrimental to patient care.
6.9 Planning and conducting the audit of performance information

The first step is to identify the objectives against which the performance of the organisation is to be
evaluated. The question the auditor seeks to answer is simply: is the organisation achieving its
objectives?
Objectives will usually already have been determined by the organisation itself (or by a higher level of
government). The organisation itself may already have determined its own specific numerical measures
(KPIs). It may then be determined whether a targeted (aimed for) or standard (minimum acceptable)
level of performance has been achieved on the basis of these measures. Alternatively, objectives can take
the form of general verbal statements, such as 'to improve performance against quality indicators', from
which numerical measures may then be derived by the auditor.
Having identified the objectives, the auditor plans procedures to test whether they have been achieved.
The procedures used may include audit-type procedures, but may also involve an element of social-
scientific research in the form of both quantitative and qualitative research methods.
Interactive question 5: Procedures

The Department of Transport of Proculsia is currently undertaking a large infrastructure project to build
a new underground metro system in the country's second largest city, Pravus. The supreme auditor of
Proculsia has been tasked with conducting a study of the Department's role in developing the project
and funding it.
Considerable local media attention has been directed at the progress of the project, focusing on the
report of a whistleblower who claimed that delays mean that it will not be completed on time. In
response the Department has stated that the project will be completed within its budget of $14 billion,
and by a deadline of five years' time.
Requirements
Identify procedures that should be performed in order to assess the following:
(a) The Department's management of its financial exposure on the project
(b) The Department's confidence that it will meet the prescribed project schedule
6.10 Concluding and reporting

The auditor expresses a conclusion on the entity's achievement of its objectives. There is no specific form
of words that must be used.
The report may take the form of an integrated report of performance against the entity's objectives.
Such a report would present the auditor's conclusion alongside the performance information itself. The
conclusions of other audit processes may also be presented within the report, such as an audit
conclusion on value for money.

If the auditors do not themselves produce the integrated report then it will be necessary for them to
ensure that the performance information included in the report is consistent with the information on
which they have given a conclusion.
Worked example: Maternity services

In 2013 the National Audit Office (NAO) issued a report on maternity services in England. The report
was an integrated report which presented audited Key Facts on maternity services, such as:
694,241 £2.6 billion 1 in 133
live births in England in 2012 cost of National Health Service babies are stillborn or die
(NHS) maternity care in 2012–13 within 7 days of birth
The report gave an overview of maternity services, the organisations involved in delivering the services,
and the government department's objectives for maternity care. As the government department had
few of its own quantified measures of performance (there was a problem with the existence of
information), the NAO developed its own measures.
Key Findings were presented for the performance of maternity services (performance information) and
the management of maternity services. A conclusion was given on value for money, and
recommendations were made for the relevant department.
The report contained details of the methodology used for the audit, the evidence base on which
conclusions were based, and progress made by the department against recommendations made in the
past.
The following paragraph was included within Key Findings, and is illustrative of the matters which
auditors consider in reports such as this.
'Outcomes in maternity care are good for the vast majority of women and babies but, when things
go wrong, the consequences can be very serious. In 2011, 1 in 133 babies were stillborn or died
within seven days of birth. This mortality rate has fallen, but comparisons with the other UK nations
suggest there may be scope for further improvement. There are wide unexplained variations in the
performance of individual trusts [regional healthcare organisations] in relation to complication rates
and medical intervention rates, even after adjusting for maternal characteristics and clinical risk
factors. This variation may be partly due to differences in aspects of women's underlying health not
included in the data and inconsistencies in the coding of the data.'
(Source: Maternity services in England, © National Audit Office 2013, p. 8, para. 14)
The overall conclusion expressed is worth reading. It begins with a general conclusion (first paragraph
below), and then outlines some difficulties found. It is noteworthy that one of the difficulties was that of
measuring performance in this area.
'For most women, NHS maternity services provide good outcomes and positive experiences. Since
2007 there have been improvements in maternity care, with more midwifery-led units, greater
consultant presence, and progress against the government's commitment to increase midwife
numbers.
However, the Department's implementation of maternity services has not matched its ambition:
the strategy's objectives are expressed in broad terms which leaves them open to interpretation
and makes performance difficult to measure. The Department has not monitored progress against
the strategy and has limited assurance about value for money. When we investigated outcomes
across the NHS, we found significant and unexplained local variation in performance against
indicators of quality and safety, cost, and efficiency. Together these factors show there is
substantial scope for improvement and, on this basis, we conclude that the Department has not
achieved value for money for its spending on maternity services.'
(Source: Maternity services in England, © National Audit Office 2013, p. 40)

C
Summary and Self-test H
A
P
T
E
R
Summary
26
Social and Environmental and
environmental Reasons for:
audits social auditing
– Stakeholder expectations
– Enhance company
– Achievement of
social targets Social
– Safeguarding responsibility Effects on statutory audit
the environment reporting
Effects on – Enhanced risk

assurance assessment
services Sustainability Overall – Focus on going
reporting regulation concern and
and standard asset valuation
– Additional format
Triple
procedures bottom line
verifying social/
environmental No standard
information at present
– Additional
assurance
reporting
– Due diligence

Self-test
1 Chemico plc
You are the auditor of Chemico plc, a company which produces chemicals for use in household
products. You are responsible for the planning of the audit for the year ended 31 December 20X8
and have attended a meeting with the finance director during which you have obtained the
following information.
 Production had to be suspended during October 20X8 due to a strike by plant workers. Their
main complaints were over working hours and the adequacy of health and safety procedures.
The finance director has assured you that these issues have been dealt with.
 The company has received a letter from the environmental health department dated
10 January 20X9 indicating that samples taken from a nearby river have shown traces of a
chemical which is harmful to wildlife. The environmental health department believes that
Chemico plc is the source. The initial complaint was made by a landowner with fishing rights
on the river. Chemico plc has denied responsibility.
 One of the products made by Chemico plc is to be withdrawn from use in household
products under EU law. Chemico plc will therefore cease production of this chemical by
31 December 20X8 and the company has made plans to decommission this part of the plant.
The directors anticipate that there may be a number of redundancies as a result and have
included a provision for the estimated redundancy costs in the financial statements for the
year ended 31 December 20X8.
Requirements
(a) Identify and explain how social and environmental matters would affect the planning of the
audit of Chemico plc.
(b) The finance director is aware that other companies in his sector are including social
responsibility reports as part of their corporate reports. He has asked you to clarify the
requirement to include this type of information and to explain the benefits of doing so.
2 Gooding and Brown plc
Gooding and Brown plc (GB), a listed UK clothes retailer, has recently publicised GB World, a
ten-year sustainability plan for the business. It focuses on many ecological and ethical issues,
including the following:
(i) Fair trade – with commitments to ensuring the following:
 All raw materials used in GB materials fairly traded within six months
 Supply chain 100% fair trading within two years
(ii) Waste – with commitments to ensuring all of the following:
 GB carrier bags are replaced by paper bags within one year
 Paper waste from GB operations to be 100% recycled within five years
 All waste from GB operations not to go to landfill within ten years
(iii) Climate change – with a commitment to making GB stores carbon neutral within ten years
The board of directors intends to publish a report on the progress of the plan as part of its annual
review which will be included in the document which contains the audited accounts. The board
has consulted with the audit engagement partner as to whether the firm might be able to provide
a level of certification of progress with GB World annually.
Requirements
(a) Outline whether the GB World plan will have any impact on future audits of Gooding and
Brown plc.
(b) Describe the matters the audit partner should consider in determining whether to accept an
assurance engagement in relation to GB World.

(c) Outline the evidence you would seek in respect of the commitments about waste, if such an
engagement were accepted. C
H
(d) Discuss the current regulatory situation with regard to UK companies issuing sustainability reports. A
P
T
Now go back to the Learning objectives in the Introduction. If you are satisfied you have achieved these E
objectives, please tick them off. R
26


Potential benefits of social/environmental report to Westwitch plc
Westwitch plc is operating in three environmentally contentious areas. Its link with oil in Nigeria (scene
of past human rights abuses) could damage its reputation (as BP's link with Chinese oil pipelines
through Tibet). Nuclear waste disposal is an activity that could cause local hostility in South Africa,
ethical hostility at home, and concern over the long-term financial implications of a health and safety
disaster. As well as ethical and environmental concerns, working practices in developing countries could
also endanger stakeholder relations.
By publishing a social and environmental report, Westwitch plc would be signalling that:
 it recognises the potential concerns of stakeholders; and
 it is attempting to address those concerns through a process of regular review and improvement.

(1) Recognition of a provision
The auditor will need to determine whether the accounting treatment adopted by the company in
respect of the costs of rectifying the environmental damage have been accounted for in
accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
In terms of recognition, any costs of environmental damage caused by the opening of the mine
represent a current obligation as a result of a past event at the year-end date. The opening of the
mine is the obligating event, so the fact that the costs do not need to be incurred until completion
of mining is irrelevant. A provision should therefore be recognised.
As no mining has taken place, any environmental costs arising from the extraction of the mineral
would not need to be provided for at the year-end date. Until mining actually commences there is
no obligating event. Potentially management could avoid these costs by changing the entity's
future operations. Instead a provision for these costs should be recognised as the mining
progresses.
(2) Measurement
The amount of the provision recognised should represent the best estimate of the expenditure
required to settle the obligation. The auditor will need to determine the basis on which
management have calculated the amount of the provision and assess whether this is reasonable.
Factors to consider might include:
 the expertise of those involved in estimating the costs;
 the cost of rectifying environmental damage on similar projects; and
 the reliability of previous estimates made by the company.

(a) Acceptance considerations
There are four key things that the audit engagement partner should consider:
(i) Impact of the new engagement on the audit
The audit engagement partner needs to ensure that the objectivity of the audit is not
adversely affected by accepting any other engagements from an audit client. This is of
primary importance.

Factors that he will consider include the impact that any fees from the engagement will have on
total fees from the client and what staff will be involved in carrying out the new engagement (ie, C
will they be audit staff, or could the engagement be carried out by a different department). H
A
In favour of the engagement, he would consider that such an engagement should increase his P
knowledge of the business and its suppliers and systems, and might enhance the audit firm's T
E
understanding of the inherent audit risk attaching to the business.
R
(ii) Competence of the audit firm to carry out the assignment
The audit engagement partner needs to consider whether the firm has the necessary
26
competence to carry out the engagement in a quality manner, so as to minimise the risk of
being sued for negligence.
This will depend on the nature of the engagement and assurance required (see below) and on
whether the auditor felt it would be cost effective to use the work of an expert, if required.
(iii) Potential liability of the firm for the report
As the engagement is not an audit engagement, the partner should consider to whom he
would be accepting liability in relation to this engagement, and whether the risk that that
entails is worth it, in relation to the potential fees and other benefits of doing the work (such
as keeping an audit client happy, and not exposing an audit client to the work of an
alternative audit firm).
Unless otherwise stated, liability is unlikely to be restricted to the shareholders for an
engagement such as this; indeed, it is likely to extend to all the users of the annual report.
This could include the following:
 The bank
 Future investors making ethical investing decisions
 Customers and future customers making ethical buying decisions
The partner should also consider whether it might be possible to limit the liability for the
engagement, and disclaim liability to certain parties.
(iv) Nature of the engagement/criteria/assurance being given
Before the partner accepted any such engagement on behalf of the firm, he should clarify
with the directors the exact nature of the engagement, the degree of assurance required and
the criteria by which the directors expect the firm to assess the assertions.
As the engagement is not an audit engagement, the audit rules of 'truth and fairness' and
'materiality' do not necessarily apply. The partner should determine whether the directors
want the firm to verify that the assertions are 'absolutely correct' or 'correct in x% of cases'
and also what quality of evidence would be sufficient to support the conclusions drawn – for
example, confirmations from suppliers, or legal statements, or whether the auditors would
have to visit suppliers and make personal verifications.
This engagement might be less complex for the audit firm if they could conduct it as an
'agreed-upon procedures' engagement, rather than an assurance engagement.
(b) Assertions
(i) Animal testing
The assertion is complex because it does not merely state that products sold have not been
tested on animals, but that ingredients in the products have not been tested on animals.
This may mean a series of links have to be checked, because Naturascope's supplier who is the
manufacturer of one of its products may not have tested that product on animals, but may
source ingredients from several other suppliers, who may in turn source ingredients from
several other suppliers, etc.
The audit firm may also find that it is a subjective issue, and that the assertion 'not tested on
animals' is not as clear cut as one would like to suppose. For example, the dictionary defines
'animal' as either 'any living organism characterised by voluntary movement …' or 'any mammal,
especially man'. This could suggest that the directors could make the assertion if they didn't test
products on mammals, and it might still to an extent be 'true', or that products could be tested on

'animals' that, due to prior testing, were paralysed. However, neither of these practices are likely to
be thought ethical by animal lovers who are trying to invest or buy ethically.
Potential sources of evidence include: assertions from suppliers, site visits at suppliers' premises
and a review of any licences or other legal documents in relation to testing held by suppliers.
(ii) Child labour
This assertion is less complex than the previous assertion because it is restricted to
Naturascope's direct overseas suppliers.
However, it contains complexities of its own, particularly the definition of 'child labour', for
example in terms of whether labour means 'any work' or 'a certain type of work' or even 'work
over a set period of time', and what the definition of a child is, when other countries do not have
the same legal systems and practical requirements of schooling, marriage, voting etc.
There may also be a practical difficulty of verifying how old employees actually are in certain
countries, where birth records may not be maintained.
Possible sources of evidence include: assertions by the supplier and inspection by auditors.
(iii) Recycled materials
This may be the simplest assertion to verify, given that it is the least specific. All the packaging
must have an element of recycled materials. This might mean that the assertion is restricted to
one or a few suppliers. The definition of packaging may be wide; for example, if all goods are
boxed and then shrink-wrapped, it is possible that those two elements together are termed
'packaging' and so, only the cardboard element need contain recycled materials.
The sources of evidence are the same as previously – assertions from suppliers, inspections by
the auditors or review of suppliers' suppliers to see what their methods and intentions are.

At first glance, North Hospital may appear to have the worse mortality rate, with 23 deaths compared
with 19 at South Hospital. These absolute figures may be misleading, however, so it is necessary to
calculate the relative mortality rates for each hospital:
North Hospital = 23 / 763 = 3.0%
South Hospital = 19 / 549 = 3.5%
On this basis, North appears to be the better performing hospital. On further investigation, however,
the picture becomes more complex.
Adjusting for emergency patients
It is likely that emergency procedures carry a higher risk of death than planned procedures. An uneven
distribution of emergency procedures between the two hospitals would indicate different risk profiles in
each hospital's underlying patient population for the period, which would be expected to affect the
mortality rate for each hospital.
At North Hospital, 12 patients died during planned procedures, which gives a mortality rate of 2.0%
(12/610) for planned procedures.
At South Hospital, 7 patients died during planned procedures, which gives a mortality rate of 1.4%
(7/494) for planned procedures.
After adjusting for emergency procedures, it would appear that South Hospital has the lower (better)
mortality rate. This appears to indicate that South Hospital is performing better for ordinary planned
procedures.
It should be noted, however, that South Hospital has a much higher mortality rate for emergency
procedures:
North Hospital: (23 – 12) / (763 – 610) = 11 / 153 = 7%
South Hospital: (19 – 7) / (549 – 494) = 12 / 55 = 22%

This could be indicative of problems at South Hospital in relation to emergency procedures. It may also
be a sign of differences in the underlying populations. Further information on the types of patients C
operated on in each hospital would be needed in order to determine which performed better in H
A
emergency situations.
P
T
E
Procedures include the following:
(a) Review overall project expenditure and compare with budgeted expenditure 26
 Interview relevant management and staff to determine reasons for any variations from budget
 Interview key management and staff to identify their expectations of whether the project will
be completed within budget
 Analyse the Department's business case for the project to determine whether the planned
expenditures will meet the overall aims of the project
(b) Review project timetable and compare progress with planned schedule
 In relation to the whistleblower's claim, identify the delays referred to and ascertain the
impact these are likely to have on the timetable
 Interview key management and staff to identify their expectations of whether the project will
be completed on time, and in particular what the effect may be of any delays already
experienced
 Ascertain any knock-on effects that the delays may have, and inquire of management what
actions they have taken to mitigate these effects
 Review of results of any internal challenges to management in relation to the delays, ie, how
management responded

1 Chemico plc
(a) Key issues
The key issues which would need to be addressed in planning the audit of Chemico plc
Understanding the entity
The chemical production industry is highly regulated and as such the business is likely to be
subject to a wide range of regulation including both environmental and health and safety.
The auditor would need to have an awareness of these if he is to have a good understanding
of the business.
Risk assessment
 The nature of the industry in which Chemico plc operates is particularly risky in terms of
its compliance with regulation. This risk assessment will be affected by the following
factors:
– Whether there is a history of penalties and legal proceedings against the company.
A review of previous years' files should provide information together with
discussions with members of staff involved in previous audits.
– The entity's attitude towards these matters. Chemico plc has experienced problems
in both environmental matters and health and safety during 20X8 which may
indicate poor governance.
– The likelihood of the existence of other related problems. While a number of issues
have been identified there is a risk that other breaches exist which have not yet
been identified, particularly if poor practice is widespread.
 The impact of the strike.
Issues include the following:
– Whether the working hours complained of constituted a breach in employment law
and health and safety
– Whether the lack of adequate safety procedures has resulted in any accidents
leading to litigation
– Whether the issues have genuinely been resolved so that any breaches of
regulations are not ongoing
– Whether the company is liable to be fined and/or sued as a result
– Whether any fines or penalties have been properly accounted for or provided for
 The contamination of the river
Issues include the following:
– Whether the leak constitutes an adjusting event after the reporting period. Although
the letter has been received after the year end it is likely that, if responsible, any leak
from Chemico plc occurred before the year end. The financial statements would
need to be adjusted for the consequences.
– The likelihood of Chemico plc being responsible for the leak. The audit plan would
include procedures to review the evidence held by Chemico plc and any legal
correspondence which might indicate the likely outcome.
– The potential size of any penalty including any compensation claim from the
landowner, as this may have an impact on the viability of the business.

 Withdrawn product
C
– There is a risk that items of plant may be impaired as a result of the withdrawn H
product. Audit procedures will be required to identify the assets affected and to A
ensure that they have been written down to their recoverable amount. P
T
– If assets are to be sold they should be classified and accounted for as held for sale in E
accordance with IFRS 5. R
– The audit plan will need to include procedures to ensure that any other costs
associated with the shut-down of this part of production have been identified and 26
provided for in accordance with IAS 37.
– Audit procedures will be required to determine whether the provision for
redundancies should be recognised. If the cessation of the production constitutes a
restructuring in accordance with IAS 37 and a constructive obligation exists the
redundancy costs would be recognised in 20X8. In this case there is no indication of
any announcement of the redundancies, in which case a provision should not be
made.
– The overall impact of the withdrawal on the viability of the business will need to be
considered.
(b) There is currently no requirement in law to provide social responsibility information beyond
that required in the Strategic Report under Companies Act 2006. Many companies go beyond
this minimum requirement and produce a separate corporate responsibility report. There is no
consensus as to what that information should contain. In practice, however, it is becoming
more common with many companies following the guidance issued by the Global Reporting
Initiative.
The benefits of providing this type of information include the following:
 It is an indication that the company is well run and that governance issues are taken
seriously. This enhances the reputation of the company with investors, employees and
the general public.
 Abuses of the environment and/or human rights can damage the reputation of the
company and therefore affect the share price.
 Potential investors want to be able to measure the performance of a company in a
number of different ways, not necessarily just financial performance. This information
helps investors make ethical decisions.
 As this type of information becomes more common it may appear that companies who
do not provide it are failing to meet social and environmental standards.
2 Gooding and Brown plc
(a) Impact on the audit
Inclusion of statement in annual report
The GB World plan will directly affect the audit in the sense that the directors plan to report
on it in each annual report and the auditors will therefore have a duty to ensure that there are
no material misstatements or inconsistencies between the GB World information and audited
information contained within the annual report in accordance with ISA (UK) 720 (Revised
June 2016) The Auditor's Responsibilities Relating to Other Information.
Impact on financial statements
In addition, the GB World plan has the potential to impact on various aspects of the financial
statements, and therefore the audit, although the degree of materiality of the impacts will
differ.
(i) Commitment to be a fair trader. This commitment will impact on inventory value and
gross margins (if clothing that does not meet the criteria has to be divested quickly) and
on supply systems and chains.

Inventory at risk of becoming obsolete after six months might be sold in the normal
course of business. If not, it is likely to be sold at an unusually low margin as sale items to
ensure that the commitment is met, and this sale might be larger than the sales the
company (and therefore) auditors are accustomed to, causing changes in sales and gross
margin patterns.
A potential risk is any legal issues caused if GB were to break any contracts with
suppliers who did not meet their ethical criteria. The longer lead time of two years is
unlikely to make this happen, as they are unlikely to have such onerous contracts that
they cannot be divested over a two-year period, but if contracts were changed in order
to meet the six-month deadline, then the company might have to make provision for
settlements in the next financial statements.
Assuming adequate controls are in place over the supply chain, any changes in supply
over the longer period of two years should also not impact the financial statements
unduly.
This commitment has a potential impact on costs too – switching to fair trade implies an
increase in basic product cost. The auditors should be aware of this and assess the
context in terms of whether there is shareholder expectation of certain profit targets,
regardless of the GB World plan, as this could lead to pressure on management in
respect of the results.
Lastly, the auditor should bear in mind customer expectation concerning the GB World
plan and monitor the impact the plan has on operations. It is probable that the board of
directors is responding to the perceived desire of its shoppers in terms of ethical and
environmental friendliness. Given the possible increase in cost that these commitments
entail, if the board has misjudged the desire of the consumer, the GB World plan could
result in lost custom, and reduced sales. Alternatively, given the long timescale that some
aspects of the GB World plan have, customers might become impatient for change and
transfer loyalty to a retailer that has a similar plan but is working faster towards the same
aims. In the extreme, both these situations could lead to going concern issues for
Gooding and Brown.
(ii) Commitment to changing waste patterns. Waste disposal is likely to impact the
statement of profit or loss and other comprehensive income in the form of annual
expenses. There may be some fluctuations in cost of which the auditors should be aware.
(iii) Commitment to be carbon neutral. The issue with the largest potential impact on the
financial statements is the commitment to make the company carbon neutral. It may be
possible to achieve this objective simply by changing energy supply and type, but it
might also be necessary to make changes to existing assets to achieve this objective. For
example, the company might have to make use of solar panels and windmills, in which
case there will be non-current asset additions for the auditor to consider. Alternatively,
GB might own premises which it would be difficult to carbon neutralise, which might
involve moving premises, hence sales of assets and possible construction of carbon
neutral premises, hence construction of assets.
(b) Matters to consider in respect of assurance engagement
(i) Ethical: The key issue to consider is whether it is possible to accept any other
engagement in relation to Gooding and Brown and maintain audit independence. This
will depend on factors such as the amount of 'other' work already carried out for
Gooding and Brown, the staff and partners that would be involved in any assurance work
and whether they were separated from the audit team and Gooding and Brown's status
itself. With regard to the latter, for example, Gooding and Brown is a listed company
therefore specific conditions within the FRC Ethical Standard must be applied.
(ii) Nature of the engagement/criteria/assurance being given: Before the partner accepts
any such engagement on behalf of the firm, he should clarify with the directors the
exact nature of the engagement, the degree of assurance required and the criteria by
which the directors expect the firm to assess any assertions made in the annual report. At
present the commitments seem very general and vague but, if there is a more detailed

underlying plan, there might be more scope for the audit firm to provide an assurance
engagement. C
H
As the engagement is not an audit engagement, the audit rules of 'truth and fairness' A
and 'materiality' do not necessarily apply. The partner should determine whether the P
directors want the firm to verify that any assertions are 'absolutely correct' or 'correct in T
E
x% of cases' and also what quality of evidence would be sufficient to support the
R
conclusions drawn – for example, confirmations from suppliers, or legal statements, or
whether the auditors would have to visit suppliers and make personal verifications.
This engagement might be less complex for the audit firm if it could conduct it as an 26
'agreed-upon procedures' engagement, rather than an assurance engagement.
(iii) The firm also needs to consider the following:
 Whether the firm has the appropriate skills to undertake the work (are they experts
in renewable energy?)
 What liability they would incur as a result of the work and to whom (this is unlikely
to be limited to shareholders as a result of the number of people who have access
to the annual report and the fact that there is no legal precedent for restricting
liability solely to the shareholders in respect of this type of work)?
(c) Sources of evidence
Potential sources of evidence with regard to the waste commitments:
 Contracts/invoices with waste removal companies/recycling companies
 Contracts/invoices with bag supplier(s)
 Store inspection to observe bags used in stores
 Inspection of waste disposal
(d) Current regulatory situation with regard to sustainability reports
There is currently no consensus on the type of information that should be disclosed in a
sustainability report. Historically, companies whose activities have the greatest social and
environmental impact have been the most active in developing this type of reporting, for
example companies within the oil and gas industry like Shell. In more recent years
sustainability reporting has become more common but guidance is still developing.
An increasing number of companies are following guidance issued by the Global Reporting
Initiative (GRI). The GRI aims to develop transparency, accountability, reporting and
sustainable development. Its vision is that reporting on economic, environmental and social
issues should become as routine and comparable as financial reporting. In addition, the
Companies Act 2006 now requires most companies to include information on environmental,
employment, social and community issues in a strategic report. From October 2013 reporting
on greenhouse gas emissions has been mandatory for quoted companies.

CHAPTER 27
Internal auditing
Introduction
Topic List
1 Role of internal audit
2 Regulation
3 Scope of internal audit
4 Internal audit assignments
5 Multi-site operations
6 Internal audit reporting
Technical reference
1459
Introduction
Learning objective Tick off
 Evaluate the role of internal audit and design appropriate procedures to achieve the
planned objectives
Specific syllabus references for this chapter are: 17(a)

1 Role of internal audit
Section overview
 Internal audit helps management to achieve the corporate objectives.
 It plays a key role in assessing and monitoring internal control policies and procedures.
 There are a number of key differences between internal and external audit.
1.1 Introduction
You have already been introduced to the concept of internal audit and the use of the internal audit
function by the external auditor in your earlier studies. ISA (UK) 610 (Revised June 2016) Using the Work C
of Internal Auditors was covered in Chapter 6. H
A
At the Advanced Level you are expected to have a broader understanding of the topic and to be able to P
apply your knowledge to more complex situations. T
E
You are also expected to be able to consider the role of internal audit in its own right within the R
business. This will be the main focus of this chapter.
27
1.2 Internal audit
Definition
Internal audit function: A function of an entity that performs assurance and consulting activities
designed to evaluate and improve the effectiveness of the entity's governance, risk management and
internal control processes. (ISA 610.14).
Internal audit departments are normally a feature of larger organisations. They help management to
achieve the corporate objectives and are an essential feature of a good corporate governance structure
(corporate governance including audit committees is covered in Chapter 4). This is highlighted by the
fact that the UK Corporate Governance Code states that companies with a premium listing without an
internal audit function should annually review the need to have one. The need for internal audit will
depend on the following factors:
 The scale, diversity and complexity of the company's activities
 The number of employees
 Cost-benefit considerations
 Changes in the organisational structures, reporting processes or underlying information systems
 Changes in key risks
 Problems with internal control systems
 An increased number of unexplained or unacceptable events
Internal audit can play a key role in assessing and monitoring internal control policies and procedures.
The internal audit function can help the board in other ways as well:
 by, in effect, acting as auditors for board reports not audited by the external auditors;
 by being the experts in fields such as auditing and accounting standards in the company and
helping with the implementation of new standards; and
 by liaising with external auditors, particularly where external auditors can use internal audit work
and reduce the time and therefore cost of the external audit. In addition, internal audit can check
that external auditors are reporting back to the board everything they are required to under
auditing standards.
Companies with a premium listing with an internal audit function should annually review its scope,
authority and resources.
Internal auditing 1461

1.3 WorldCom
The importance of internal audit in achieving good corporate governance can also be seen in the role it
had to play in bringing to light the WorldCom scandal.
Cynthia Cooper, who was the Vice President for internal auditing at the time, has been credited with
uncovering the fraud and reporting it to the board of directors. Together with her team she uncovered
that billions of dollars of operating costs had been capitalised, turning a $662 million loss into a
$1.4 billion profit in 2001. This was in spite of being told by the company's auditors, Arthur Andersen
and the Chief Financial Officer that there were no problems. On 12 June 2002 she revealed her findings
to the head of the audit committee. Such was the magnitude of her actions that she was named The
Times person of the year for 2002.
1.4 Objectives of internal audit

The role of the internal auditor has expanded in recent years as internal auditors seek to monitor all
aspects (not just accounting) of organisations, and add value to their employers. The work of the
internal auditor is still prescribed by management, but it may cover the following broad areas.
(a) Review of the accounting and internal control systems. The establishment of adequate
accounting and internal control systems is a responsibility of management and the directors.
Internal audit is often assigned specific responsibility for the following tasks.
 Reviewing the design of the systems
 Monitoring the operation of the systems by risk assessment and detailed testing
 Recommending cost-effective improvements
Review will cover both financial and non-financial controls.
(b) Examination of financial and operating information. This may include review of the means used
to identify, measure, classify and report such information and specific inquiry into individual items,
including detailed testing of transactions, balances and procedures.
(c) Review of the economy, efficiency and effectiveness of operations.
(d) Review of compliance with laws, regulations and other external requirements and with internal
policies and directives and other requirements including appropriate authorisation of transactions.
(e) Review of the safeguarding of assets. Are valuable, portable items such as computers and cash
secured, is authorisation needed for dealing in investments?
(f) Review of the implementation of corporate objectives. This includes review of the effectiveness
of planning, the relevance of standards and policies, the organisation's corporate governance
procedures and the operation of specific procedures such as communication of information.
(g) Identification of significant business and financial risks, monitoring the organisation's overall
risk management policy to ensure it operates effectively, and monitoring the risk management
strategies to ensure they continue to operate effectively.
(h) Special investigations into particular areas, for example suspected fraud.
1.5 Differences between internal and external audit

Internal auditors are employees of the organisation whose work is designed to add value and who
normally report to an audit committee where one exists and, if not, to the board of directors. External
auditors are from accountancy firms and their role is to report on the financial statements to
shareholders.
Both internal and external auditors review controls, and external auditors may place reliance on the
internal auditors' work as you are aware from your previous studies.

The following table highlights the differences between internal and external audit.
Internal audit External audit
Purpose Internal audit is an activity designed to External audit is an exercise to enable

add value and improve an organisation's auditors to express an opinion on the
operations. Its work can cover any aspect financial statements.
of an organisation's business or
operations, and is not just concerned with
issues affecting the truth and fairness of
Reporting to Internal audit reports to the board of The external auditors report to the
directors, or others charged with shareholders, or members, of a company C
governance, such as the audit on the stewardship of the directors. H
committee. A
P
Relating to Internal audit's work relates to the External audit's work relates to the financial T
operations of the organisation. statements. They are concerned with the E
financial records that underlie these. R
Relationship Internal auditors are very often External auditors are independent of the
with the employees of the organisation, company and its management. They are 27
company although sometimes the internal audit appointed by the shareholders.
function is outsourced.
The table shows that, although some of the procedures that internal audit undertake are very similar to those
undertaken by the external auditors, the whole basis and reasoning of their work is fundamentally different.
The difference in objectives is particularly important. Every definition of internal audit suggests that it
has a much wider scope than external audit, which has the objective of considering whether the
accounts give a true and fair view of the organisation's financial position.
Interactive question 1: Internal and external audit

The growing recognition by management of the benefits of good internal control, and the complexities of an
adequate system of internal control, have led to the development of internal auditing as a form of control
over all other internal controls. The emergence of internal auditors as specialists in internal control is the result
of an evolutionary process similar in many ways to the evolution of external auditing.
Requirement
Explain why the internal and external auditors' review of internal control procedures differ in purpose.
2 Regulation
Section overview
 The Institute of Internal Auditors issue a Code of Ethics and International Standards for the
Professional Practice of Internal Auditing.
 The Code of Ethics includes principles and rules of conduct.
 There are two categories of standard:
– Attribute standards
– Performance standards
 An adapted version of these standards is issued in the UK by HM Treasury to give guidance to
internal auditors in central government departments.

2.1 Institute of Internal Auditors
Internal auditing is not regulated in the same way that statutory audit is. There are no legal
requirements associated with being an internal auditor and the scope and nature of the internal
auditor's work is more likely to be set by company policy than by external guidelines.
The FRC and IAASB do not issue detailed auditing standards in relation to internal audit work. Where
they are applicable, the standards set out in Auditing Standards are likely to be good practice, but they
are not prescriptive in the same way that they are for external auditors.
In contrast to external auditors, internal auditors are not required to be members of a professional body
such as ICAEW. However, this does not mean that they cannot be, and many are. There is also a global
Institute of Internal Auditors (IIA) which internal auditors may become members of. This aims to
represent, promote and develop the professional practice of internal audit. Currently it has over 7,000
members in the UK and Ireland and 180,000 members in 190 countries worldwide. The IIA has issued
mandatory guidance in the form of its Code of Ethics and International Standards for the
Professional Practice of Internal Auditing.
2.2 Code of Ethics

The purpose of the Code of Ethics is to promote an ethical culture in the profession of internal auditing.
It includes two components:
(1) Principles
(2) Rules of conduct
2.2.1 Principles
These are defined by the IIA as follows:
Integrity The integrity of internal auditors establishes trust and thus provides the basis
for reliance on their judgement.
Objectivity Internal auditors exhibit the highest level of professional objectivity in
gathering, evaluating, and communicating information about the activity or
process being examined. Internal auditors make a balanced assessment of all
the relevant circumstances and are not unduly influenced by their own
interests or by others in forming judgements.
Confidentiality Internal auditors respect the value and ownership of information they receive
and do not disclose information without appropriate authority unless there is
a legal or professional obligation to do so.
Competency Internal auditors apply the knowledge, skills and experience needed in the
performance of internal audit services.
2.2.2 Rules of conduct

These describe in more detail the behaviour expected of the internal auditor. The key points are as
follows:
(a) Integrity
Internal auditors shall perform their work with honesty, diligence and responsibility. They shall
observe the law and not knowingly be party to any illegal activity. The ethical objectives of the IIA
should be respected.
(b) Objectivity
Internal auditors shall not:
 participate in any activity or relationship; or
 accept anything.
that may impair or be seen to impair their objectivity.
Any facts known to them which may distort the reporting of activities should be disclosed.

(c) Confidentiality
Internal auditors shall be prudent in their use of confidential information and should not use it for
personal gain.
(d) Competency
Internal auditors shall only provide services for which they have the relevant knowledge, skills and
experience and should continually strive to improve the quality of their service. Work should be
performed in accordance with International Standards for the Professional Practice of Internal
Auditing (see below).
Interactive question 2: Ethics

Explain the reasons why internal auditors should or should not report their findings on internal control C
to the following company officials: H
A
(a) The board of directors P
T
(b) The chief accountant
E
See Answer at the end of this chapter. R
27
2.3 International Standards for the Professional Practice of Internal Auditing
The IIA states that the purpose of the International Standards for the Professional Practice of Internal
Auditing is to:
 delineate basic principles that represent the practice of internal auditing;
 provide a framework for performing and promoting a broad range of value-added internal
auditing;
 establish the basis for the evaluation of internal audit performance; and
 foster improved organisational processes and operations.
There are two categories of standard which apply to all internal audit services:
(1) Attribute standards
These address the characteristics of organisations and parties performing internal audit activities.
(2) Performance standards
These describe the nature of internal audit activities and provide quality criteria against which
the performance of these services can be evaluated.
These were revised in October 2016 and are effective from January 2017.
Implementation standards apply to specific types of internal audit activity.

2.3.1 Attribute standards
These are summarised as follows:
Purpose, authority and The purpose, authority and responsibility of the internal audit
responsibility activity must be formally defined in an internal audit charter,
consistent with the Mission of Internal Audit, and the mandatory
elements of the International Professional Practices Framework (the
Core Principles for the Professional Practice of Internal Auditing, the
Code of Ethics, the Standards, and the definition of Internal
Auditing).
Independence and objectivity The internal audit activity must be independent, and internal
auditors must be objective in performing their work. In particular:
 the chief audit executive must report to a suitably senior level
within the organisation;
 conflicts of interest must be avoided; and
 internal auditors must refrain from assessing specific operations
for which they were previously responsible.
Proficiency and due Engagements must be performed with proficiency and due
professional care professional care.
 The chief audit executive must obtain competent advice and
assistance if the internal auditors lack the necessary skills to
perform all or part of an engagement.
 Internal auditors must have sufficient knowledge to evaluate the
risk of fraud and the manner in which it is managed by the
organisation but are not expected to be experts in detecting
and investigating fraud.
Internal auditors must exercise due professional care by considering
the:
 extent of the work needed to achieve the engagement's
objectives;
 relative complexity, materiality, or significance of matters to
which assurance procedures are applied;
 adequacy and effectiveness of governance, risk management
and control processes;
 probability of significant errors, fraud, or non-compliance; and
 cost of assurance in relation to potential benefits.
Quality assurance and The chief audit executive must develop and maintain a quality
improvement programme assurance and improvement programme that covers all aspects of
the internal audit activity. A quality assurance and improvement
programme is designed to enable an evaluation of the internal
audit activity's conformance with the Standards and of whether
internal auditors apply the Code of Ethics. The programme also
assesses the efficiency and effectiveness of the internal audit activity
and identifies opportunities for improvement. The chief audit
executive should encourage board oversight in the quality
assurance and improvement programme.
Both internal and external assessments of the performance of the
internal audit activity must be conducted.

2.3.2 Performance standards
These are as follows:
Managing the internal audit The chief audit executive must effectively manage the internal audit
activity activity to ensure it adds value to the organisation. In particular:
 the internal audit plan of engagement must be based on a risk
assessment performed at least annually; and
 these plans must be communicated to senior management and
to the board for review and approval.
Nature of work The internal audit activity must evaluate and contribute to the
improvement of governance, risk management and control C
processes using a systematic, disciplined and risk-based approach. H
It must: A
P
 evaluate risk exposures relating to the organisation's T
governance, operations and information systems; E
R
 help and evaluate the effectiveness and efficiency of controls,
promoting continuous improvement; and
27
 assess and make recommendations regarding governance
processes.
Engagement planning Internal auditors must develop and document a plan for each
engagement, including the scope, objectives, timing and resource
allocations. Planning considerations must include the following:
 The strategies and objectives of the activity being reviewed and
the means by which the activity controls its performance
 The significant risks to the activity's objectives, resources and
operations and the means by which the potential impact of risk
is kept to an acceptable level
 The adequacy and effectiveness of the activity's governance, risk
management and control processes compared to a relevant
control framework or model
 The opportunities for making significant improvements to the
activity's risk management and control processes
Performing the engagement Internal auditors must identify, analyse, evaluate and document
sufficient information to achieve the engagement's objectives.
Engagements must be properly supervised to ensure that objectives
are achieved, quality is assured and staff are developed.
Communicating results Internal auditors must communicate the engagement results.
Communications must be accurate, objective, clear, concise,
constructive, complete and timely. Corrected information must be
circulated in instances where significant errors or omissions are
identified.
Monitoring progress The chief audit executive must establish and maintain a system to
monitor the disposition of results communicated to management.
There must be a follow-up process to ensure that management
actions have been effectively implemented or that senior
management has accepted the risk of not taking action.
Communicating the acceptance When the chief audit executive concludes that senior management
of risks has accepted a level of residual risk that may be unacceptable to
the organisation, the chief audit executive must discuss the matter
with senior management. If the decision regarding residual risk is
not resolved, the chief audit executive must communicate the
matter to the board.

2.4 Public Sector Internal Audit Standards (PSIAS)
HM Treasury (together with the Government Internal Audit Agency) issues standards for internal
auditors working in the public sector in the UK. These comprise the IIA standards as detailed above but
with certain additional requirements included in text boxes in order to address the accountability
structures and related assurance and consulting requirements of the public sector and central
government.
3 Scope of internal audit
Section overview
 Internal audit has two key roles to play in relation to risk management:
– Ensuring the company's risk management system operates effectively
– Ensuring that strategies implemented in respect of business risks operate effectively
 Internal auditors may have a role in preventing and detecting fraud.
3.1 Business risk

The UK Corporate Governance Code states that the board is responsible for determining the nature and
extent of the significant risks it is willing to take in achieving its strategic objectives. This will include
business risks. As we have seen in Chapter 5, this is the risk inherent to the company in its operations
and encompasses risk at all levels of the business.
Business risk cannot be eliminated, but it must be managed by the company.
Designing and operating internal control systems is a key part of a company's risk management. This
will often be done by employees in their various departments, although sometimes (particularly in the
case of specialised computer systems) the company will hire external expertise to design systems.
3.2 The role of internal audit

The internal audit department has a twofold role in relation to risk management.
 It monitors the company's overall risk management policy to ensure it operates effectively.
 It monitors the strategies implemented to ensure that they continue to operate effectively.
Going back to the diagram used earlier, this can be shown as:
As a major risk management policy in companies is to implement strong internal controls in order to
reduce risks, internal audit has a key role in assessing systems and testing controls.

Internal audit may help with the development of systems. However, its key role will be in monitoring
the overall process and in providing assurance that the systems which the departments have designed
meet objectives and operate effectively.
It is important that the internal audit function retains its objectivity towards these aspects of its role,
which is another reason why internal audit would generally not be involved in the assessment of risks
and the design of the system.
3.3 Responsibility for fraud and error

Fraud is a key business risk. It is the responsibility of the directors to prevent and detect fraud. As the
internal auditor has a role in risk management, he is involved in the process of managing the risk of
fraud.
C
The internal auditor can help to prevent fraud by carrying out work on assessing the adequacy and H
effectiveness of control systems. The internal auditor can help to detect fraud by being mindful when A
carrying out his work and reporting any suspicions. P
T
The very existence of an internal audit function may act as a deterrent to fraud. The internal auditors E
R
might also be called upon to undertake special projects to investigate a suspected fraud.
4 Internal audit assignments 27
Section overview
 Internal audit can be involved in many different assignments as directed by management.
 These include the following:
– Value for money audits
– IT audits
– Best value audits
– Financial audits
– Operational audits
4.1 Value for money

Value for money (VFM) audits examine the economy, efficiency and effectiveness of activities and
processes. These are known as the three Es of VFM audits. This topic is referred to in Audit and
Assurance at the Professional Level in the context of public sector auditing. The following is a summary
of the key points.
4.1.1 The three Es
Definitions
Economy: Attaining the appropriate quantity and quality of physical, human and financial resources
(inputs) at lowest cost. An activity would not be economic if, for example, there was overstaffing or
failure to purchase materials of requisite quality at the lowest available price.
Efficiency: This is the relationship between goods or services produced (outputs) and the resources used
to produce them. An efficient operation produces the maximum output for any given set of resource
inputs, or it has minimum inputs for any given quantity and quality of product or service provided.
Effectiveness: This is concerned with how well an activity is doing in achieving its policy objectives or
other intended effects.
The internal auditors will evaluate these three factors for any given business system or operation in the
company. Value for money can often only be judged by comparison. In searching for value for money,
present methods of operation and uses of resources must be compared with alternatives.

Economy, efficiency and effectiveness can be studied and measured with reference to the following.
Inputs Economy
Inputs means money or resources – the Economy is concerned with the cost of inputs, and it
labour, materials, time and so on consumed, is achieved by obtaining those inputs at the lowest
and their cost. For example, a VFM audit into acceptable cost.
State secondary education would look at the
Economy does not mean straightforward cost-cutting,
efficiency and economy of the use of resources
because resources must be acquired which are of a
for education (the use of schoolteachers,
suitable quality to provide the service to the desired
school buildings, equipment, cash) and
standard. Cost-cutting should not sacrifice quality to
whether the resources are being used for their
the extent that service standards fall to an
purpose: what is the pupil/teacher ratio and
unacceptable level. Economising by buying poor
are trained teachers being fully used to teach
quality materials, labour or equipment is a 'false
the subjects they have been trained for?
economy'.
Outputs Efficiency
Outputs mean the results of an activity, Efficiency means the following.

measurable as the services actually produced,
 Maximising output for a given input, for
and the quality of the services. In the case of a
example maximising the number of transactions
VFM audit of secondary education, outputs
handled per employee or per £1 spent
would be measured as the number of pupils
taught and the number of subjects taught per  Achieving the minimum input for a given output
pupil; how many examination papers are
taken; and what is the pass rate.
Impacts Effectiveness
Impacts are the effect that the outputs of an Effectiveness means ensuring that the outputs of a
activity or programme have in terms of service or programme have the desired impacts; in
achieving policy objectives. Policy objectives other words, finding out whether they succeed in
might be to provide a minimum level of achieving objectives and, if so, to what extent.
education to all children up to the age of 16,
In a profit-making organisation, objectives can be
and to make education relevant for the
expressed financially in terms of target profit or
children's future jobs and careers. This might
return.
be measured by the ratio of jobs vacant to
unemployed school leavers. In not for profit organisations, such as charities,
effectiveness cannot be measured this way, because
the organisation has non-financial objectives. The
effectiveness of performance in these organisations
could be measured in terms of whether targeted non-
financial objectives have been achieved.
4.1.2 Selecting areas for investigation

Value for money checklists can be used. The following list identifies areas of an organisation, process or
activity where there might be scope for significant value for money improvements. Each of these should
be reviewed within individual organisations.
 Service delivery (the actual provision of a public service)
 Management process
 Environment
An alternative approach is to look at areas of spending. A value for money assessment of economy,
efficiency and effectiveness would look at whether:
 too much money is being spent on certain items or activities to achieve the targets or objectives of
the overall operation;
 money is being spent to no purpose because the spending is not helping to achieve objectives; and
 if changes could be made to improve performance.

An illustrative list is shown below of the sort of spending areas that might be looked at, and the aspects
of spending where value for money might be improved.
 Employee expenses
 Premises expenses
 Suppliers and services
 Establishment expenses
 Capital expenditure
4.2 Information technology

An information technology (IT) audit is a test of control in a specific area of the business, the
computer systems. Increasingly in modern business, computers are vital to the functioning of the
C
business, and therefore the controls over them are key to the business. H
A
It is likely to be necessary to have an IT specialist in the internal audit team to undertake an audit of the
P
controls, as some of them will be programmed into the computer system. T
E
The diagram below shows the various areas of IT in the business which might be subject to a test of
R
controls by the auditors.
Database System
Operational 27
E-business management development
system system process
Access
control IT Systems Problem
management
Capacity Desktop Asset Change

management audit management management
Figure 27.1: IT Systems
4.3 Financial
The financial audit is internal audit's traditional role. It involves reviewing all the available evidence
(usually the company's records) to substantiate information in management and financial reporting.
This role in many ways echoes the role of the external auditor, and is not a role in which the internal
auditors can add any particular value to the business. Increasingly, it is a minor part of the function of
internal audit.
4.4 Operational audits
Definition
Operational audits: Audits of the operational processes of the organisation. They are also known as
management and efficiency audits. Their prime objective is the monitoring of management's
performance, ensuring company policy is adhered to.
There are two aspects of an operational assignment:

 Ensure policies are adequate
 Ensure policies work effectively

In terms of adequacy, the internal auditor will have to review the policies of a particular department by:
 reading them
 discussion with members of the department
Then the auditor will have to assess whether the policies are adequate, and possibly advise the board of
improvement.
The auditor will then have to examine the effectiveness of the controls by:
 observing them in operation
 testing them
This will be done on similar lines to the testing of controls discussed in Chapter 7.
Specific examples of operational audits include the following:
Procurement Procurement is the process of purchasing for the business. A procurement

audit will therefore concentrate on the systems of the purchasing
department(s). The internal auditor will be checking that the system
achieves key objectives and that it operates according to company
guidelines.
Marketing Marketing is the process of assessing and enhancing demand for the
company's products. Marketing and associated sales are very important for
the business and also therefore for the internal auditor but, as the associated
systems do not directly impact on the financial statements, they do not
usually concern the external auditor.
It is important for the internal auditor to review the marketing processes to
ensure the following:
 The process is managed efficiently.
 Information is freely available to manage demand.
 Risks are being managed correctly.
An audit may be especially critical for a marketing department which may be
complex with several different teams, for example:
 research
 advertising
 promotions
 after-sales
It is vital to ensure that information is passed on properly within the
department and that activities are streamlined.
Treasury Treasury is a function within the finance department of a business. It
manages the funds of a business so that cash is available when required.
There are risks associated with treasury, in terms of interest rate risk and
foreign currency risk, and the internal auditor must ensure that the risk is
managed in accordance with company procedures.
As with marketing audits, it is vital to ensure that information is available to
the treasury department, so that they can ensure funds are available when
required.
Human resources The human resources department on one hand procures a human resource
(employee) for the operation of the business and on the other supports
those employees in developing the organisation.
It is important to ensure that the processes in place ensure that people are
available to work as the business requires them and that the overall
development of the business is planned and controlled.
Again, ensuring company policies are maintained and information is
freely available are key factors for internal audit to assess.

4.5 Preparation and conducting of audits
As we have seen, the Code of Ethics and International Standards for the Professional Practice of Internal
Auditing, published by the IIA, sets out the Ethics, Attributes and Standards for conducting audits. As
each organisation uniquely develops its own structure for systems, controls and business processes, so
too must the approach of internal auditing be considered on an organisation-specific basis. To do this,
internal auditors will tend to adopt the following key steps in order to conduct and manage audits:
Business process objective For the process being reviewed, consider what its purpose and
objective is, as this will facilitate understanding the potential risk to
the organisation.
Audit terms of reference Prepare a Terms of Reference for the audit review. This will describe
the area to be considered and the approach adopted. This is C
agreed with the business and approved by the Audit Manager. H
A
Review current processes and Before commencing testing, meet with functional management to P
controls understand actual processes, systems and controls in place. T
E
Contrast this with expected systems and controls expected to be in R
place.
Risks Prepare a list of risks associated with the processes. This can be
graded (possibly in terms of impact and frequency) to enable 27
judgement in respect to testing to be performed.
The risks can be mapped to the controls, to understand the
purpose of the control and process.
Testing and results Consider appropriate testing that can be conducted to provide
evidence that the risk is being managed.
Perform tests, agreeing conclusions with auditees. Observations to
both effectiveness and efficiency of controls and processes should
be considered.
Reporting Drafting of report, providing details of process, testing, results and
conclusion reached. Where issues are identified, recommendations
for improvement should be provided and agreed with functional
management.
The report should be forwarded to both the function being
reviewed and the senior management as agreed within the Terms
of Reference.
Management actions and Functional management should provide agreed actions to each
monitoring recommendation, a target date and responsible person to
undertake the action. Internal audit monitor and follow up the
actions to ensure control deficiencies are rectified.

5 Multi-site operations
Section overview
 The internal auditor needs to take into account a number of practical considerations when
auditing multi-site operations.
 A number of approaches may be adopted including:
– compliance-based audit approach; and
– process-based audit approach.
Some organisations have several outlets which all operate the same systems. A good example of this
would be a retail chain, which would have a number of shops where systems relating to inventory and
cash, for example, would be the same.
The objective of audits of multi-site operations is the same as the objective of single site operations.
However, as results might vary across the different locations, the internal auditor has to take a different
approach. Some possible approaches to multi-site operations audits are set out below.
(a) Compliance-based audit approach
With a compliance-based audit approach, a master audit programme is drawn up which is used to
check the compliance of the branches with the set procedures, after which the results from the
branches are compared. There are two possible ways of undertaking the compliance-based
approach:
(i) Cyclical. This approach is based on visiting all the sites within a given time frame.
(ii) Risk-based. This alternative determines which branches are to be visited based on the risk
attached to them.
(b) Process-based audit approach
With a process-based audit approach, the audit is planned so that specific key processes are
audited. In a retail operation, for example, this could involve the important process of cash
handling being audited. This approach can also be undertaken in two ways:
(i) Cyclical. Aims to audit all processes in a business within a set time frame.
(ii) Risk-based. The processes to be audited are determined with reference to the risk attached to
them.
5.1 Practical considerations

The practical issues to consider in relation to multi-site operations are as follows:
 Which sites to visit
 How often to visit various sites
 Whether to conduct routine or surprise visits and the mix of these types of visit
Remember that the considerations behind which sites to visit will not be the same as for external
auditors. Internal auditors may consider issues (among others) such as the following:
 Size of operation
 History of systems compliance
 Quality/experience of staff on site
 Past results of testing
 Management interest in particular sites
Interactive question 3: Multi-site operations

You are the Chief Internal Auditor of Adam Ltd, which owns and operates three large department stores
in Wandon, Thuringham and Tonchester. Each store has more than 22 departments.

You are at present preparing your audit plan and you are considering carrying out detailed audit tests
on a rotational basis. You consider that all departments within the stores should be covered over a
period of five years but that more frequent attention should be given to those where the 'audit risk'
demands it.
Requirement
Describe the factors which you would consider in order to evaluate the audit risk attaching to each
department.
C
6 Internal audit reporting H
A
P
Section overview T
E
 There are no formal reporting requirements for internal audit reports. R
 This section therefore can only indicate best practice.
27
6.1 Objectives of reporting
The most important element of internal audit reporting is to promote change in the form of either new
or improved controls. Descriptions of failings should promote change by emphasising the problems
that need to be overcome and advising management on the steps needed to improve risk management
strategies.
The auditors' report can emphasise the importance of control issues at times when other issues are
being driven forward, for example new initiatives. Auditors can also help managers assess the effect of
unmitigated risk. If auditors find that the internal control system is sound, then resources can be
directed towards developing other areas.
Auditors should aim to have their recommendations agreed by operational managers and staff, as
this should enhance the chances of their being actioned.
6.2 Forms of report

There are no formal requirements for internal audit reports as there are for the statutory audit. By
contrast, the statutory audit report is a highly stylised document that is substantially the same for any
audit. However, the following provides an indication of good practice.
The executive summary of an internal audit report should give the following information.
 Objectives of the assignment
 Major outcomes of the work
 Key action points
 Summary of the work left to do
The main body of the report will contain the detail; for example the audit tests carried out and their
findings, full lists of action points, including details of who has responsibility for carrying them out, the
future timescale and costs.
One clear way of presenting observations and findings in individual areas is as follows:
 Business objective that the manager is aiming to achieve
 Operational standard
 The risks of current practice
 Control weaknesses or lack of application of controls
 The causes of the weaknesses
 The effect of the weaknesses
 Recommendations to solve the weaknesses

The results of individual areas can be summarised in the main report:
 The existing culture of control, drawing attention to whether there is a lack of appreciation of the
need for controls or good controls but a lack of ability to ensure compliance
 Overall opinion on managers' willingness to address risks and improve
 Implications of outstanding risks
 Results of control evaluations
 The causes of basic problems, including links between the problems in various areas
When drafting recommendations internal audit needs to consider the following:
 The available options, although the auditors' preferred solution needs to be emphasised
 The removal of obstacles to control. It may be most important to remove general obstacles such as
poor communication or lack of management willingness to enforce controls before making specific
recommendations to improve controls
 Resource issues, how much will recommendations actually cost and also the costs of poor control
Recommendations should be linked in with the terms of reference, the audit performed and the results.

Summary
– Ensuring company’s risk

management systems
work adequately
– Ensure risk management
– Objectives of
strategies are effective C
report H
– Preventing fraud and
– Form of report A
error
P
T
E
Internal audit Work on multi-site R
Scope
reports operations
27
Internal audit
Internal audit
Overview Regulation
assignments
– Objectives – Institute of Internal – Value for money

– Comparison to Auditors – Information
external audit – Code of ethics technology
– Rules of conduct – Financial
– International standards – Operational audits
for internal auditors
– Government Internal
Audit Standards

Self-test
1 Blackfoot Emissions Ltd
Blackfoot Emissions Ltd has grown exponentially in recent years providing emissions monitoring
and environmental management services to clients within the UK. All the management systems are
centralised at the head office, although there exist five regional offices across the country in order
to provide local response to clients' requirements. These local offices all use the corporate systems
on a networked basis.
The board of directors have agreed that it is appropriate to establish an Internal Audit Function and
you have been appointed as the Internal Audit Manager.
Requirements
(a) You have been requested to recommend to the board how the function will operate. Prepare
an Audit Charter.
(b) The Finance Director has called you into his office and expressed concerns over the
management of the payroll system, particularly now that the company has grown and is
employing many consultants.
The Payroll department is incorporated within the Human Resources department and uses a
software package called Upay. A single person has full responsibility for its operation and
administers the whole process. Prepare a draft of the business process objective, and identify
the key risks and appropriate controls that you would expect to find that require testing.
(c) Draft the Terms of Reference for the Payroll Audit in preparation for circulation to senior
management.

Technical reference
1 Attribute standards (AS)

 Purpose, authority and responsibility AS 1000
 Independence and objectivity AS 1100
 Proficiency and due professional care AS 1200
 Quality assurance and improvement programme AS 1300
2 Performance standards (PS)

C
 Managing the internal audit activity PS 2000
H
 Nature of work PS 2100 A
 Engagement planning PS 2200 P
 Performing the engagement PS 2300 T
E
 Communicating results PS 2400
R
 Monitoring progress PS 2500
 Communicating the acceptance of risks PS 2600
27


The internal auditors review and test the system of internal control and report to management in order
to improve the information received by managers and to help in their task of running the company. The
internal auditors will recommend changes to the system to make sure that management receive
objective information that is efficiently produced. The internal auditors will also have a duty to search for
and discover fraud.
In most jurisdictions, the external auditors review the system of internal control in order to determine
the extent of the substantive work required on the year-end accounts. The external auditors report to
the shareholders rather than the managers or directors. It is usual, however, for the external auditors to
issue a letter of weakness to the managers, laying out any control deficiencies and recommendations for
improvement in the system of internal control. The external auditors report on the truth and fairness of
the financial statements, not directly on the system of internal control. The external auditors do not
have a specific duty to detect fraud, although they should plan the audit procedures so as to have
reasonable assurance that they will detect any material misstatement in the accounts on which they give
an opinion.

(a) Board of directors
A high level of independence is achieved by the internal auditors if they report directly to the
board. There may be problems with this approach.
(i) The members of the board may not understand all the implications of the internal audit
reports when accounting or technical information is required.
(ii) The board may not have enough time to spend considering the reports in sufficient depth.
Important recommendations might therefore remain unimplemented.
A way around these problems might be to delegate the review of internal audit reports to an audit
committee, which would act as a kind of subcommittee to the main board. The audit committee
might be made up largely of non-executive directors who have more time and independence from
the day to day running of the company.
(b) Chief accountant
It would be inappropriate for internal audit to report to the chief accountant, who is in charge of
running the system of internal control. It may be feasible for him or her to receive the report as
well as the board. Otherwise, the internal audit function cannot be effectively independent, as the
chief accountant could suppress unfavourable reports or could just not act on the
recommendations of such reports.

Risk may be evaluated by considering:
 the probability of an event
 the potential size of the event
In the case of an audit the event concerned is undetected material error or fraud.
In evaluating risk in the context of the audit of a company owning and operating three large
department stores, the factors to be considered are as follows.

(a) Factors influencing probability
(i) Strengths and deficiencies in the system of internal control, overall and for each individual
store and department in respect of all types of internal control. It would be appropriate to
consider such controls under the following headings.
(1) Organisation of staff
(2) Segregation of staff
(3) Physical controls
(4) Authorisation and approval
(5) Arithmetic and accounting
(6) Personnel
(7) Supervision
(8) Management
C
(ii) Experience derived from previous audits and the conclusion of previous audit reports H
A
(iii) Whether the prices of goods sold are fixed by head office or variable by local store or P
departmental managers T
E
(iv) Extent of local purchasing for each store or department R
(v) The nature of the inventory (for example high unit value, attractiveness)
(vi) Effectiveness of cash-handling systems 27
(b) Factors influencing size

(i) Relative size of department in terms of:
(1) revenue
(2) number of transactions
(3) average value of inventory
(ii) Internal statistics of losses through shoplifting and staff theft
(c) Other general factors
(i) Comparison among stores and among like departments in the three stores, using ratio
analysis
(ii) Risk of deterioration or obsolescence of inventories
(iii) Rate of turnover of store staff

Answer to Self-test
1 Blackfoot Emissions Ltd

(a) Internal audit charter
Purpose
Internal Audit is an independent review function set up within the organisation to provide
assurance to the board on the adequacy and effectiveness of business systems and controls.
Independence
Internal Audit maintains an independent stance from the activities which it audits to ensure
the unbiased judgements essential to its proper conduct and impartial advice to
management.
Role and scope
The main role of Internal Audit is to help management with providing assurance as to the
adequacy and efficiency of its business systems and controls. It does this by understanding the
key risks of the organisation and by examining and evaluating the adequacy and effectiveness
of the system of risk management and internal control as operated by the organisation.
Internal Audit, therefore, has unrestricted access to all activities and information undertaken in
the organisation, in order to review, appraise and report on the following:
 The adequacy and effectiveness of the systems of internal control. These shall include
both financial and operational systems.
 The suitability, accuracy, reliability and integrity of financial and other management
information and the systems used to generate such information.
 The extent of compliance with rules and standards established by management, and
with externally set laws and regulations.
 The efficient acquisition and use of assets, ensuring that they are accounted for and
safeguarded from losses of all kinds arising from waste, extravagance, inefficient
administration, poor value for money, fraud or other cause and that adequate business
continuity plans exist.
 The integrity of processes and systems, including those under development, to ensure
that controls offer adequate protection against error, fraud and loss of all kinds; and that
the process aligns with the organisation's strategic goals.
 The effectiveness of the function being audited, and to ensure that services are provided
in a way which is economical and efficient.
 The follow-up action taken to remedy deficiencies identified by Internal Audit review,
ensuring that good practice is identified and communicated widely.
 The operation of the organisation's corporate governance arrangements.
The board shall monitor the performance of the Internal Audit Function and the Head of
Internal Audit shall report annually on the function's performance.
Reporting
Internal Audit reports regularly on the results of its work to the Audit Committee, which is a
Board subcommittee. The Head of Internal Audit is accountable to the Audit Committee for
the following:
 Providing regular assessments of the adequacy and effectiveness of the organisation's
systems of risk management and internal control based on the work of Internal Audit.
 Reporting significant control issues and potential for improving risk management and
control processes.
 Periodically providing information on the status and results of the annual audit plan and
the sufficiency of Internal Audit resources.

Responsibility
The Head of Internal Audit reporting to the Managing Director and Audit Committee is
responsible for effective review of all aspects of risk management and control throughout the
organisation's activities.
The Head of Internal Audit is responsible for the following:
 Developing an annual audit plan based on an understanding of the significant risks to
which the organisation is exposed; and agreeing it with the Audit Committee
 Implementing the agreed audit plan
 Maintaining a professional audit staff with sufficient knowledge, skills and experience to
carry out the plan
C
(b) Business objective for Human Resources payroll function H
A
To provide accurate, agreed and timely payment to staff, in compliance with legislative and P
tax requirements, while providing effective, reliable, secure and maintainable records. T
E
Key risks and controls R
Category Risk Control

27
Reliability and integrity of Creation of ghost Segregation of data input and
financial and operational employees activation of payroll accounts within the
management system.
Limited and controlled access to the
system (eg, user logins and passwords).
Creation or changes can only be
entered on receipt of authorised change
forms.
Accuracy of data Each employee must have an individual
input payroll number and personnel file
containing details of employment.
Verification of data changes within the
system by a separate person.
Information relating to new starters is

authorised and passed to payroll for
input.
Advances, loans and additional
payments are supported by managerial
authorisation, and separately identified
within the system.
Timely input of Regular system report to detail changes
information for comparison to employee files.
Leavers are promptly removed or
suspended within the system, as
accepted within the agreed notice
period.
Payroll verifies to the business that input
has occurred.

Accuracy of Payment report generated and

payment data reviewed in advance of payment date.
Payment run report and exception
report are generated detailing data
changes from previous period.
This is authorised by an independent
person before transfer of payments.
Overtime payments are based on
authorised timesheets.
Inaccurate financial Payment report reconciled to bank
reporting statement and general ledger by
independent person.
Insecure and Access to IT systems and network is
unreliable IT limited to authorised personnel only.
systems
Payroll system Upay access is restricted
by user login and secure password
restrictions.
Adequate back-up and recovery
processes are established and tested on
a regular basis.
Insecure personnel Personnel files are held securely, with
files restricted access.
Personnel information management
systems are registered with the
Information Commission Data
Commissioner.
Effectiveness and efficiency of Payroll department Payroll department has been
operation inadequately established with clearly defined
resourced objectives and adequate resources.
Potential for Policies and procedures are in place to
inconsistent give guidance on the use and control of
processes and the system and business processes.
practices
Amendments to IT systems and
processes are conducted in a controlled
and authorised manner.
Safeguarding of assets Aggravation of staff Ensure efficient operation of process
within the key controls identified.
Compliance with legislation, Inexperienced Payroll personnel are suitably
codes and law payroll staff experienced and qualified.
They have information feeds that keep
them abreast of changes to legislation
and requirements.
Tax Office Changes to tax codes are only actioned
communications on receipt of formal notification from
are not passed to HMRC.
the Payroll function

Inability to produce Procedures exist for the generation of

legally required legally required documents such as P60,
reports P45 and P11D.
Reports generated Diary system operated to ensure that

late payment of all tax liabilities meets the
requirements of statutory authority.
Inaccurate or late Tax and National Insurance are
payment of tax and collected by the system, reconciled on a
National Insurance monthly basis and paid over in
accordance with Revenue guidelines C
and timescales. H
A
Data is not secure Payroll system access is restricted, and P
T
in compliance with users have agreed to operate within an E
Data Protection Act agreed 'Code of Conduct'. R
requirements
Information and reports generated are
issued on controlled circulation listing.
27
(c) Draft terms of reference
Subject: Payroll
Managers responsible: Head of HR
Payroll Manager
Audit scope
The audit will review the adequacy of controls and processes in existence over the
administration and management of the payroll system. In particular the audit will review the
following factors:
 System security arrangements for both IT and paper information
 Data security arrangements and compliance with the Data Protection Act
 Controls over the timely creation of new employees
 Amendment of data within the system
 Monthly reporting and reconciliation processes
 Segregation and approvals
 Conformance with statutory requirements
Management reporting
Any issues identified by the review will be discussed at the close out meeting and raised with
the appropriate manager, and a draft report prepared. The draft report will be issued to
relevant staff for comment and responses to recommendations. The final report will be
circulated to the distribution list below.
Target dates for issue of the reports are:
 issue of draft report within seven days of the audit; and
 the business to agree a final report within 21 days of the draft report being issued.
Audit report distribution
The final report will be addressed to the Managing Director.
Copies shall be issued to:
Finance Director
Operations Director
Technical Director
Head of Human Resources

Resources and timescales
Auditors: Doug Deeper
Timescale: Fieldwork commencing 1 July 20X8, for 2 weeks

Index
1487
A B
Accounting estimate, 289 Balance sheet approach, 237
Accounting for derivatives, 773 Barings Bank, 155
Accounting policies, 382, 720 Barlow Clowes, 155
Accounting policy choices, 1256 Basic earnings per share, 543
Accounting records, 15, 312 BCCI, 153
Accuracy, 268 Bearer biological assets, 597
Acquisition method, 1009 Big data, 241
Actuarial assumptions, 908 Big GAAP/little GAAP, 66
Actuarial risk, 903 Biological asset, 596
Additional EPS, 567 Biological transformation, 596
Adjusting events, 641 Black-Scholes model, 960
Adverse opinion, 411 Block/cluster sampling, 311
Advocacy threat, 115, 132 Board of directors, 166
Agreed upon procedures, 1398 Bonus and right issues, 546
Agricultural activity, 596, 597, 608 Bonus issue, 547
Agricultural produce, 596 Borrowing costs, 682
Amortised cost, 752 Bulletin 2006/5 The Combined Code on
Analytical procedures, 213, 237, 280, 383 Corporate Governance: Requirements of
Annual General Meeting (AGM), 163 Auditors Under the Listing Rules of the Financial
Antidilution, 557 Services Authority, 181
Antidilutive potential ordinary shares, 557 Bulletin: Compendium of Illustrative Auditor's
Application controls, 357 Reports on United Kingdom Private Sector
Application of IFRS, 52 Financial Statements for periods commencing
Appointment of directors, 161 on or after 17 June 2016, 403
Assertions, 267 Business issues, 1254
Asset, 58, 59, 62, 581 Business processes, 210
Asset values, 1430 Business risk, 211, 1468
Assets held for sale, 452, 453 Business risk management, 212
Associate, 1003, 1047, 1198, 1330 Business risk model (BRM), 211, 212, 237
Associate's losses, 1025
Assurance, 1371
Assurance engagement, 1371 C
Assurance services, 1433 Capital redemption reserve, 970, 974
Attribute standards, 1465 Carrying amount, 581
Attributes of directors, 166 Cash dividend cover, 1251
Audit assertions, 221 Cash flow headings, 1249
Audit committees, 175 Cash flow hedge, 834
Audit completion, 381 Cash flow hedge accounting, 836
Audit documentation, 31, 73, 235 Cash flow per share, 1251
Audit liability, 421 Cash flow ratios, 1250
Audit methodology, 212, 215, 235 Cash flows to the minority interest, 1047
Audit opinion, 10 Cash forecasts, 1396
Audit planning, 202, 229 Cash from operations/profit from operations,
Audit procedures, 234, 274, 290 1251
Audit process, 11, 201 Cash interest cover, 1251
Audit report, 400 Cash return on capital employed, 1250
Audit reviews, 1431 Cash-generating units (CGU), 588, 589
Audit risk, 215 Cash-settled share-based payment transactions,
Audit risk model, 214 946, 961, 962
Audit sampling, 309 Change of use, 594
Audit threshold, 12 Changes in financial position, 9
Auditing standards, 174 Charities, 233
Auditor's expert, 294 Civil Procedure Rules, 1405
Auditors' responsibilities, 17 Classification, 268
Available-for-sale financial assets, 750 Close family, 125
Closely related embedded derivatives, 777
Closing rate, 1116
Commercial due diligence, 1392
Companies Act 2006, 14, 421, 1424
Comparability, 57
Index 1489
Comparatives, 395
Competency, 1464
D
Compilation engagements, 1401 Data
Completeness, 268 Characteristics of, 1334
Compliance risks, 211 Data analytics, 243, 294, 312
Compliance-based audit approach, 1474 Data mining, 243
Component, 1053 Dealer lessor, 671
Component auditor, 1053 Debt instrument at fair value through other
Component materiality, 1053 comprehensive income, 792
Component of an entity, 454 Deductible temporary differences, 1178
Computer-assisted audit techniques (CAATs), Deferred tax, 1194, 1195
351, 357 Deferred tax assets, 1174, 1178
Conceptual Framework, 53 Deferred tax liabilities, 1174, 1178
Confidentiality, 117, 1464 Deficiency, 365
Confirmation of accounts receivable, 306 Defined benefit liability, 909
Conflicts of interest, 15, 109, 117 Defined benefit obligation, 906
Consolidated financial statements, 1005 Defined benefit plans, 903, 919, 923
Consolidation adjustments, 1064 Defined contribution plans, 902, 905, 922
Consolidation: audit procedures, 1065 Demographic assumptions, 908
Constant purchasing power, 63 Derecognition of financial assets, 743
Constraints on useful information, 57 Derivative financial instruments, 826
Construction contract, 503, 504 Derivatives, 736, 770
Consultation, 299 Detailed testing, 213
Contingent liabilities, 643 Detection risk, 215, 221
Contingent settlement provisions, 713 Diluted earnings per share, 543, 556, 558, 561
Contingently issuable shares, 563 Dilutive potential ordinary shares, 557
Control, 1003 Directional testing, 312
Control activities, 220, 221 Directors' loans and other transactions, 16
Control environment, 219, 1073 Directors' report, 417
Control procedures, 1073 Directors' responsibilities, 15, 16
Control risk, 215, 218 Disagreement, 411
Controls approach, 235 Disclaimer of opinion, 411
Convergence of international guidance, 172 Disclosure initiative, 83
Convertible bond, 711, 712 Amendments to IAS 1, 446
Convertible instruments, 558 Disclosure let out, 645
Corporate accountability, 157 Disclosure of financial instruments, 755
Corporate governance, 153, 154, 1073, 1391, Discontinuation of hedge accounting, 853
1422, 1461 Discontinued operation, 454
Corporate governance concepts, 156 Discount rate, 911
Corporate governance mechanisms, 180 Discounting to present value, 645
Corporate responsibility, 175 Disposal group, 452, 1339
Corporate scandals, 153 Disposal of a foreign operation, 1140
Cost, 581 Disposal of a subsidiary, 1040
Cost model, 593 Disposal of investments, 1059
Cost plus contract, 504 Dissident shareholders, 973
Covered person, 125 Distributable profit, 969
Creative accounting, 223, 1343 Distributing dividends, 968, 977
Creative accounting techniques, 227 Divestment and withdrawal, 1059
Credit analyst, 1232 Dividend, 968, 970
Credit risk, 718 Dividend cover, 1245, 1294
Credit transaction, 16 Dividend yield, 1245, 1294
Creditors' buffer, 976 Due diligence, 1390
Cumulative preference shares, 552, 553 Due diligence report, 1392
Currency swap, 769, 772 Duty to report misconduct, 103
Current cost, 62
Current ratio, 281, 1238, 1293
Current service cost, 915 E
Current tax expense, 1222 Earnings per Share (EPS), 968
Cut-off, 268 EBITDAR, 1322
Cyber security, 359 Economic factors, 1253
Cycles approach, 236 Economy (Value for money audits), 1469
Effective interest method, 752

Effective interest rate, 752 Finance lease classification, 667
Effectiveness (Value for money audits), 1469 Finance lease liabilities, 668
Efficiency (Value for money audits), 1469 Financial accounting, 4
Efficiency ratios, 1241 Financial asset, 77, 736, 737, 742, 751
Electronic commerce (e-commerce), 300 Financial asset or liability at fair value through
Electronic data interchange (EDI), 300 profit or loss, 749
Electronic mail (email), 300 Financial assumptions, 908
Elements of financial statements, 58 Financial capital maintenance, 63
Embedded derivative, 774, 775, 776, 778 Financial due diligence, 1392
Embedded forward contract, 775 Financial guarantee contract, 787
Emphasis of matter paragraph, 413 Financial instrument, 735, 736, 857
Employee and employment reports, 1428 Financial liabilities, 736, 737, 747, 757
Employee share options, 561 Financial performance, 9
Engagements to review financial statements, Financial position, 8
1381 Financial position, financial risk and projections,
Enron, 173 1392
Entity relevant to the engagement, 126 Financial risks, 211, 388, 603, 820, 1070
Environmental audits, 1432 Financial statement assertions, 237, 267, 348
Equitable Life, 155 Financial statement review, 382
Equity, 58, 60, 1024 Financial statements, 5
Equity instruments, 737 Firm commitment, 820
Equity method, 1004 Firm commitments as hedged items, 823
Equity-settled share-based payment Fixed price contract, 504
transactions, 946 Forecast transaction, 820, 834, 835
Error, 348 Forecast transactions as hedged items, 823
Ethical codes and standards, 110 Foreign currency, 1115
Ethical codes of conduct, 103 Foreign currency and consolidation, 1134
Ethical conflicts, 118 Foreign currency cash flows, 1143
Ethical issues, 1258 Foreign currency translation, 1131
Ethical threats and safeguards, 115 Foreign operations, 1116
Ethics in business, 101 Forensic auditing, 1404
Evaluating the effect of misstatements, 384 Forensic investigation, 1404
Exchange differences, 1116, 1125, 1132, 1136 Forgivable loans, 681
Exchange of shares, 754 Forming an audit opinion, 413
Exchange rate, 1115 Forum of Firms, 1075
Exclusion of a subsidiary from consolidation, Forward contract, 816
1008 Framework, 499
Existence, 268 Fraud, 74, 209, 223, 1342, 1462, 1469
Exit route, 973 Fraud risk factors, 1342, 1345
Expectation gap, 10, 1350 Fraudulent financial reporting, 1343
Expenses, 58, 62 Fraudulent trading, 15
Experts, 293 FRC, 22
External confirmation, 277, 305 FRC Revised Ethical Standard 2016, 103, 113
FRS 102 The Financial Reporting Standard
Applicable in the UK and Republic of Ireland, 6,
F 65, 70, 71, 92
Factoring, 745 FRS 104 Interim Financial Reporting, 69, 72
Factoring with full recourse, 746 FRS 105 The Financial Reporting Standard
Factoring without recourse, 746 applicable to the Micro-entities Regime, 72
Fair, 10 FRSSE, 518
Fair value, 76, 581, 768, 907, 949, 1014 FRSUKI, 518
Fair value adjustments, 1137 Functional currency, 1115, 1116, 1117, 1119,
Fair value designation for credit exposures, 851 1130
Fair value hedge, 827, 830 Functional currency determination, 1118
Fair value hedge accounting, 828 Future, 816
Fair value hedge using interest rate futures, 833 Future economic benefit, 59
Fair value measurement, 967
Fair value model, 593 G
Fairness, 156
Faithful representation, 56 Gain or loss on net monetary position, 1146
Familiarity or trust threat, 115, 132 Gains, 60
Finance income, 670 Gearing ratio, 281, 1239, 1293
Finance lease, 667, 669 General controls, 355
Index 1491
Global enterprises, 1070 IAS 28 Investments in Associates and Joint
Going concern, 75, 182, 387, 1430 Ventures, 1004, 1023
Going concern assumption, 387 IAS 29 Financial Reporting in Hyperinflationary
Goodwill, 1014 Economies, 1067, 1147
Goodwill adjustment, 1138 IAS 32 Financial Instruments: Presentation, 552
Governance, 184 IAS 34 Interim Financial Reporting, 462, 463,
Governance issues, 381 464, 466, 468
Government assistance, 681 IAS 36 Impairment of Assets, 1430
Government grants, 681, 682 IAS 37 Provisions, Contingent Liabilities and
Grant date, 948 Contingent Assets, 644, 1430
Grants related to assets, 681 IAS 39 Financial Instruments: Recognition and
Grants related to income, 681 Measurement, 744
Greenhouse gas statement, 1378 IAS 40 Investment Property, 591
Greenhouse gases (GHGs), 1378 IAS 41 Agriculture, 596
Gross profit margins, 281 IASB Conceptual Framework for Financial
Gross profit percentage, 1235, 1293 Reporting, 53
Group, 1116 IASB Framework for the Preparation and
Group audit, 1052 Presentation of Financial Statements
Group engagement partner, 1052 (Framework), 53
Group engagement team, 1053 ICAEW Code of Ethics (ICAEW Code), 103, 110,
Guidance on Board Effectiveness, 166 114
IESBA Code of Ethics for Professional Accountants
(IESBA Code), 101, 103, 110
H IFRIC 12 Service Concession Arrangements, 501
Haphazard selection, 311 IFRIC 13 Customer Loyalty Programmes, 501
Hedge accounting, 720, 828, 843, 844 IFRS 1 First-time Adoption of International
Hedge effectiveness, 845 Financial Reporting Standards, 458
Hedge ineffectiveness, 846 IFRS 2 Share-based Payment, 963
Hedged forecast transaction, 835 IFRS 3 Business Combinations, 1079
Hedged instrument, 825 IFRS 4 Insurance Contracts, 604
Hedged item, 820, 821 IFRS 5 Non-current Assets Held for Sale and
Hedging an overall net position, 822 Discontinued Operations, 453
Hedging instruments, 825 IFRS 6 Exploration for and Evaluation of Mineral
Hedging of firm commitments, 833 Resources, 600
Held for sale, 452 IFRS 8 Operating Segments, 447
Held for sale assets, 279 IFRS 9 Financial Instruments, 779
Held-to-maturity investments, 750, 825 IFRS 9 hedge accounting, 850
Historical cost, 62 IFRS 9 impairment assessment, 786
Historical volatility, 960 IFRS 10 Consolidated Financial Statements, 1003,
Human resources, 1472 1004
Human resources due diligence, 1393 IFRS 11 Joint Arrangements, 1025
Hyperinflationary currency, 1133 IFRS 12 Disclosure of Interests in Other Entities,
1034
IFRS 13 Fair Value Measurement, 75, 721, 967
I IFRS 14 Regulatory Deferral Accounts, 469
IAPN 1000 Special Considerations in Auditing IFRS 15 Revenue from Contracts with Customers,
Financial Instruments, 858 511
IAS 1 Preparation of Financial Statements, 387 IFRS 16 Leases, 82, 677
IAS 7 Statement of Cash Flows, 698, 1249 IFRS 17 Insurance Contracts, 83, 605
IAS 8 Accounting Policies, Changes in Accounting IFRS for SMEs, 67
Estimates and Errors, 80, 1019, 1173 IIA Code of Ethics
IAS 10 Events After the Reporting Period, 385 Impact of preference shares, 1464
IAS 12 Income Taxes, 1173, 1209 Impairment, 278
IAS 20 Accounting for Government Grants and Impairment in non-monetary item, 1129
Disclosure of Government Assistance, 681 Impairment indicators, 587
IAS 21 The Effects of Changes in Foreign Impairment losses, 1025
Exchange Rates, 1067, 1147 Impairment of assets, 77, 78, 79, 80, 586
IAS 23 Borrowing Costs, 682 Important accounting ratios, 281
IAS 26 Accounting and Reporting by Retirement Inability to obtain sufficient appropriate audit
Benefit Plans, 921 evidence, 411, 412
IAS 27 Separate Financial Statements, 1004 Income, 58, 60, 62
Income smoothing, 226
Income statement: historical cost, 1146

Independence, 125, 156 Intra-group trading transactions, 1139
Independence of non-executive directors, 169 Inventory, 584, 1059
Indicators of hyperinflation, 1144 Inventory turnover, 1241, 1294
Industry analysis, 1261 Inventory turnover ratio, 281
Information systems, 178, 1073 Investment, 1003, 1330
Information technology, 238, 1471 Investment circular, 1381
Information technology due diligence, 1393 Investment hedge, 842
Inherent risk, 215, 1070, 1429 Investment property, 592, 594, 607, 1128
Initial accounts, 971 Investment risk, 903
Inquiry, 274 Investments in associates, 1003
Inspection, 275 Investments in joint ventures, 1004
Institute of Internal Auditors (IIA), 1464 Investments in subsidiaries, 1003
Insurance contract, 602 Investor, 1232
Insurance risk, 603 Investors' ratios, 1244
Intangible assets, 279, 585 ISA (UK) 200 Overall Objectives of the
Integrated reporting, 1437 Independent Auditor and the Conduct of an
Integrity, 125, 157, 1464 Audit in Accordance with International
Inter company dividends, 1140 Standards on Auditing, 9
Inter company guarantees, 1064 ISA (UK) 210 (Revised June 2016) Agreeing the
Interest cover, 1239 Terms of Audit Engagements, 202
Interim accounts, 971 ISA (UK) 220 (Revised June 2016) Quality
Interim financial report, 462 Control for an Audit of Financial Statements,
Interim period, 462 28, 381
Internal audit, 220 ISA (UK) 230 (Revised June 2016) Audit
Internal audit assignments, 1469 Documentation, 31, 235
Internal audit function, 1461 ISA (UK) 240 (Revised June 2016) The Auditor's
Internal audit reports, 1475 Responsibilities Relating to Fraud in an Audit of
Internal control, 348, 1072, 1461 Financial Statements, 117, 203
design, 349 ISA (UK) 250A (Revised June 2016)
effectiveness, 181 Consideration of Laws and Regulations in an
relevant to audit, 348 Audit of Financial Statements, 33, 117, 1431
reporting, 175 ISA (UK) 250B (Revised June 2016) Section B –
International Accounting Standards Board The Auditor’s Statutory Right and Duty to
(IASB), 51 Report to Regulators of Public Interest Entities
International audit firm networks, 1076 and Regulators of Other Entities in the Financial
International Audit Practice Notes, 21 Sector, 36
International Auditing and Assurance Standards ISA (UK) 260 (Revised June 2016)
Board (IAASB), 20 Communication With Those Charged With
International Federation of Accountants (IFAC), Governance, 184, 381
20 ISA (UK) 265 Communicating Deficiencies in
International Financial Reporting Interpretations Internal Control to Those Charged with
Committee (IFRIC), 51 Governance and Management, 364
International Financial Reporting Standards ISA (UK) 300 (Revised June 2016) Planning an
(IFRS), 6 Audit of Financial Statements, 202
International Review Engagement Practice ISA (UK) 315 (Revised June 2016) Identifying
Statements (IREPSs), 21 and Assessing the Risks of Material
International Standards for the Professional Misstatement Through Understanding the
Practice of Internal Auditing, 1464 Entity and Its Environment, 178, 202, 207,
International Standards on Assurance 267
Engagements (ISAEs), 20 ISA (UK) 320 (Revised June 2016) Materiality in
International Standards on Auditing (ISAs), 18 Planning and Performing an Audit, 202, 228
International Standards on Quality Control ISA (UK) 330 (Revised June 2016) The Auditor's
(ISQCs), 21 Responses to Assessed Risks, 202, 234, 274
International Standards on Related Services ISA (UK) 402 Audit Considerations Relating to an
(ISRSs), 21 Entity Using a Service Organisation, 297, 352
International Standards on Review ISA (UK) 450 (Revised June 2016) Evaluation of
Engagements (ISREs), 21 Misstatements Identified During the Audit, 384
Internet, 238 ISA (UK) 500 Audit Evidence, 271
Intimidation threat, 115, 133 ISA (UK) 501 Audit Evidence – Specific
Intra-entity hedging transactions, 823 Considerations for Selected Items, 648
Intra-group balances, 1064 ISA (UK) 505 External Confirmations, 305
Intra-group hedge, 821 ISA (UK) 510 (Revised June 2016) Initial Audit
Intra-group hedging transactions, 823 Engagements – Opening Balances, 291, 396
Index 1493
ISA (UK) 520 Analytical Procedures, 280, 381 ISRE (UK and Ireland) 2410 Review of Interim
ISA (UK) 530, Audit Sampling, 309 Financial Information Performed by the
ISA (UK) 540 (Revised June 2016) Auditing Independent Auditor of the Entity, 1386
Accounting Estimates, Including Fair Value ISRE 2400 (Revised September 2012)
Accounting Estimates, and Related Disclosures, Engagements to Review Financial Statements,
855 1381
ISA (UK) 540 (Revised June 2016) Auditing ISRS 4400 Engagements to Perform Agreed-Upon
Accounting Estimates, Including Fair Value Procedures Regarding Financial Information,
Estimates, and Related Disclosures, 289 1398
ISA (UK) 550 Related Parties, 472 ISRS 4410 (Revised) Compilation Engagements,
ISA (UK) 560 Subsequent Events, 381, 385 1401
ISA (UK) 570 (Revised June 2016) Going
Concern, 381, 388, 1431
ISA (UK) 580 Written Representations, 397 J
ISA (UK) 600 (Revised June 2016) Special Joint arrangement, 1026
Considerations – Audits of Group Financial Joint control, 1026
Statements (Including the Work of Component Joint operation, 1026
Auditors), 1052 Joint venture, 1003, 1026, 1198
ISA (UK) 610 (Revised June 2016) Using the Judgement, 157
Work of Internal Auditors, 1461 Judgement sampling, 310
ISA (UK) 620 (Revised June 2016) Using the Judgements and estimates, 1258
Work of an Auditor's Expert, 293 Judgements required, 509
ISA (UK) 700 (Revised June 2016) Forming an
Opinion and Reporting on Financial
Statements, 381, 400 K
ISA (UK) 701 Communicating Key Audit Matters Key audit matters, 408
in the Independent Auditor’s Report, 381, 408
ISA (UK) 705 (Revised June 2016) Modifications
to Opinions in the Independent Auditor's L
Report, 386
ISA (UK) 705 (Revised June 2016) Modifications Lease term, 668
to the Opinion in the Independent Auditor's Leased assets, 668
Report, 381, 411 Leases, 592, 678
ISA (UK) 706 (Revised June 2016) Emphasis of Legal due diligence, 1393
Matter Paragraphs and Other Matter Lessor, 669, 670
Paragraphs in the Independent Auditor's Liability, 58, 59, 62, 414
Report, 381, 412 Liability adequacy test, 604
ISA (UK) 710 Comparative Information – Listing Rules, 159
Corresponding Figures and Comparative Litigation and claims, 648, 649
Financial Statements, 381, 395 Loan, 16
ISA (UK) 720 (Revised June 2016) The Auditor's Loans and receivables, 750
Responsibilities Relating to Other Information, London & General Bank (No 2) 1895, 972
381 Long-term disability benefits, 920
ISA 800 (Revised) Special Considerations – Audits Long-term employee benefits, 920
of Financial Statements Prepared in Accordance Long-term solvency ratios, 1238
with Special Purpose Frameworks, 417 Losses, 61
ISA 805 (Revised) Special considerations – Audits
of Single Financial Statements and Specific M
Elements, Accounts or Items of a Financial
Statement, 418 Management accounting, 5
ISA 810 (Revised) Engagements to Report on Management buy-in, 1061
Summary Financial Statements, 419 Management buy-out, 1061
ISAE 3000 (Revised) Assurance Engagements Management commentary, 1339
Other than Audits or Reviews of Historical Management threat, 115, 134
Financial Information, 1371 Management's expert, 272, 925
ISAE 3400 The Examination of Prospective Manufacturer or dealer lessors, 671
Financial Information, 1395 Market prices, 761
ISAE 3402 Assurance Reports on Controls at a Market risk, 725
Service Organisation, 1376 Market-based vesting conditions, 948
ISQC (UK) 1 (Revised June 2016) Quality Control Marketing, 1472
for Firms that Perform Audits and Reviews of Material inconsistencies, 416
Financial Statements and other Assurance and Material misstatements of fact, 416
Related Services Engagements, 24 Materiality, 55, 74, 228, 1065, 1382

Mattel Inc, 271 Other adjustments in respect of preference
Maxwell Communications Corporation, 153 shares, 552
Measurement in financial statements, 62 Other information, 415
Measuring units current at the reporting date, Other long-term employee benefits, 920
1145 Other matter paragraph, 413
Minimum lease payments, 668 Other reporting responsibilities, 417
Misappropriation of assets, 1343 Overall review, 382
Misstatement of fact, 415 Overseas financial risk, 1071
Modified opinions, 411 Overseas subsidiaries, 1067
Monetary items, 1116, 1121, 1125 Owner-managed businesses, 233
Monetary measure of capital, 63
Money laundering regulations, 121
Monitoring, 178, 1073 P
Multi-site operations, 1474 Parmalat Finanziaria Spa, 273
Participating equity instruments, 555
N Participating securities and two-class ordinary
shares, 555
Net asset turnover, 1241, 1294 Performance, 60
Net asset value, 1245, 1294 Performance materiality, 230
Net investment in a foreign operation, 1116 Performance ratios, 1233
Nomination committee, 167 Performance standards, 1465
Non-adjusting events, 641 Person closely associated with, 125
Non-audit services, 175 Persons connected with a director, 16
Non-compliance, 33 Pervasive effects, 411
Non-controlling interests, 1141 Physical capital maintenance, 63
Non-cumulative preference shares, 552 Plan assets, 907
Non-current asset analysis, 1243 Planning the audit, 74, 1429
Non-current assets, 1059 Political risks, 1072
Non-executive directors, 167 Polly Peck International, 153
Non-financial performance measures, 1262 Post-employment benefits, 902
Non-hyperinflationary currency, 1131 Preference shares classified as equity, 552
Non-market based vesting conditions, 948, Preference shares classified as liabilities, 552
953, 954 Present value, 62
Non-monetary items, 1122, 1127 Presentation currency, 1115
Not closely related embedded derivatives, 778 Price/earnings (P/E) ratio, 1245, 1294
Principles, 1464
Process alignment, 302
O Process based audit approach, 1474
Objective of financial statements, 8 Procurement, 1472
Objectivity, 125, 1464 Professional appointment, 115
Obligation, 59 Professional scepticism, 202, 302
Obligation to dismantle, 647 Profit, 60
Observation, 275 Profit forecasts, 1396
Occurrence, 268 Profits available for distribution, 969
OECD Principles of corporate governance, 171 Profit-sharing and bonus plans, 901
Off-balance sheet financing, 226 Property, plant and equipment, 581
Off-balance sheet transactions, 175 Prospective financial information, 1395
Offsetting, 712, 1204 Provision, 644
Onerous contracts, 644 Public Company Accounting Oversight Board
Opening balances, 291 (PCAOB), 174
Operating cost percentage, 1236, 1293 Public interest entity, 23, 126
Operating leases, 668 Public Sector Internal Audit Standards (PSIAS),
Operating margin, 1236, 1293 1468
Operating risks, 211 Published prices, 762
Operating segment, 447, 448 Purchased options in cash flow hedges, 826
Operational audits, 1471 Purpose of the audit, 9
Operational due diligence, 1393
Option, 816 Q
Options and diluted EPS, 560
Options and warrants, 560 Qualified opinion, 411
Options contract, 712 Qualifying asset, 682
Index 1495
Qualitative characteristics of financial Rights issue, 549
statements, 55 Rights of group auditors, 1053
Qualitative disclosures, 723 Risk assessment, 178, 855, 1073
Quality control, 24, 73, 381 Risk assessment process, 216
Quality control procedures, 175 Risks from financial instruments, 717
Quasi-loan, 16 Rules of conduct, 1464
Quick or acid test ratio, 281
Quick ratio, 1238, 1293
S
R Sabbatical leave, 920

Sale and leaseback as a finance lease, 672
Random sampling, 311 Sale and leaseback as an operating lease, 673
Rate regulation, 469 Sale and leaseback transactions, 672
Rate regulator, 469 Sample design, 310
Ratio analysis, 281 Sample size, 311
Ratios, 281 Sarbanes-Oxley Act, 173, 382, 1074
Realisable (settlement) value, 62 Scope and authority of IFRS, 53
Reasonableness tests, 282 Securitisations, 745
Recalculation, 276 Segment reporting, 447
Receivables ratio, 281 Self-constructed investment properties, 592
Reclassifying financial assets, 755 Self-interest threat, 115, 126
Recognition, 61 Self-review threat, 115, 129
Recognition of deferred tax assets for unrealised Sensitivity analysis, 724
losses, 1195 Serious Organised Crime Agency (SOCA), 124
Recognition of elements in financial statements, Service organisations, 297, 352, 356
61 Setting of IFRS, 52
Recover or settle the carrying amount, 1174 Settlement, 914
Recycling gains and losses from equity, 837 Settlement date accounting, 741
Regulatory deferral account balance, 469 Share consolidation, 547
Regulatory risks, 1072 Share premium account, 973
Related party, 74, 472 Share-based payment, 963, 966
Related party relationship, 456 Share-based payment with a choice of
Related party transaction, 456 settlement, 963
Relevance, 55 Shearer v Bercain Ltd 1980, 973
Relevance of information, 509 Short-term compensated absences, 900
Relevant accounts, 971 Short-term employee benefits, 899
Remuneration committee, 163 Short-term liquidity ratios, 1237
Reperformance, 277 Significant component, 1053
Replacement property, 596 Significant deficiency in internal control, 187,
Reportable segments, 448 365
Reporting, 1397, 1399 Significant influence, 1003
Reporting – compilation engagement, 1402 Significant risks, 209
Reporting to management, 187 Social audits, 1432
Re-pricing of share options, 957 Social responsibility reporting, 1422
Repurchase agreements, 745 Special dividend and share consolidation, 548
Residual value, 581 Spot exchange rate, 1116
Responding to assessed risks, 234 Statement of changes in equity, 9
Responsibilities of Directors, 177 Statement of financial position, 6, 8
Restructuring, 647 Statement of financial position: historical cost,
Retirement benefit plans, 922 1146
Return on capital employed (ROCE), 281, 1233, Statements of cash flows interpretation, 1248
1293 Statistical sampling, 310
Return on plan assets, 909 Stewardship, 8
Return on shareholders' funds (ROSF), 1234, Strategic report, 1424
1293 Structured entity, 1034
Revaluation, 60, 583 Subsequent events, 385
Revenue, 60 Subsidiary, 1003, 1330
Revenue recognition, 226, 227 Substance over form, 56
Reversal of past impairments, 590 Substantive analytical procedures, 286
Reverse acquisitions, 1019 Substantive procedures, 237, 274, 280, 285
Review, 381 Summarising errors, 383
Revised Ethical Standard 2016, 110 Supervision, 298
Rights and obligations, 268 Sustainability reporting, 1422

Swap, 772 Type 1 report, 353
Systematic/Interval sampling, 311 Type 2 report, 353
Systems approach, 235
Systems audit, 239
U
T UK Corporate Governance Code, 158, 382,

1461
Tax base, 1176, 1177 UK GAAP, 7
Tax due diligence, 1394 UK regulatory framework, 53, 69
Taxable temporary differences, 1178, 1182 Underlying asset, 678
Technical due diligence, 1393 Understandability, 57
Teeming and lading, 307 Understanding the entity, 207
Temporary differences, 1178 Undistributable reserves, 970
Termination benefits, 920 Undrawn loan commitments, 787
Terms of audit engagement, 73 Unguaranteed residual value, 669
Testing for dilution, 560 Unvested options, 562
Tests of controls, 213, 274, 351 Unwinding the discount, 645
The UK Stewardship Code, 170 User auditor, 352
Theoretical Ex-Rights Price (TERP), 551 User information needs, 1231
Those charged with governance, 184, 347 Users and their information needs, 7
Tipping off, 124
Top-down approach, 212
Trade date accounting, 741 V
Trade payables payment period, 1242, 1294 Valuation and allocation, 268
Trade receivables collection period, 1242, 1294 Valuation of large holding, 762
Transaction costs, 592 Value for money (VFM), 1469
Transaction cycle approach, 236 Vested options, 562
Transaction integrity, 302 Vesting conditions, 948
Transactions with a choice of settlement, 946 Vesting date, 948
Transfer pricing, 1073 Vesting period, 948
Translation of a foreign operation, 1134
Translation of financial instruments, 1129
Translation of property – revaluations, 1128 W
Transnational audit, 1075
Wal-Mart, 109
Transnational Auditors Committee (TAC), 1075
Warranties, 1394
Treasury, 1472
Weighted average number of shares, 544
Trend analysis, 282
Whistleblowing, 175
Triangulation, 273
Working capital cycle, 1242, 1294
Triple bottom line reporting, 1423
Written representations, 397
True and fair view, 10
Wrongful trading, 15
Turnbull Report, 171, 176
Index 1497
Notes
Corporate Reporting
Notes
Corporate Reporting
Notes
Corporate Reporting
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CHAPTER 16

Learning objectives Tick off

 Identify and explain current and emerging issues in corporate reporting

734 Corporate Reporting

 IAS 39 Financial Instruments: Recognition and Measurement

1.2 Summary of material covered at Professional Level

Financial instruments: recognition and measurement 735

736 Corporate Reporting

Interactive question 2: Classification

Interactive question 3: Transactions covered by IAS 39

1.3 Overview of accounting treatment of financial assets and liabilities

Financial instruments: recognition and measurement 737

Available-for-sale Non-derivative financial assets designated as Fair value In other

Interactive question 4: Convertible bonds

738 Corporate Reporting

Interactive question 6: Recording and measurement

See Answer at the end of this chapter.

Financial instruments: recognition and measurement 739

Interactive question 8: Bonds

Summary of accounting treatment of liabilities

740 Corporate Reporting

2.2 Initial recognition

2.3 Regular way transactions

Financial instruments: recognition and measurement 741

Worked example: Regular way purchase of a financial asset

Interactive question 9: Regular way sale of a financial asset

742 Corporate Reporting

Worked example: Risks and rewards

2.4.2 Accounting treatment

Worked example: Derecognition

Financial instruments: recognition and measurement 743

Consolidate all subsidiaries (including any SPE)

Determine whether the derecognition principles below are applied to

Have the rights to the Yes

Has the entity transferred

Has the entity assumed

Has the entity transferred Yes

Has the entity retained

Has the entity retained No

Continue to recognise the asset to the extent of the entity’s continued

Figure 16.1: Derecognition

744 Corporate Reporting

2.4.4 Repurchase agreements

Illustration: Derecognition of repurchase agreement

Financial instruments: recognition and measurement 745

Illustration: Factoring with full recourse

Illustration: Structured entities

746 Corporate Reporting

2.5 Derecognition of financial liabilities

Illustration: Extinguishing a financial liability

2.6 Partial derecognition of financial assets and financial liabilities

Financial instruments: recognition and measurement 747

Interactive question 11: Derecognition of financial assets and liabilities

2.7 Exchange or modification of debt

748 Corporate Reporting

3.2 Initial measurement

Financial instruments: recognition and measurement 749

Worked example: Fair value of interest-free loan

3.3 Transaction costs

750 Corporate Reporting

Worked example: Transaction costs 1

Worked example: Transaction costs 2

3.4 Subsequent measurement of financial assets