The Conceptual Framework

In March 2018, the International Accounting Standards Board (the

Board) finished its revision of The Framework for Financial
Reporting (the Framework).

The primary purpose of financial information is to be useful to existing and potential

investors, lenders and other creditors (users) when making decisions about the
financing of the entity and exercising rights to vote on, or otherwise influence,
management’s actions that affect the use of the entity’s economic resources. The
Framework sets out the information needed to assess management’s stewardship,
and separates this from the information that users need to assess the prospects of
the entity’s future net cash flows.

Chapter 1 – The objective of general-purpose financial

reporting

The purpose of the Framework is to:

 assist the IASB to develop and revise its standards

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

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

When considering the objective of general-purpose financial reporting, the Board

reintroduced the concept of ‘stewardship’. This is a relatively minor change and, as

1
many of the respondents to the Discussion Paper highlighted, stewardship is not a
new concept. The importance of stewardship by management is inherent within the
existing Framework and within financial reporting, so this statement largely
reinforces what already exists.

Users base their expectations of returns on their assessment of:

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

Chapter 2 – Qualitative characteristics of useful financial

information

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

Relevance and faithful representation remain as the two fundamental qualitative

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

Whilst the qualitative characteristics remain unchanged, the Board decided to

reinstate explicit references to prudence and substance over form.

Prudence is introduced in support of the principle of neutrality for the purposes of

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

The Board concluded that substance over form was not a separate component of
faithful representation. The Board also decided that, if financial statements

2
represented a legal form that differed from the economic substance, then they could
not result in a faithful representation.

Whilst that statement is true, the Board felt that the importance of the concept
needed to be reinforced and so a statement has now been included in Chapter 2 that
states that faithful representation provides information about the substance of an
economic phenomenon rather than its legal form.

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

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

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

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

3
provides information about the substance of an economic phenomenon instead of
merely providing information about its legal form.

Chapter 3 – Financial statements and the reporting entity

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

It is useful to users to understand that the general purpose financial statements are
prepared on the assumption that the reporting entity is a going concern. If this
assumption is not appropriate, they are prepared in accordance with a basis other
than IFRSs. The Framework explains that this assumption means that the entity has
neither the intention nor the need to enter liquidation or cease trading in the
foreseeable future. The Framework also states that the financial statements are
prepared from the perspective of the reporting entity as a whole, not from the
perspective of some or all of the entity’s users. This is a useful clarification for users,
because in practice the perspective taken in drafting the various standards is not
always clear.

4
Chapter 4 – The elements of financial statements

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

  2010 2018 Supporting concept

definition definition

Asset (of an A resource controlled A present economic  

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

Economic   A right that has  

resource the potential to
produce economic
benefits

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

entity) of the entity arising of the entity to to transfer and
from past events, the transfer an economic economic resource

5
 settlement of which resource as a result of must have
is expected to result past events. the potential to
in an outflow from require the entity to
the entity of transfer an economic
resources embodying resource to another
economic benefits. party.

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

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

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

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

The proposed change to the definition of assets and liabilities will leave these
unaffected. The Board has explained that these standards don’t rely on an

6
argument that items fail to meet the definition of an asset or liability. Instead, these
standards include probable inflows or outflows as a criterion for recognition. The

Board believes that this uncertainty is best dealt with in the recognition or

measurement of items, rather than in the definition of assets or liabilities.

Chapter 5 – Recognition and derecognition

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

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

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

This is potentially controversial, and the Framework addresses this specifically as

chapter 5; paragraph 15 states that ‘an asset or liability can exist even if the
probability of an inflow or outflow of economic benefits is low’.

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

7
Even stating all of this, the Framework acknowledges that the most likely location for
items such as this is to be included within the notes to the financial statements.

Finally, a major change in chapter 5 relates to derecognition. This is an area not

previously addressed by the Framework but the Framework states that derecognition
should aim to represent faithfully both:

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

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

Chapter 6 – Measurement

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

A balance is needed between giving entities the flexibility to provide relevant

information that faithfully represents the entity’s assets, liabilities, equity, income and
expenses; and requiring information that is comparable, both from period to period
and across entities.

Effective communication in financial statements is also supported by considering that

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

The first of the measurement bases discussed is historical cost. The accounting
treatment of this is unchanged, but the Framework now explains that the carrying
amount of non-financial items held at historical cost should be adjusted over time to
reflect the usage (in the form of depreciation or amortisation). Alternatively, the

8
carrying amount can be adjusted to reflect that the historical cost is no longer
recoverable (impairment). Financial items held at historical cost should reflect
subsequent changes such as interest and payments, following the principle often
referred to as amortised cost.

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

Fair value continues to be defined as the price in an orderly transaction between

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

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

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

Conversely, the Framework suggests that fair value may not be relevant if items are
held solely for use or to collect contractual cash flows. Alongside this, the Framework
specifically mentions items used in a combination to generate cash flows by
producing goods or services to customers. As these items are unlikely to be able to
be sold separately without penalising the activities, a cost-based measure is likely to
provide more relevant information, as the cost is compared to the margin made on
sales.

Chapter 7 – Presentation and disclosure

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

9
The first of these principles is that income and expenses should be included in the
statement of profit or loss unless relevance or faithful representation would be
enhanced by including a change in the current value of an asset or a liability in OCI.

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

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

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

Written by a member of the Strategic Business Reporting examining team

10
Profit, loss and other comprehensive income

This article outlines what differentiates profit or loss from other

comprehensive income and where items should be presented.

 It includes consideration of:

 The Conceptual Framework for Financial Reporting

 Income and expenses included in OCI and reclassification
 Arguments for and against reclassification
 Accounting mismatches
 Users’ views

The Conceptual Framework for Financial Reporting

The International Accounting Standards Board’s (IASB ®) Conceptual Framework for

Financial Reporting (Conceptual Framework) includes guidelines on how to present
financial performance, including the role of other comprehensive income (OCI) and
whether income and expenses included in OCI in one period should be reclassified
into the statement of profit or loss in a future period. Reclassification is sometimes
also referred to as ‘recycling’. The statement of profit or loss and OCI is the primary
source of information about an entity’s financial performance for the reporting period.
Many users of financial statements incorporate profit for the year (net profit) in their
analysis either as a starting point for that analysis or as the main indicator of the
entity’s financial performance for the period. However, in order to understand an
entity’s financial performance for the period, an analysis of all income and expenses
is required including income and expenses in OCI.

The statement of profit or loss and OCI is designed to be useful to a broad range of
users. In particular, users will often attempt to assess the future net cash inflows of

11
an entity from this statement which should be understandable and comparable. An
entity can choose to present a single statement of profit or loss and OCI or may
present a statement of profit or loss and a statement of OCI separately. OCI should

show separately those items which may be reclassified to profit or loss and those
items which may not be reclassified. The related tax effects must be allocated to
these sections.

Most items of income and expense are included in the statement of profit or loss.
However, in certain circumstances, an International Financial Reporting Standard
(IFRS® Standard) may require that income or expenses arising from a change in the
current value of an asset or liability are to be included in OCI when doing so would
result in the statement of profit or loss providing more relevant information, or a more
faithful representation of the entity’s financial performance.

Income and expenses that are measured using historical cost are included in the
statement of profit or loss. Additionally, income and expenses relating to a change in
the current value of an asset or liability may also be included in profit or loss if an
IFRS Standard allows or requires it. An example is an investment in another entity’s
debt instruments where the investing entity has an objective of both collecting
contractual cash flows and selling some of the investment in debt. Since the
contractual terms of the debt instruments would give rise on specified dates to cash
flows that are solely payments of principal and interest and the business model
includes an element of selling the investment in debt, this investment would be
measured at fair value through other comprehensive income in accordance with
IFRS 9 Financial Instruments. With such an investment, the interest income which
would be collected from holding the debt instruments is separable from other
changes in value of the investment itself. In this case, interest income is included in
the statement of profit or loss even though the gains and losses related to changes
in fair value are presented in OCI.

Income and expenses included in OCI and reclassification

Generally, income and expenses included in OCI in one period are reclassified into
the statement of profit or loss in a future period. This principle should result in the
statement of profit or loss providing more relevant information, or a more faithful

12
representation, of the entity’s financial performance. If, in producing an IFRS
Standard, the IASB feels that there is no clear basis for reclassification then income
and expenses included in OCI are not reclassified. Only the IASB can make the

decision to report an item of income or expense in OCI by explicitly including this in

an IFRS Standard.

An entity will typically incur various expenses as a result of its operations, including
tax expenses, salaries and some provisions. If these expenses related to the entity’s
operations are not reported in profit or loss, the statement of profit or loss would
generally provide too positive a reflection of the cash flows an entity is generating. A
faithful representation of the entity’s financial performance would normally require
these expenses to be reported in profit or loss.

There are certain items that are not reclassified to profit or loss according to IFRS
Standards. These include revaluation of property, plant and equipment (International
Account Standard (IAS®) 16), revaluation of intangible assets (IAS 38), and
remeasurements of defined benefit plans (IAS 19). IFRS 9 provides examples of
some items that are not reclassified and some items that are reclassified. For
example, gains and losses from investments in equity instruments designated at fair
value through other comprehensive income and changes in fair value attributable to
changes in the liability’s credit risk for particular liabilities designated as at fair value
through profit or loss, are not reclassified. However, the effective portion of gains or
losses on hedges of net investments in foreign operations per IFRS 9 are
reclassified as are the effective portion of gains and losses on hedging instruments
in a cash flow hedge. Other items which may be reclassified to profit or loss include
gains and losses on disposals arising from translating the financial statements of a
foreign operation in accordance with IAS 21.

Arguments for and against reclassification

There are arguments for and against reclassification. If reclassification ceased, then
there would be no need to define profit or loss, or any other total or subtotal in profit
or loss, and any presentation decisions could be left to specific IFRS Standards. It is
argued that reclassification protects the integrity of the statement of profit or loss and
provides users with relevant information about a transaction that occurred in the

13
period. Additionally, it can improve comparability where IFRS Standards permit
similar items to be recognised in either profit or loss or OCI.

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

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

Accounting mismatches

An accounting mismatch occurs when assets and liabilities that are economically
related are treated inconsistently for financial reporting purposes. For example, this
could occur when an investment in another entity’s debt instruments is held in a
business model whose objective is achieved by both collecting contractual cash
flows and selling some of the debt instruments, with changes in fair value recognised
directly in OCI, while a related liability is measured at amortised cost with changes in
fair value not recognised. In such circumstances, an entity may conclude that its
financial statements would provide more relevant information if both the asset and
the liability were measured at fair value through profit or loss.

A mismatched remeasurement arises where an item of income or expense

represents an economic phenomenon so incompletely that presenting that item in
profit or loss would provide information that has little relevance in assessing the
entity’s financial performance. An example of this is when a derivative is used to
hedge a forecast transaction as part of a cash flow hedge; changes in the fair value
of the derivative may arise before the income or expense resulting from the forecast
transaction are recognised. Before the results of the derivative and the hedged item
can be matched together, any gains or losses resulting from the remeasurement of
14
the derivative, to the extent that the hedge is effective and qualifies for hedge
accounting as a cash flow hedge, should be reported in OCI. Subsequently, those
gains or losses are reclassified into profit or loss when the forecast transaction
affects profit or loss. This allows users to see the results of the hedging relationship.

Users’ views

Some users think that OCI is confusing and see it as a black hole or ‘dumping
ground’ for anything that is an accounting issue. There is a lack of clarity among
users about the roles of profit or loss and OCI, and when OCI items should or should
not be reclassified to profit or loss. A common misunderstanding is that the
distinction is based upon realised versus unrealised gains. This lack of a consistent
basis for determining how items should be presented has led to an inconsistent use
of OCI in IFRS Standards. It may be difficult to deal with OCI on a conceptual level
since the IASB themselves are finding it difficult to find a sound conceptual basis.

Many users do not analyse OCI items in detail because of a lack of understanding of
OCI or because they do not consider them to be operating cash flows from which
they can predict long-term trends. As a result, it can be argued that improving the
presentation of OCI would not provide additional relevant information for their
analysis.

There is a general lack of agreement about which items should be presented in profit
or loss and in OCI. This is especially true of the principles behind reclassification
which includes the logic of when and which OCI items should be reclassified. Users
are confused by the lack of consistency and of a conceptual basis for the use of OCI
in IFRS Standards. As a result, some users may feel that OCI is used to report
controversial items. Users may pay less attention to OCI because some preparers
give it less prominence than profit or loss as some entities provide less
disaggregation and explanatory disclosures about items of OCI than items of profit or
loss. This results in poor presentation and insufficient disclosures for OCI items.

Many users are thought to ignore OCI as the changes reported are generally not
caused by the operating cash flows which can be assessed from other parts of the
financial statements. Similarly, users may not analyse OCI items in detail either

15
because of a lack of understanding of OCI or because they do not consider them to
be operating cash flows from which they can infer long-term trends.

Written by a member of the Strategic Business Reporting examining team

Bin the clutter

The effects of clutter have typically come in for little consideration

by the preparers of annual reports. However, the phenomenon is
increasingly under discussion, with initiatives recently launched to
combat it.

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

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

Clutter in annual reports is a problem, obscuring relevant information and making it

more difficult for users to find the key points about the performance of the business
and its prospects for long-term success. The main observations of the discussion
paper published by the FRC were:

16
  there is substantial scope for segregating standing data, either to a separate
section of the annual report (an appendix) or to the company’s website
 immaterial disclosures are unhelpful and should not be provided
 the barriers to reducing clutter are mainly behavioural
 there should be continued debate about what materiality means from a
disclosure perspective.

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

A significant cause of clutter in annual reports is the vast array of requirements

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

17
There may a need for a proportionate approach to the disclosure requirements for
small and mid-cap quoted companies that take account of the needs of their
investors, as distinct from those of larger companies. This may be achieved by
different means. For example, a principles-based approach to disclosures in IFRS
standards, specific derogations from requirements in individual IFRS standards or
the creation of an appropriately adapted local version of the IFRS for
SMEs standard. Pressures of time and cost can understandably lead to defensive
reporting by smaller entities and to choosing easy options, such as repeating
material from a previous year, cutting and pasting from the reports of other
companies and including disclosures of marginal importance.

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

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

Preparers wish to present balanced and sufficiently informative disclosures and may
be unwilling to separate out relevant information in an arbitrary manner. The

18
suggestion of relegating all information to a website assumes that all users of annual
reports have access to the internet, which may not be the case. A single report may
best serve the investor, by having one reference document rather than having the
information scattered across a number of delivery points.

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

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

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

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

19
‘boilerplate’, providing little specific detail of how companies apply their general
policies to particular transactions.

IFRS standards require disclosure of ‘significant accounting policies’. In other words,

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

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

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

Written by a member of the Strategic Business Reporting examining team

20
Measurement

This article considers the relevance of information provided by

different measurement methods and explains the effect that they
may have on the financial statements.

The relevance of information provided by a particular measurement method depends

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

The existing Conceptual Framework for Financial Reporting ® (the

framework) provides very little guidance on measurement, which constitutes a
serious gap in the Framework. A single measurement basis may not provide the
most relevant information to users and therefore IFRS ® standards adopt a mixed
measurement basis, which includes fair value, historical cost, and net realisable
value. Different information from different measurement bases may be relevant in
different circumstances. A particular measurement bases may be easier to

21
understand, more verifiable and less costly to implement. However, if different
measurement bases are used, it can be argued that the totals in financial statements
have little meaning. Those that prefer a single measurement method favour the use
of current values to provide the most relevant information. 

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

The International Accounting Standards Board favour a mixed measurement

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

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

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

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

22
It would be easier if measurement bases were categorised as either historical cost or
current value. The Exposure Draft on the Conceptual Framework describes these
two categories but also states that cash-flow-based measurement techniques are
generally used to estimate the measure of an asset or a liability as part of a
prescribed measurement basis. Cash-flow-based measurement can be used to
customise measurement bases, which can result in more relevant information but it
may also be more difficult for users to understand. As a result the Exposure Draft
does not identify those techniques as a separate category.

There are several areas of debate about measurement. For example,should any
discussion of measurement bases include the use of entry and exit values, entity-
specific values and the role of deprival value. Again should an entity’s business
model affect the measurement of its assets and liabilities. Many would advocate that
different measurement methods should be applied that are dependent both on the
nature of assets and liabilities and also, importantly, on how these are used in the
business. For example, property can be measured at historical cost or fair value
depending upon the business model.

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

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

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

23
Current values have a variety of alternative valuation methods. These include market
value, value-in-use and fulfilment value. Of these various methods, there is less
ambiguity around current market prices as with any other measure of current value,
there is likely to be specific rules in place to avoid inconsistency. In the main, the
details of how these different measurement methods are applied, are set out in each
accounting standard.

Written by a member of the Strategic Business Reporting examining team

Accounting ethics in the digital age

This article considers a variety of ethical threats which a

contemporary accountant working in the digital age may encounter
and considers how these threats might be addressed.

It is widely accepted that accountants require more than merely professional

competence because their actions contribute to the moral and ethical culture of
organisations. This is increasingly true in recent times as accountants are faced with
new digital technologies which may impact on the ethical considerations required. 

Ethical dilemmas are not easily resolved as they often involve different perspectives
and choices. Often there are different ethical and moral considerations which may
include the environment, wealth distribution and personal relationships.
Consequently, accountants frequently face a range of ethical dilemmas and
recognising and dealing with these dilemmas is a significant part of being a
professional accountant. Some of these issues can be resolved if accountants
regularly engage with others as this engagement is likely to improve the accountant’s
ethical thinking by helping to view an issue from different perspectives. The ultimate
decisions and actions an accountant might take can be affected by culture and social
norms.

24
Strong ethical principles and behaviour are increasingly important in the digital age
as there is potential for an increased range of threats. The threats to ethical
behaviour can be categorised as follows:

 Self-interest threat: a financial or other interest (personal/organisational) will

inappropriately influence a professional accountant’s judgement or behaviour.
 Familiarity threat: owing to an established or close relationship with a client or
employer, a professional accountant will be too sympathetic to that party’s
interests or too accepting of their work.
 Intimidation threat: a professional accountant will be deterred from acting
objectively because of actual or perceived pressures, including attempts to
exercise undue influence over the professional accountant.

 Self-review: a professional accountant will not evaluate appropriately the

results of a previous judgement, made earlier in the course of providing a
current service.
 Advocacy: a professional accountant will promote a client’s or employer’s
position to the point that the professional accountant’s objectivity is
compromised.

A contemporary accountant needs to be aware of these issues to allow him/her to

deal with new digital scenarios. These will include cybersecurity, platform-based
business models, big data and analytics, cryptocurrencies , distributed ledgers and
artificial intelligence (AI). Ethical behaviour helps to build trust. Stakeholders are
much more likely to continue investing their trust in the accountant if there is belief
that the accountant will always act ethically.

The ethical principles which are most likely to be compromised by digital

developments are professional competence and due care. Ethical challenges are
likely to arise as the digital age can present new problems that have not been seen
before. The accountant needs to understand the situation in depth and its context
before being able to act. A lack of knowledge and expertise will create the risk of
compromising professional competence and due care. It is difficult to apply ethical
judgement on the use of digital technology without an understanding of what it is,
and the opportunities and challenges it poses. To behave ethically and instil trust,
professional accountants will need to learn new information relatively quickly, and to
apply their judgement to this information, often in situations they may not have seen

25
before. In addition to being directly connected to ethical situations that are personally
experienced, it is possible to be indirectly connected to ethical situations by being an
observer. In these situations, the ethical responsibility of the accountant is not
diminished in any way.

Data theft is the most immediate and common impact of a breach in cybersecurity.
Organisations hold a lot of valuable data in a variety of systems. The data itself could
be internal (eg employee-related) or external (eg customer-related). The effects of
data theft include financial loss and reputation/brand damage. Hackers can expose
the vulnerability in an insecure database where commercial implementations have
not been adequately secured.

IT security is a technology issue but the accountant is a custodian of sensitive data

and needs to be aware of the risks. The risk that objectivity may be compromised
arises from intimidation from a hacker’s threats that data will be misused or
destroyed. Additionally, the ethical duty of confidentiality, which would relate to
customer or employee data, will also be compromised. Professional accountants
need to know where there is information of value to external parties and should
ensure that there are controls to secure it.

Regulation on data collection and analytics is increasing and organisations need to

ensure the involvement of all relevant stakeholders. The accountant has a
responsibility to ensure that regulations are understood, and properly addressed.
The accountant could be accused of failure to act with integrity, competence and due
care if customers’ data is misused. The organisation should be honest in the way it
has obtained consent from customers for using their data and should not
compromise customers’ confidentiality.

The accountant needs heightened ethical awareness when it comes to considering

what action to take when there has been a breach of security in either their own
organisation, or in one that they are advising. Given the accountant’s obligation to
act in the public interest, it might be necessary to make a public disclosure, such as
informing customers that their personal information has been exposed.

26
Platform-based businesses create value by bringing together consumers and
producers. Examples are Airbnb, Uber, Google, Facebook, YouTube, eBay, and
Alibaba. They have minimum levels of physical assets or inventory of their own to
sell and do not need necessarily an increase in employee numbers to expand. They
simply need to build up a substantial user base and connect them to a list of trusted
specialist suppliers  to provide the services. The individuals whose services these
businesses offer may be contracted to work for the business (but are not
employees)and this can often raise questions about employee protection and
governance issues. The accountant may need to evaluate whether the supplier is
being unfairly treated by the business, for example whether they are indeed
employees and have specific rights or whether they are suppliers without such legal
rights. Preventing unfair treatment of stakeholders is an issue for the accountant. In
this scenario, there is a need to balance the commercial interests of the business
with the interests of the suppliers and customers.

Distributed ledger technology (DLT) is a digital system for recording asset

transactions in which the transactions and their details are recorded in multiple
places at the same time. It is a digital database of records with information relevant
to a group of participants. Unlike traditional databases, distributed ledgers have no
central data store or administration functionality. All participants are looking at a
common, shared, view of the records which are updated at the same time for all
participants.

For example, in the UK, the Land Registry expects to use DLT to revolutionise the
land registration and property buy-sell process. The reliability of such a system is
paramount as is the need to ensure that sensitive citizen data is not at risk. Such a
system will affect a significant proportion of the population and could result in
significant economic consequences if it went wrong. In turn, this may present ethical
challenges to the government’s accountants and auditors. Accountants will therefore
require a knowledge of distributed ledgers and be able to assess the risk of hacking
or other unauthorised access to data. Professional accountants must be honest
about whether they are comfortable with their knowledge of DLT and may need to
consider the public interest when they are dealing with large volumes of sensitive
information.

The increasing use of big data, and AI can enable quicker more consistent,
evidence-based and accurate decisions. AI should be lawful, ethical and robust.

27
However, the characteristics of AI create questions around the ethical use of the new
technologies. Artificial intelligence and machine learning technologies are rapidly
transforming society and will almost certainly continue to do so in the coming
decades. This social transformation will have deep ethical impacts, with these
powerful new technologies both improving and disrupting human lives.

 The accountant should review the governance and assurance needed around AI, so
that all stakeholders can have confidence in its appropriate use. The following
ethical issues may arise for the accountant:

 Artificial intelligence, like human intelligence, may be used maliciously.

 There are risks of bias in the system in unexpected and potentially detrimental
ways.
 AI will be a threat to certain categories of employment.

 There is the question of technical safety and failure.

The principles embodied in ethical codes will remain highly relevant in the face of big
data, and AI. However, while the ethical principles do not necessarily need to
change, compliance is likely to become more difficult. A challenge is the lack of
understanding around the contractual terms regarding the use of data.

Finally, the list of contexts in which confidentiality can be breached is ever growing,
which makes it unique amongst the fundamental principles. However, the
fundamental ethical principles are still fit for purpose. AI may well remove certain
ethical threats for example, intimidation threat, but it may also complicate
demonstration of compliance with the principles.

There are various ways of addressing an ethical issue and one such way is outlined
below:

 The accountant must determine the nature of the decision that has to be
made by determining the context of the ethical dilemma.
 The accountant must determine whose rights and interests are affected by the
decision.
 The accountant must determine the rules of professional practice, internal and
external governance codes and relevant laws.

28
  The accountant needs to set out the arguments in for and against taking a
particular course of action.
 The accountant needs to formulate a solution that does justice to the
arguments for and against the action to be taken.
 The accountant needs to take into account any negative consequences of
taking or not taking the action.

It can therefore be seen that, although the environment in which an accountant

operates may change, in this case become more digitalised, the basic ethical
considerations remain the same. However, there may be some additional things that
the accountant may need to think about if s/he finds herself/himself in an ethical
dilemma that is set in a digital context. These considerations are summarised above
and SBR candidates should have an awareness of these whilst preparing
themselves for their forthcoming SBR exam and professional career.

Written by a member of the Strategic Business Reporting examining team

A look at the standards for transactions with

related parties
Related party relationships are a natural feature of business activity and could
have an effect on the financial performance and position of an entity because
of related party influence. Even if there are no transactions between related
parties, their existence may affect transactions of the reporting entity with
other parties because of significant influence. There is an inherent risk that
transactions with a related party might be on favourable terms with a potential
impact on profitability. Related party disclosure can contain important
stewardship information.

The United Nations Conference on Trade and Development (UNCTAD) guidance on

good corporate governance recognises that disclosure of related party transactions
and any related party relationships where control exists should be disclosed as well
as disclosure of the decision-making process for approving related party
transactions. 

29
Although IAS 24, Related Party Disclosures (2009), sets out the scope of related
party disclosures, it does not apply to the measurement of related party transactions.
Prior to the current standard, the definition of a related party in IAS 24 had been the
subject of criticism because some believed that it was inherently inconsistent and too
complex to apply in practice because it included multiple cross-references that were
difficult to interpret. 

The International Accounting Standards Board (IASB) therefore simplified the

definition of a related party whilst providing relief for government-related entities as
regards the amount of information such entities needed to disclose.

A related party can be a person or an entity. Therefore the standard separates the
definition of a related party into two parts. First, a related party can be a person or a
close member of that person’s family where that person has control or joint control or
significant influence over the reporting entity or is a member of the key management
personnel. 

Second, IAS 24 sets out several conditions where an entity is related to a reporting
entity. Examples of these are where the entity and the reporting entity are members
of the same group, where one entity is an associate or joint venture of the other and
where both are joint ventures of the same third party.

Exclusions

The definition of a related party includes joint ventures but not joint operations. The
list of related parties in IAS 24 is exhaustive and joint operations are not included in
that list and are therefore outside its scope. The exclusion is not discussed in the
standard but it is consistent with the principle that joint operations are viewed as part
of the entity itself. It is also consistent with IFRS 12, Disclosure of Interests in Other
Entities, which does not require summarised financial information for
joint operations. 

Additionally, under IFRS 11, Joint Arrangements, each of the transactions, assets

and liabilities of a joint operation is attributable to one or other of the participants and
each participant recognises the amounts in its own financial statements. Since these
transactions are viewed as the participant’s own transactions, a participant in a joint

30
operation does not need to disclose transactions with the joint operation entity as
related party transactions.

In formulating the definition of a related party, the IASB adopted the specific
approach, which it outlined in the ‘Basis for Conclusions’. When an entity assesses
whether two parties are related, it should interpret significant influence as being
equivalent to the relationship that exists between an entity and a member of its key
management personnel. Thus significant influence and key management personnel
relationships are treated as the same level of closeness. 

However, the IASB goes on to state that such relationships are not as close as a
relationship of control or joint control. All direct relationships involving control, joint
control or significant influence are related party relationships. Further if one entity (or
person) controls (or jointly controls) a second entity and the first entity (or person)
has significant influence over a third entity, the second and third entities are related
to each other. Conversely, if two entities are both subject to significant influence by
the same entity (or person), the two entities are not related to each other. Finally, if

one party is related to a second party, the second party is also related to the first
party because of the symmetrical nature of their relationship. 

Relationships between a reporting entity and a corporate investor and between a

reporting entity and an individual investor are treated in the same manner. In
analysing related party relationships, an individual and close members of that
individual’s family are treated as one party as are members of the same group. A
post-employment benefit plan for employees of the reporting entity is considered to
be a related party of that entity and the definition of a related party was extended by
the Annual Improvements 2010-2012. This ‘improvement’ clarified that an entity
providing key management personnel to the reporting entity is itself a related party of
the reporting entity.

IAS 24 contains no specific exemptions for intragroup transactions in consolidated

financial statements. When intragroup transactions are eliminated, they are not part
of the group financial statements and are therefore not disclosed under IAS 24.
However, the amendments to accounting standards relating to investment entities
have the effect that intragroup related party transactions between an investment

31
entity and its subsidiaries that are measured at fair value through profit or loss, are
not eliminated in the group financial statements. 

As a result, transactions and any amounts outstanding between an investment entity

and its unconsolidated subsidiaries are disclosed under IAS 24. Many jurisdictions
have extensive management remuneration disclosure requirements, which may
overlap with the requirements of IAS 24. The financial statements must include the
disclosures required by IAS 24, but only have to include the additional local
jurisdictional disclosures if so specified in local law.

IAS 24 does not specifically state whether a related relationship should exist at the
reporting date for the transactions to be reported. It is, therefore, not apparent
whether all related party events and transactions for the period should be disclosed. 

Related parties relationships can commence and cease in the period, leaving
questions as to whether disclosure should be made of the transactions before or
after these relationships started or ended. However, para 18 of IAS 24 states that ‘if
an entity has had related party transactions during the periods covered by the
financial statements, it shall disclose the nature of the relationship as well as

information about those transactions and outstanding balances, including

commitments, necessary for users to understand the potential effect of the
relationship on the financial statements’. 

Sufficient disclosure

The principle to be applied is whether there has been sufficient disclosure made to
enable users to assess the potential impact of related party transactions on the
entity’s financial position and performance. Also, regardless of whether there have
been transactions between a parent and a subsidiary, an entity must disclose the
name of its parent and, if different, the ultimate controlling party. Where parties
become related after the date of the financial statements, but before the financial
statements are authorised, it may constitute a non-adjusting event under
IAS 10, Events After the Reporting Period. 

32
In determining whether a related party transaction exists, the substance of the
relationship and not merely the legal form must be considered. IAS 24 gives
examples of situations where parties are not necessarily related. For example,
entities may have a common member of key management or may be economically
dependent upon each other but these situations do not necessarily mean that the
entities are related unless there is some other connection. Similarly, two venturers
are not necessarily related parties simply because they share joint control over a
joint venture.  

Challenges

In some jurisdictions, entities face challenges in identifying and disclosing related

party transactions among government-related entities. Government may not be able
to exert sufficient influence over economic transactions with related parties or in
some circumstances entities may not be able to identify government related entities.
IAS 24 gives an entity exemption from the disclosure of transactions with a related
party that is either a government that has control, joint control or significant influence
over the entity or is another entity that is under the control, joint control or significant

influence of the same government as the entity. If the entity applies the exemption,
then there are alternative disclosures which must be made.

Many accounting frauds have involved related party transactions and this has
created concern among market participants about appropriate disclosures and the
auditing of those transactions. These types of transactions are considered to pose
an increased risk of material misstatement in financial statements. 

Partially, as a result of these concerns, the US Securities and Exchange

Commission has approved a Public Company Accounting Oversight Board standard
on auditing transactions with related parties. As a result, companies will need to
revisit the controls they have in place to identify, account for and disclose related
party transactions. 

In order to meet some of the recent requirements, auditors will need management
assistance. For example, for any related party transactions that require financial
statement disclosure or represent a significant risk, the standard makes explicit that

33
auditors will have to evaluate the ability of the related parties to meet any financial
obligations. Clearly, such transactions should be viewed with increased auditor
scepticism.

Graham Holt is director of professional studies at the accounting, finance and

economics department at Manchester Metropolitan Business School

Revenue revisited

On 28 May 2014, the International Accounting Standards Board (the Board), as a

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

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

34
Historically, there has been a significant divergence in practice over the recognition
of revenue, mainly because IFRS standards have contained limited guidance in
certain areas. The original standard, IAS® 18, Revenue, was issued in 1982 with a
significant revision in 1993, however, IAS 18 was not fit for purpose in today’s
corporate world as the guidance available was difficult to apply to many transactions.
The result was that some companies applied US GAAP when it suited their needs.

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

IFRS 15 replaces the following standards and interpretations:

 IAS 11, Construction Contracts

 IAS 18, Revenue
 IFRIC 13, Customer Loyalty Programmes
 IFRIC 15, Agreements for the Construction of Real Estate

 IFRIC 18, Transfer of Assets from Customers

 SIC-31, Revenue – Barter Transactions Involving Advertising Services

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

Using the five-step model

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

35
Step one in the five-step model requires the identification of the contract with the
customer. Contracts may be in different forms (written, verbal or implied), but must
be enforceable, have commercial substance and be approved by the parties to the
contract. The model applies once the payment terms for the goods or services are
identified and it is probable that the entity will collect the consideration. Each party’s
rights in relation to the goods or services have to be capable of identification. If a
contract with a customer does not meet these criteria, the entity can continually
reassess the contract to determine whether it subsequently meets the criteria.

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

Step two requires the identification of the separate performance obligations in

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

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

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

36
third party – for example, government taxes. An entity must determine the amount of
consideration to which it expects to be entitled in order to recognise revenue.

The transaction price might include variable or contingent consideration. Variable

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

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

Variable consideration is wider than simply contingent consideration as it includes

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

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

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

component exists. This is likely to be the case where there are long-term
arrangements with multiple performance obligations such that goods or services are
delivered and cash payments received throughout the arrangement. For example, if
an advance payment is required for business purposes to obtain a longer-term

37
contract, then the entity may conclude that a significant financing obligation does not
exist.

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

Step four requires the allocation of the transaction price to the separate

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

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

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

Where the transaction price includes a variable amount and discounts, it is

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

38
This will be a major practical issue as it may require a separate calculation and
allocation exercise to be performed for each contract. For example, a mobile
telephone contract typically bundles together the handset and network connection
and IFRS 15 will require their separation.

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

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

 The customer simultaneously receives and consumes the benefits provided

by the entity’s performance as the entity performs.
 The entity’s performance creates or enhances an asset that the customer
controls as the asset is created or enhanced.
 The entity’s performance does not create an asset with an alternative use to
the entity and the entity has an enforceable right to payment for performance
completed to date.

Revenue is recognised in line with the pattern of transfer. Whether an entity

recognises revenue over the period during which it manufactures a product or on
delivery to the customer will depend on the specific terms of the contract.

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

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

39
In addition to the five-step model, IFRS 15 sets out how to account for the
incremental costs of obtaining a contract and the costs directly related to fulfilling a
contract and provides guidance to assist entities in applying the model to licences,
warranties, rights of return, principal-versus-agent considerations, options for
additional goods or services and breakage.

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

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

Read part 2

Written by a member of the Strategic Business Reporting examining team

This is the second part of an article looking at the key principles of IFRS
15, Revenue from contracts with customers.

The five-step model was explained in the first of this pair of articles. This article will
explore the issues surrounding the definition and nature of a contract according to
IFRS 15 in greater depth, as well as the scope of the standard and its interaction
with other standards.

40
Definition and nature of a contract

The definition of what constitutes a contract for the purpose of applying the standard
is critical and is based on the definition of a contract in the US and is similar to that in
IAS 32, Financial Instruments: Presentation. A contract exists when an agreement
between two or more parties creates enforceable rights and obligations between
those parties.

The agreement does not need to be in writing to be a contract, but the decision as to
whether a contractual right or obligation is enforceable is considered within the
context of the relevant legal framework of a jurisdiction.

Thus, whether a contract is enforceable will vary across jurisdictions. Indeed, the
performance obligation could include promises that result in a valid expectation that
the entity will transfer goods or services to the customer even though those promises
are not legally enforceable.

IFRS 15 sets out five criteria that must be met before an entity can apply the revenue
recognition model to that contract and these have been derived from previous
revenue recognition and other standards. If some or all of these criteria are not met,
then it is unlikely that the contract establishes enforceable rights and obligations. The
criteria are assessed at the beginning of the contract and are not reassessed unless
there has been a significant change in circumstances, which make the remaining
contractual rights and obligations unenforceable.

The first of the criteria is that the parties should have approved the contract and
are committed to perform their respective obligations. In the case of oral or
implied contracts, this may be difficult, but all relevant facts and circumstances

should be considered in assessing the parties’ commitment. The parties need not
always be committed to fulfilling all of the obligations under a contract.

IFRS 15 gives the example where a customer is required to purchase a minimum

quantity of goods, but past experience shows that the customer does not always do
this and the other party does not enforce their contract rights. There needs to be
evidence, however, that the parties are substantially committed to the contract. If

41
IFRS 15 had required all of the obligations to be fulfilled, there would have been
circumstances, as set out above, where revenue would not have been recognised,
even though the parties were substantially committed to the contract.

The second and third criteria state that it is essential that each party’s rights and
the payment terms can be identified regarding the goods or services to be
transferred. This latter requirement is the key to determining the transaction price.
The construction industry was concerned as to whether it was possible to identify the
payment terms for orders where the scope of work had been determined but the
price of the work may not be decided for a period of time. These transactions are
referred to as unpriced change orders or claims. IFRS 15 includes the need to
determine whether the unpriced change order or contract claim should be accounted
for on a prospective basis or a cumulative catch-up basis. If the scope of the work
has been approved and the entity expects that the price will be approved, then
revenue may be recognised.

The fourth criteria states that the contract must have commercial

substance before revenue can be recognised as without this requirement, entities
might artificially inflate their revenue and it would be questionable whether the
transaction has economic consequences.

Finally, it should be probable that the entity will collect the consideration due
under the contract. An assessment of a customer’s credit risk is an important
element in deciding whether a contract has validity, but customer credit risk does not
affect the measurement or presentation of revenue. The consideration may be
different to the contract price because of discounts and bonus offerings.

The entity should assess the ability of the customer to pay and the customer’s
intention to pay the consideration. In cases where the contract does not meet the
criteria for recognition as a contract according to IFRS 15, the consideration received

should only be recognised as revenue when the contract is either complete or

cancelled, or until the contract meets all of the criteria for recognition.

IFRS 15 does not apply to wholly unperformed contracts where all parties have the
enforceable right to end the contract without penalty. These contracts do not affect
an entity’s financial position until either party performs under the contract. The

42
standard defines the term ‘customer’ as a ‘party that has contracted with an entity to
obtain goods or services that are an output of the entity’s ordinary activities in
exchange for consideration’. This is to distinguish contracts that should be accounted
for under IFRS 15 from under other IFRSs.

Some respondents asked for a clarification of the meaning of ordinary activities, but
none was given. Instead reference was made to the description of revenue in the
IASB’s Conceptual Framework and the FASB Concepts Statement No 6. An entity
needs to consider all relevant facts and circumstances, such as the purpose of the
activities undertaken by the other party, to determine whether that party is a
customer.

At first sight this definition may seem relatively straightforward to apply; however,
there are circumstances where an appropriate assessment is needed. For example,
in cases where there is collaborative research and development between
biotechnology and pharmaceutical entities, or grants received for research activity
where the grantor specifies how the output from the research activity will be used.
Additionally, it is possible that a joint arrangement accounted for under IFRS 11 Joint
Arrangements could fall within the scope of IFRS 15 if the partner meets the
definition of a customer.

In the case of the transfer of non-financial assets that are not an output of an entity’s
ordinary activities, it is now required that an entity applies IFRS 15 in order to
determine when to derecognise the asset and to determine the gain or loss on
derecognition. This is because these transactions are more like transfers of assets to
customers, rather than other asset disposals.

IAS 18 did not provide specific guidance for variable consideration in these
circumstances, but IFRS 15 does.

Back to top 

Scope, exclusions and interactions with other

standards

43
IFRS 15 excludes transactions involving non-monetary exchanges between entities
in the same industry to facilitate sales to customers or to potential customers. It is
common in the oil industry to swap inventory with another oil supplier to reduce
transport costs and facilitate the sale of oil to the end customer. The party
exchanging inventory with the entity meets the definition of a customer, because of
the contractual obligation which results in the party obtaining output of the entity’s
ordinary activities. In this situation, the recognition of revenue would not be
appropriate as there would be an overstatement of revenue and costs.

Leases, insurance contracts, and financial instruments and other contractual rights
or obligations within the scope of IFRS 9, Financial Instruments, IFRS
10, Consolidated Financial Statements, IFRS 11, Joint Arrangements, IAS 27,
Separate Financial Statements, and IAS 28, Investments in Associates and Joint
Ventures, are also scoped out in the standard. Some contracts with customers will
fall partially under IFRS 15 and partially under other standards.

An example of this would be a lease arrangement with a service contract. If other

IFRSs specify how to account for the contract, then the entity should first apply those
IFRSs. The specific subject standard would take precedence in accounting for a part
of a contract and any residual consideration should be accounted for under IFRS 15.
Essentially, the transaction price will be reduced by the amounts that have been
measured by the other standard.

As with all standards examined in the Diploma in International Financial Reporting

exam, you should first aim to understand the principles of the standard, then make
sure that you practice applying these to practical questions.

Written by a member of the examining team

IFRS 13, Fair Value Measurement

44
IFRS 13 has required a significant amount of work by entities to
simply understand the nature of the principles and concepts
involved.

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

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

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

Interestingly an entity cannot argue that prices are too low relative to its own
valuation of the asset and that it would be unwilling to sell at low prices. The prices to
be used are those in ‘an orderly transaction’. An orderly transaction is one that

45
assumes exposure to the market for a period before the date of measurement to
allow for normal marketing activities to take place and to ensure that it is not a forced
transaction. If the transaction is not ‘orderly’ then there will not have been enough
time to create competition and potential buyers may reduce the price that they are
willing to pay. Similarly if a seller is forced to accept a price in a short period of time,
the price may not be representative. Therefore, it does not follow that a market in
which there are few transactions is not orderly. If there has been competitive tension,
sufficient time and information about the asset, then this may result in an acceptable
fair value.

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

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

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

Sensibly an entity does not have to carry out an exhaustive search to identify either
market but should take into account all available information. Although transaction
costs are taken into account when identifying the most advantageous market, the fair
value is calculated before adjustment for transaction costs because these costs are

characteristics of the transaction and not the asset or liability. However, if location is
a factor, then the market price is adjusted for the costs incurred to transport the

46
asset to that market. Market participants must be independent of each other and
knowledgeable, and able and willing to enter into transactions.

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

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

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

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

47
  significant, then it may require the fair value to be classified as level 3.

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

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

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

48
undertake the activity. Transaction price is not always the best indicator of fair value
at recognition because entry and exit prices are conceptually different.

The guidance includes enhanced disclosure requirements that include:

 information about the hierarchy level into which fair value measurements fall
 transfers between levels 1 and 2
 methods and inputs to the fair value measurements and changes in valuation
techniques, and
 additional disclosures for level 3 measurements that include a reconciliation of
opening and closing balances, and quantitative information about
unobservable inputs and assumptions used.

The above is a snapshot of a standard, which has required a significant amount of

work by entities to simply understand the nature of the principles and concepts
involved.

Written by a member of the Strategic Business Reporting examining team

49
IAS 36 impairment of assets
Companies with substantial intangible assets may find themselves under the
impairment disclosure spotlight - and facing significant charges - as the financial
crisis continues.

The UK's Financial Reporting Review Panel intends to review impairment

disclosures in 2008 accounts and will give advance notice to a number of listed
companies that their accounts will be subject to review. It is uncommon for the panel
to do this, but it claims that 'these are unusual times'.

The aim of IAS 36, Impairment of Assets, is to ensure that assets are carried at no
more than their recoverable amount.

If an asset's carrying value exceeds the amount that could be received through use
or selling the asset, then the asset is impaired and the standard requires a company
to make provision for the impairment loss.

An impairment loss is the amount by which the carrying amount of an asset or cash-
generating unit (CGU) exceeds its recoverable amount. The recoverable amount of
an asset or a CGU is the higher of its fair value less costs to sell and its value in use.

IAS 36 also outlines the situations in which a company can reverse an impairment
loss. Certain assets are not covered by the standard and these are generally those
assets dealt with by other standards, for example, financial assets dealt with under
IAS 39.

A company must assess at each balance sheet date whether an asset is impaired.
Even if there is no indication of any impairment, certain assets should be tested for
impairment, for example, an intangible asset that has an indefinite useful life.

Additionally, the standard specifies the situations that might indicate that an asset is
impaired. These are external events, such as a decline in market value, or internal
causes, such as physical damage to an asset.

If it is not possible to determine the fair value less costs to sell because there is no
active market for the asset, the company can use the asset's value in use as its

50
recoverable amount. Similarly, if there is no reason for the asset's value in use to
exceed its fair value less costs to sell, then the latter amount may be used as its
recoverable amount.

For example, where an asset is being held for disposal, the value of this asset is
likely to be the net disposal proceeds. The future cashflows from this asset from its
continuing use are likely to be negligible.

IAS 36 also explains how a company should determine fair value less costs to sell.
The best guide is the price in a binding sale agreement, in an arm's length
transaction adjusted for costs of disposal.

When calculating the value in use, typically a company should estimate the future
cash inflows and outflows from the asset and from its eventual sale, and then
discount the future cashflows accordingly.

It is important that any cashflow projections are based upon reasonable and
supportable assumptions over a maximum period of five years unless it can be
proven that longer estimates are reliable. They should be based upon the most
recent financial budgets and forecasts. The cashflows should not include any that
may arise from future restructuring or from improving or enhancing the asset's
performance.

The discount rate to be used in measuring value in use should be a pre-tax rate that
reflects current market assessments of the time value of money, and the risks that
relate to the asset for which the future cashflows have not yet been adjusted.

Where the recoverable amount of an asset is less than its carrying amount, the
carrying amount will be reduced to its recoverable amount. This reduction is the
impairment loss, which should be recognised immediately in profit or loss, unless the
asset is carried at a re-valued amount. In this case, the impairment loss is treated as
a revaluation decrease in accordance with the respective standard.

If it is not possible to calculate the recoverable amount of an individual asset, then

the recoverable amount of the CGU to which the asset belongs should be calculated.
A CGU is the smallest identifiable group of assets that can generate cashflows from
continuing use, and that are mainly independent of the cashflows from other assets
or groups of assets.

51
Any impairment loss calculated for a CGU should be allocated to reduce the carrying
amount of the asset in the following order:

 the carrying amount of goodwill should be first reduced then the carrying
amount of other assets of the unit should be reduced on a pro rata basis,
which is determined by the relative carrying value of each asset; then
 any reductions in the carrying amount of the individual assets should be
treated as impairment losses. The carrying amount of any individual asset
should not be reduced below the highest of its fair value less cost to sell, its
value in use, and zero.
 If this rule is applied then the impairment loss not allocated to the individual
asset will be allocated on a pro rata basis to the other assets of the group.

Example

Facts

A cash-generating unit has the following net assets:

Goodwill 30

Property 60

Plant and equipment 90

52
 $

180

The recoverable amount has been determined and is $135m.

Question

Allocate the impairment loss to the net assets of the entity (for answer see the
following diagram).

Propert
Goodwill Plant Total
y

$m $m $m $m

Carrying value  30 60 90 180

Impairment loss (30) (6) (9) (45)

Carrying value after impairment    - 54 81 135

53
At each reporting date a company should determine whether or not an impairment
loss recognised in the previous period may have decreased.

This does not apply to goodwill. An impairment loss may only be reversed if there
has been a change in the estimates used to determine the asset's recoverable
amount since the last impairment loss had been recognised. If this is the case, then
the carrying amount of the asset shall be increased to its recoverable amount. The
increase will effectively be the reversal of an impairment loss.

However, the increase in the carrying value of the asset can only be up to what the
depreciated historical cost would have been if the impairment had not occurred. Any
reversal of an impairment loss is recognised immediately in the income statement,
unless the asset is carried at a revalued amount, in which case the reversal will be
treated as a revaluation increase.

Practical issues

Impairment testing is time intensive and includes:

 the identification of impairment indicators;

 assessing or reassessing the cashflows;
 determining the discount rates;
 testing the reasonableness of the assumptions; and
 benchmarking the assumptions with the market.

Companies should plan ahead. Market capitalisation below net asset value is an
impairment trigger, and calculations of recoverable amount are required. If the
market capitalisation is lower than a value-in-use calculation, then the VIU

assumptions may need challenging, as the cashflow projections might not be as

expected by the market, and the reasons for this must be determined.

In a VIU test, the cashflows exclude the costs and benefits of future reorganisations
(unless the reorganisation has been provided under IAS 37) and also the costs and
benefits of future enhancement capital expenditure. Therefore, the cashflow
forecasts for a VIU test may differ from the cashflows in the approved budgets.

54
Certain intangibles such as goodwill can be tested for impairment at an earlier date
than at the end of the year with any changes updated in the year-end valuation.
Regulators have stated that many companies are not fully complying with the
somewhat onerous disclosure requirements of IAS 36. Therefore, it is essential to
disclose the discount rate and long-term growth rate assumptions in the discounted
cashflow models used. There are no exemptions from the disclosure requirements.

The discount rate used must be plausible. Interest rates are falling in many
jurisdictions, but other factors affect discount rates in impairment calculations. These
include corporate lending rates, cost of capital and risks associated with cashflows,
which are all increasing in the current environment.

Purchased goodwill has to be allocated to all the CGUs which benefit from the
acquisition. Before finalising the allocation of goodwill, it is useful to think about how
goodwill is going to be tested. The cashflows being tested should be consistent with
the assets that they relate to and the final position must make sense by comparison
to any market data available.

Forecasts need to be based on the latest budgets or forecasts, be reasonable and

supportable and consistent with analysts' forecasts for the sector and the views of
third-party experts.

Graham Holt is an ACCA examiner and principal lecturer in

accounting and finance at Manchester Metropolitan University
Business School

IAS 16 property plant and equipment

Property plant and equipment (PPE) are tangible assets that an entity holds for its
own use or for rental to others, and that the entity expects to use during more than
one period. PPE could be constructed by the reporting entity or purchased from
other entities.

55
Biological assets, intangible assets and investment property are not PPE. Neither
are investments in subsidiaries, associates and joint ventures.

The recognition and measurement of exploration and evaluation assets is set out in
IFRS 6, Exploration for and Evaluation of Mineral Resources.

Mineral rights and exploration and evaluation assets are specifically excluded from
the scope of PPE. However, productive assets held by entities in the extractive
industries are subject to the same recognition and measurement rules as other
PPE. 

Recognition

An item of PPE should be recognised as an asset, if it is probable that future

economic benefits associated with the asset will flow to the entity and the cost of the
item can be measured reliably. Future economic benefits occur when the risks and
rewards of the asset's ownership have passed to the entity. PPE is initially
recognised at its cost, which is the fair value of the consideration given.

All the directly attributable costs necessary to bring the asset into working condition
should be capitalised: these costs include delivery and installation costs, architects'
fees and import duties. Where relevant, these costs should include borrowing costs
and directly attributable overhead costs.

Any income earned during the pre-production phase, which is not necessary to bring
the asset into working condition, should be recognised in the income statement.

The cost might also include transfers from equity of gains/losses on qualifying
cashflow hedges that are directly related to the acquisition of property, plant and
equipment. Where consideration is deferred beyond normal credit terms, it should be
discounted to present value.

After initial recognition, the asset should be measured at cost less accumulated
depreciation and impairment losses or at a revalued amount, which is its fair value
less subsequent depreciation and impairment losses. In this case, fair value must be
reliably measurable. Revaluations must be made with sufficient regularity to ensure
that the carrying amount is not materially different from fair value.

56
However, if an asset is revalued, then the entire class of asset must be revalued.
The fair value of property is its market value. A professionally qualified valuer
normally undertakes the valuation. IAS 16 does not use the value to the business
model. As a consequence, IAS 16 is not prescriptive in requiring such things as non-
specialised properties to be valued at existing use value (EUV), at depreciated
replacement cost and properties surplus to requirements to be valued at open
market value.

Disclosure should be made whether the revaluation was performed by an

independent valuer or not. The same rule for revaluation of property applies to plant
and equipment. However, there are difficulties of obtaining a market value for plant
and equipment that are recognised in IAS 16. Valuation at depreciated replacement
cost is allowed when there is no real market value, because of the specialised nature
of the assets.

If a revaluation results in an increase in value it should be credited to equity, unless it

represents the reversal of a revaluation decrease of the same asset previously
recognised as an expense, in which case it should be recognised as income. A
decrease arising as a result of a revaluation should be recognised as an expense, to
the extent that it exceeds any amount previously credited to the revaluation surplus
relating to the same asset.

When a revalued asset is disposed of, any revaluation surplus may be transferred
directly to retained earnings, or it may be left in equity under the heading revaluation
surplus. The transfer to retained earnings should not be made through the income
statement so as to prevent 'recycling'.

IAS 16 capitalises subsequent expenditure on an asset using the same criteria as

the initial spend; that is, when it is probable that the future economic benefits
associated with the item will flow to the entity and the cost of the item can be
measured reliably. If part of an asset is replaced, then the part it replaces is
derecognised, regardless of whether it has been depreciated separately or not. This
is in contrast to certain local generally accepted accounting principles (for example,
UK GAAP), which require capitalisation of subsequent expenditure only when the
expenditure improves the condition of the asset beyond its previously assessed
standard of performance.

Depreciation
57
The depreciable amount (cost less prior depreciation, impairment and residual value)
should be allocated on a systematic basis over the asset's useful life. The residual
value and the useful life of an asset should be reviewed, at least, at each financial
year end. And if expectations differ from previous estimates, any change is
accounted for prospectively as a change in estimate under IAS 8.

The residual value of an item of PPE is based on the estimated amount that an entity
would currently obtain from the asset's disposal, less estimated selling costs, if the
asset were already of the age and in the condition expected at the end of its useful
life. Thus, residual values take account of changes in prices up to the balance sheet
date, but not of expected future changes. Residual values are not based on prices
prevailing at the date of acquisition (or revaluation) of an asset, but take account of
subsequent price changes.

Depreciation commences when an asset is in the location and condition that enables
it to be used in the manner intended by management. Depreciation ceases at the
earlier of its derecognition (sale or scrapping) or its reclassification as 'held for sale'
and should be reviewed at least at each year end.

Temporary idle activity does not preclude depreciating the asset, as future economic
benefits are consumed not only through usage but also through wear and tear and
obsolescence. IAS 16 does not include any reference to renewals accounting and,
therefore, does not allow any departure from the principle that the depreciation
expense is determined by reference to an asset's depreciable amount.

Derecognition

PPE is derecognised on disposal or when no future economic benefit is expected

from its use or disposal. Gains on disposal should not be classified in the income
statement as revenue.

When an entity purchases or constructs an asset, it may take on a contractual or

statutory obligation to decommission the asset or restore the asset site. These costs
should be capitalised at the date on which the entity becomes obligated to incur

58
them. The amount capitalised as part of the asset's cost will be the amount
estimated to be paid, discounted to the date of initial recognition.

The related credit is recognised in provisions. There may be significant changes in

the initial (and subsequent) estimates of decommissioning costs of an asset,
particularly where asset lives are long. These changes in estimate may be because
of changes in legislation, technology and timing of the decommissioning and or
management's assumptions.

An entity that uses the cost model records changes in the existing liability and
changes in the discount rate, adjusting the cost of the related asset in the current
period. An entity using the revaluation model accounts for changes effectively
through the revaluation reserve.

Impairment

Impairments should be accounted for in accordance with IAS 36, Impairment of

Assets. An impairment loss under the revaluation model is treated as a revaluation
decrease to the extent of previous revaluation surpluses. Any loss that takes the
asset below historical depreciated cost is recognised in the income statement.

Where there is a reversal of an impairment loss, the amount of the reversal that can
be recognised is restricted to increasing the carrying value of the asset to the
carrying value that would have been recognised had the original impairment not
occurred. In other words, after taking account of normal depreciation that would have
been charged had no impairment occurred. Compensation may be received in the
form of reimbursements and is recorded in the income statement when the
compensation becomes receivable.

Impairment indicators are more likely to be prevalent at the present time, therefore
requiring assets to be evaluated for impairment. Owing to the current economic
environment, it may be more likely that impairment indicators exist. Impairment must
be considered at both interim and annual reporting dates.

Recoverability

59
When PPE is tested for recoverability, it might also be necessary to review
depreciation and amortisation estimates and methods. The manufacturing sector is
likely to be severely affected. For instance, there could be cancelled sales orders.
This would cause some of the PPE to become idle and the utilisation rate of the
machinery is likely to drop.

As a result of the lower utilisation rate, there is an implication for the impairment of
plant, given that the plant will be idle and not be involved in generating cashflows to
the entity. Non-cash generating units are an indication of impairment, as the return
on assets in this situation is significantly reduced.

Graham Holt, ACCA examiner and principal lecturer in

accounting and finance, Manchester Metropolitan University
Business School

IAS 16 and componentisation

At first sight, the componentisation of property, plant and equipment (PPE) seems a
fairly straightforward process, but the devil lies in the detail.

The rationale of componentisation is simple: the various elements or components of

PPE assets do not have identical useful lives. They may wear out or depreciate at

60
different rates, and some may have a higher risk of impairment or obsolescence than
others.

IAS 16, Property, Plant and Equipment, sets out the criteria for recognising, valuing
and depreciating non-current assets. The standard requires the various components
of an asset to be identified and depreciated separately if they have differing patterns
of benefits and are significant relative to the total cost of the item. Entities must
ensure that the overall value of an asset is split fairly between significant
components that need to be accounted for separately, and that the components’
useful lives and the method of depreciation are determined on a reasonable and
consistent basis.

Where a significant component is expected to wear out more quickly than the overall
asset, it is depreciated over a shorter period and any subsequent expenditure on
restoring or replacing it is capitalised. This approach means that different
depreciation periods may be used for each component of PPE.

Examples of components of property can be land, roof, walls, boilers and lifts. These
individual components would be depreciated over their respective useful lives.
Significant parts of an asset with similar useful lives and patterns of consumption can
be grouped together. There is no minimum requirement for how many parts of an
asset should be identified. The number of parts may vary depending on the nature
and complexity of the asset. All relevant parts of an asset are identified at the date of
initial recognition and the number of identified parts should not vary after the date
that the asset is ready for use.

When the International Accounting Standards Board (IASB) modified IAS 16 to

require the allocation of components, it did not anticipate a large change in practice.
The IASB wanted to eliminate the practice of accruing the costs of major future
overhauls or inspections before they were incurred. In such circumstances, no
obligation for the expenditure exists at the date of accrual, and the resulting debit
created does not represent an existing asset. The IASB decided to require the
allocation of the cost of an asset into its components for the purposes of depreciation
to allow entities to reflect the effect of a pending overhaul.

Componentisation can be a challenging process for entities especially where there is

insufficient detail held on the values of the different components. For example, when
a valuation is carried out on a property, it is unusual for the various component parts
to be valued.

61
Consequently, there may be a need to involve company personnel in the analysis of
the data to arrive at the component elements, and there may be a need to consider
whether the entity’s current systems can perform the required calculations.
Application of component accounting to all assets will involve a significant amount of
work and some difficulties in estimating the value of components.

The challenge is to determine how far the asset should be broken down into
components for the purpose of separate recognition by applying the concept of
‘materiality’. To perform materiality testing, a de minimis limit is normally set, below
which assets are excluded from component accounting. Materiality may be
considered in terms of the effect on the reported depreciation cost and the carrying
values of assets but essentially it is a matter of professional judgment.

Once a materiality level has been set, the meaning of ‘significant component’ needs
to be considered and applied to individual assets. A significant component may be
one that has a significant value compared to the asset as a whole but a significantly
shorter useful life and will require replacement on at least one occasion during the
life of the asset as a whole. Clearly, any measure used to determine components is
subjective.

Asset registers may need to be rewritten if spreadsheet systems are no longer

suitable for managing the asset register. Deficiencies in historical records may also
prevent entities from splitting some asset values into their constituent components,
and significant cost may be incurred in providing bespoke information.

Where a component is replaced or restored, the carrying amount of the old

component is derecognised to avoid double-counting and the new component
reflected in the carrying amount, subject to the recognition principles. Recognition
and derecognition occur regardless of whether the replaced part has been
depreciated separately. Derecognition of a PPE component takes place when no
future economic benefits are expected from its use – that is, its service potential is
used up.

Where it is not possible to determine the carrying amount of the replaced part of an
item of PPE, best estimates are required. Entities often use the cost of the new part
to estimate the cost of the replaced part at the time of its acquisition or construction.
This may involve using the replacement cost of the component, indexed back to the
original component’s inception and adjusted for any subsequent depreciation and

62
impairment. This can cause complexity especially where the asset has been
revalued.

Where an item of PPE has been revalued, the value will be apportioned over the
significant components already recognised for separate depreciation. Judgment is
required to determine the most appropriate method to achieve that apportionment
and the treatment of any revaluation surplus thus created.

When a component is replaced, the written-down value of the component replaced

should be charged to the income statement and the cost of the new component
recognised in the statement of financial position. The componentisation of an item of
PPE is not required where depreciating the item as a single asset is unlikely to result
in a material misstatement of either the depreciation charges or the carrying amount
of PPE. However, entities will need to collect the evidence required to demonstrate
that a material misstatement has not occurred.

The general rule is that there should be retrospective application of IAS 16 and
componentisation. However, the component approach may be applied prospectively
from the date of transition to IFRS. The entity can apply the ‘fair value as deemed
cost’ exemption to restate the asset to fair value at the date of transition. The fair
value is then allocated to the different significant parts of the asset.

For example, in the UK, local authorities have decided not to apply retrospectively
the IAS 16 requirements for componentisation, on the basis that retrospective
application is not expected to have a material impact on their accounts, as the IAS
16 requirement does not differ significantly from the existing UK standard. In this
case, the prospective requirements are applicable to enhancement expenditure
incurred, acquisition expenditure incurred, and revaluations carried out.

An item of PPE is enhanced when a new component is added to the asset, an

existing asset component is refurbished or upgraded, or an asset component is
replaced. Although there is no requirement to depreciate investment property,
component accounting will apply in respect of the recognition and derecognition of
components when enhancement expenditure is incurred on these properties.
Componentisation also applies to assets recognised under IFRIC 12, Service
Concession Arrangements, and IAS 17, Leases.

Componentisation has significant implications for the provision for deferred tax when
the period in which the expense is allowed for tax purposes does not coincide with

63
the life expectancy of the capitalised expense. There is a possibility that the earnings
per share figure could be affected and impairment calculations will have to be
revisited. The accounting treatment of PPE can be subjective in the determination of
the life expectancy and residual values of assets, and the determination of the value
of an asset.

Componentisation adds to this subjectivity, as can be seen from the example on this
page. The additional depreciation charge can be significant. Alternatively, because of
the subjective nature of the assessment, it is possible to arrive at the same
depreciation charge by adjusting assets’ lives accordingly.

Accountants and other professionals must use their professional judgment when
establishing significance levels, assessing the useful lives of components and
apportioning asset values over recognised components. Discussions with external
auditors will be key during this process.

Graham Holt is an examiner for ACCA and executive head of

the accounting and finance division at Manchester
Metropolitan University Business School

How to measure fair value

The International Accounting Standards Board (IASB) has recently completed a joint
project with the Financial Accounting Standards Board (FASB) on fair value
measurement. The result is IFRS 13, Fair Value Measurement. The standard defines
fair value, establishes a framework for measuring it, and requires significant
disclosures relating to it.

64
The IASB wanted to enhance disclosures for fair value so that users could better
assess the valuation techniques and inputs used to measure it. There are no new
requirements in IFRS 13 about when fair value accounting is required - the IASB is
relying on guidance on fair value measurements in existing standards. Although
IFRS 13 moves International Financial Reporting Standards (IFRS) and US GAAP
closer on how to measure fair value, differences remain about when fair value
measurements are required and the recognition of gains or losses on initial
recognition.

The guidance in IFRS 13 does not apply to transactions dealt with by certain
standards (such as share-based payment transactions in IFRS 2, Share-based
Payment, and leasing transactions in IAS 17, Leases) nor to measurements that are
similar to fair value but are not fair value (such as net realisable value calculations in
IAS 2, Inventories, or value in use calculations in IAS 36, Impairment of Assets).

IFRS 13 applies therefore to fair value measurements that are required or permitted
by those standards not scoped out by IFRS 13. It replaces the inconsistent guidance
found in various IFRSs with a single source of guidance on measurement of fair
value, and has an effective date of 1 January 2013. The standard is applied
prospectively and can be adopted early.

The exit price

Fair value has a different meaning depending on the context and usage. The IASB's
definition of fair value is: the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date. In other words, it is an exit price.

Fair value is focused on the assumptions of the marketplace and is not entity-
specific. It therefore takes into account any assumptions about risk. It is measured
using the same assumptions and taking into account the same characteristics of the
asset or liability as market participants would. Such characteristics include the
condition and location of the asset and any restrictions on its sale or use.

The basic principles thus remain similar to current IFRS, but if an entity did not use
these principles before IFRS 13, it could result in significant change. For example, if
an entity's view of fair value did not take into account the highest and best use of the

65
asset when revaluing its property, plant and equipment, then IFRS 13 could result in
a higher fair value.

It is not a relevant argument in the valuation process for the entity to insist that prices
are too low relative to its own valuation of the asset and that it would be unwilling to
sell at such low prices. The prices to be used are those in 'an orderly transaction' -
one that assumes exposure to the market for a period before the date of
measurement to allow for normal marketing activities and to ensure that it is not a
forced transaction.

If the transaction is not 'orderly' there will not have been enough time to create
competition, and potential buyers may reduce the price that they are willing to pay.
Similarly, if a seller is forced to accept a price in a short period of time, then the price
may not be representative.

However, it does not follow that a market with few transactions is not an orderly one.
If there has been competitive price tension, and sufficient time and information about
the asset, then the market may return a fair value for the asset.

Unit of account

The unit of account to be employed for measuring fair value is not specified by IFRS
13, but is determined by the individual standard. A 'unit of account' is the single asset
or liability or a group of assets or liabilities.

The characteristic of an asset or liability must be distinguished from a characteristic

arising from the holding of an asset or liability by an entity. An example is where an
entity has to sell a large block of shares at a discount to the market price. This
discount is a characteristic of holding the asset rather than of the asset itself and
should not be taken into account when fair-valuing the asset.

Which market?

Fair value measurement assumes that the transaction to sell the asset or transfer the
liability takes place in the principal market for the asset or liability or, in the absence
of a principal market, in the most advantageous market for the asset or liability. The

66
principal market is the one with the greatest volume and level of activity for the asset
or liability that can be accessed by the entity.

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

Sensibly, an entity does not have to carry out an exhaustive search to identify either
market but should take into account all available information. Although transaction
costs are taken into account when identifying the most advantageous market, the fair
value is not after adjustment for transaction costs because these costs are a
characteristic of the transaction, not the asset or liability.

If location is a factor, then the market price is adjusted for the costs incurred to
transport the asset to that market. Market participants must be independent of each
other and knowledgeable, and able and willing to enter into transactions.

IFRS 13 sets out a valuation approach that refers to a broad range of techniques.
These techniques are threefold: the market, income and cost approaches.

When measuring fair value, the entity is required to maximise the use of observable
inputs and minimise the use of unobservable inputs. To this end, the standard
introduces a fair value hierarchy, which prioritises the inputs into the fair value
measurement process.

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

Input hierarchy

Level 1 inputs are unadjusted quoted prices in active markets for items identical to
the asset or liability being measured. As with current IFRS, if there is a quoted price
in an active market, an entity uses that price without adjustment when measuring fair
value. An example of this would be prices quoted on a stock exchange. The entity
needs to be able to access the market at the measurement date.

67
Active markets are ones where transactions take place with sufficient frequency and
volume for pricing information to be provided. An alternative method may be used
where it is expedient, and the standard sets out criteria where this may be
applicable.

For example, it may be that the price quoted in an active market does not represent
fair value at the measurement date, a situation which may occur when a significant
event such as a business reorganisation or combination takes place after the close
of the market.

Determining whether a fair value measurement is a level 2 or level 3 input depends

on whether the inputs are observable or unobservable, and on their significance.

Level 2 inputs are inputs other than quoted prices in level 1 that are observable for
that asset or liability. They are quoted assets or  liabilities for similar items in active
markets or supported by market data – for example, interest rates, credit spreads or
yield curves. Adjustments may be needed to level 2 inputs, and if these are
significant, the fair value may need to be classified as level 3.

Level 3 inputs are unobservable inputs, which should be used as a minimum. Where
situations occur when relevant inputs are not observable, they must be developed to
reflect the assumptions that market participants would use when determining an
appropriate price for the asset or liability.

The entity should maximise the use of relevant observable inputs and minimise the
use of unobservable ones. The general principle of using an exit price remains and
IFRS 13 does not preclude an entity from using its own data. For example, cashflow
forecasts may be used to value an entity that is not listed. Each fair value
measurement is categorised on the basis of the lowest level input that is significant
to it.

Valuation concepts

IFRS 13 also sets out certain valuation concepts to assist in the determination of fair
value. For non-financial assets only, fair value is decided based on the highest and
best use of the asset as determined by a market participant.

68
The fair value of a liability or the entity's own equity assumes it is transferred to a
market participant on the measurement date. Often there is no observable market to
provide pricing information and the highest and best use is not applicable.

The fair value is then based on the perspective of a market participant who holds the
identical instrument as an asset. If there is no corresponding asset, a valuation
technique is used, as is the case with a decommissioning activity.

The fair value of a liability reflects the non-performance risk based on the entity's
own credit standing plus any compensation for risk and profit margin a market
participant might require to undertake the activity. Transaction price is not always the
best indicator of fair value at recognition because entry and exit prices are
conceptually different.

Disclosure

The guidance includes enhanced disclosure requirements that could result in more
work for reporting entities. Required disclosures include: 

 information about the hierarchy level into which fair value measurements fall;
 transfers between levels 1 and 2;
 methods and inputs to the fair value measurements and changes in valuation
techniques; and
 additional disclosures for level 3 measurements that include a reconciliation of
opening and closing balances, and quantitative information about
unobservable inputs and assumptions used.

This article is merely a snapshot of a standard that will require a significant amount
of work by entities simply to understand the nature of the principles and concepts
involved.

Graham Holt is an examiner for ACCA and executive head of

the accounting and finance division at Manchester
Metropolitan University Business School

69
How do changes to IAS 16, 38 and IRFS 11 impact you?

In May 2014, the International Accounting Standards Board (IASB) issued two
amendments to standards, entitled Clarification of Acceptable Methods of
Depreciation and Amortisation (Amendments to IAS 16 and IAS 38) and Accounting
for Acquisitions of Interests in Joint Operations (Amendments to IFRS 11). At first
sight, these amendments may not seem to be of significance; however, to some
entities they will have a profound effect.

"They will have a profound effect."

A variety of depreciation methods are used to allocate the depreciable amount of an
asset over its useful life. These methods include the: 

 straight-line method
 diminishing balance method
 units of production method. 

The method used is selected on the basis of the expected pattern of consumption of
the expected future economic benefits and is applied consistently, unless there is a
change in the expected pattern of consumption.

The IASB decided to amend IAS 16, Property, Plant and Equipment, to address
issues that had arisen over the use of a revenue-based method for depreciating an
asset. This is a method that is based on revenues generated in an accounting period
as a proportion of the total revenues expected to be generated over the asset’s
useful economic life.

Clarification

The total revenue takes into account any anticipated changes due to price inflation
but the IASB felt that inflation has no bearing on the way in which an asset is
consumed. The amendment came as a result of a request to clarify the meaning of
‘consumption of the expected future economic benefits embodied in the asset’ when

70
deciding on the amortisation method to be used for intangible assets of service
concession arrangements. IAS 16 requires the depreciation method to reflect the
pattern in which the asset’s future economic benefits are expected to be consumed
by the entity.

Revenue may be a measurement of the output generated by the asset, but does not
represent the way in which an item of PPE is used. Such methods reflect a pattern of
generation of economic benefits that arise from the operation of the business of
which an asset is part, rather than the pattern of consumption of an asset’s expected
future economic benefits.

The IASB concluded that a method of depreciation that is based on revenue

generated from an activity that includes the use of an asset is not appropriate, but
that the diminishing balance method is an accepted depreciation method. This has
the capability of reflecting accelerated consumption of the future economic benefits
in the asset.

This latter conclusion regarding the diminishing balance method was a clarification
due to concerns raised by Committee members who questioned whether the
proposed amendment, given the influence of a pricing factor, would limit the ability to
apply a diminishing balance depreciation method to manufacturing equipment.

The original exposure draft proposed that there might be circumstances in which a
revenue-based method gave the same result as a ‘units-of-production’ method. This
statement was thought to contradict the proposed amendments and so was dropped.

The principle in IAS 38, Intangible Assets, is that an amortisation method should

reflect the pattern of consumption of the expected future economic benefits and not
the pattern of generation of expected future economic benefits. IAS 38 is therefore
amended to introduce a rebuttable presumption that a revenue-based amortisation
method for intangible assets is inappropriate for the same reasons as in IAS 16.
However, there are limited circumstances when this presumption can be overturned.
They are where the intangible asset is expressed as a measurement of revenue and
where it can be demonstrated that revenue and the consumption of the intangible
asset is directly linked to the revenue generated from the asset.

Both standards now contain an explanation that expected future reductions in selling
prices might be indicative of an increased rate of consumption of the future economic
benefits of that asset. The amendments are effective for annual periods beginning on

71
or after 1 January 2016 with earlier application permitted. Full retrospective
application of the amendments would have been too onerous for some entities.

Outstanding issues

In 2011, the IASB issued IFRS 11, Joint Arrangements, which introduced several
changes. Principally, there are now only two types of joint arrangements, which are
joint ventures and joint operations.

"A key issue is accounting for the acquisition of an interest in a

joint operation, which represents a business."
Further, proportionate consolidation is no longer permitted for arrangements
classified as joint ventures, as equity accounting has to be applied. Although the
standard deals with most issues arising out of the accounting for joint operations,
there are certain matters that it does not address.

A key issue is accounting for the acquisition of an interest in a joint operation, which
represents a business. As both IFRS 11 and its predecessor, IAS 31, Joint Ventures,
did not deal with the issue, significant diversity in practice has occurred. The
approaches used in practice in accounting for a joint operation, which constituted a
business, were as follows:

 IFRS 3, Business Combinations, approach: identifiable assets and liabilities were

normally measured at fair value and goodwill recognised. Additionally, transaction
costs were not capitalised and deferred taxes were recognised on initial recognition
of assets and liabilities. The guidance in IFRS 3 was not followed where it was not
appropriate; for example, in this situation there would not be non-controlling interests.
 Cost approach: the total cost of acquiring the interest in the joint operation was
allocated to the individual identifiable assets on the basis of their relative fair values.
The premium paid, if any, was allocated to the identifiable assets and not recognised
as goodwill. Transaction costs were capitalised and deferred taxes were not
recognised as per the exception in IAS 12, Income Taxes.
 Hybrid approach: preparers in this group applied IFRS 3 and other IFRSs selectively
with the result that mainly identifiable assets and liabilities were measured at fair
value and goodwill was recognised.

Transaction costs were capitalised with contingent liabilities and deferred taxes
generally not recognised.

72
This diversity has led to different treatments of any premium paid on acquisition,
recognition or non-recognition of any deferred taxes arising on acquisition and
acquisition costs being capitalised or expensed.

As a result of the above diversity, the IFRS Interpretations Committee was asked to
clarify whether the acquirer of such interests in joint operations should apply the
principles in IFRS 3 or whether the acquirer should account for it as a group of
assets. The committee referred the matter to the IASB, suggesting that the most
appropriate approach was to apply the relevant principles for business combinations
in IFRS 3 and other IFRSs.

Defining a business

One of the key judgments is whether the activities of the joint operation, or the set of
activities and assets contributed to the joint operation on its formation, represent a
business as defined by IFRS 3.

IFRS 3 defines a business as ‘an integrated set of activities and assets that is
capable of being conducted and managed for the purpose of providing a return in the
form of dividends, lower costs or other economic benefits directly to investors or
other owners, members or participants’.

Further guidance explains that a business is a series of inputs and processes

applied to those inputs that have the ability to create outputs. However, outputs are
not required for the activities to qualify as a business. An output should have the
ability to provide a return in the form of dividends, lower costs or other economic
benefits to owners.

The assessment of whether a set of activities and assets represent a business is still
extremely judgmental.

As a result of the IASB’s deliberations, an amendment to IFRS 11 has been

made. Accounting for Acquisitions of Interests in Joint Operations (Amendments to
IFRS 11) requires that the acquirer of an interest in a joint operation which
constitutes a business, as defined in IFRS 3, is required to apply all of the principles
in IFRS 3 and other IFRSs with the exception of those principles that conflict with the
guidance in IFRS 11. As a result, a joint operator that has acquired such an interest
has to:

73
  measure most identifiable assets and liabilities at fair value
 expense acquisition-related costs (other than debt or equity issuance costs)
 recognise deferred taxes
 recognise any goodwill or bargain purchase gain
 perform impairment tests for the cash-generating units to which goodwill has been
allocated
 disclose information required relevant for business combinations.

The amendments apply to the acquisition of an interest in an existing joint operation

and also to the acquisition of an interest when a joint operation is formed. IFRS
1, First-time Adoption of International Financial Reporting Standards, has also been
amended to extend the business combination exemptions. The amendments are
effective for annual periods beginning on or after 1 January 2016 and apply
prospectively.

"For some companies, the amendment will represent a significant

change to current practice."
For some companies, the amendment will represent a significant change to current
practice and will present a number of challenges as a result of having to apply
business combinations accounting, while others relate to the nature of the proposed
amendment itself.

For example, joint arrangements are common in the mining and metals sector;
therefore any changes in the accounting can have wide-ranging implications. Some
key implications for those companies are the increased time, cost and effort needed
to determine fair values for the identifiable assets acquired and liabilities assumed.
This in turn will lead to changes in the profiles of the financial statements and the
need for more detailed record keeping.

Graham Holt is director of professional studies at the

accounting, finance and economics department at
Manchester Metropolitan University Business School.

74
Pension poser

In 2011, the International Accounting Standards Board (IASB) issued amendments

to IAS 19, Employee Benefits, and indicated that there were further matters that
required a more fundamental review of pensions and related benefits. These matters
included the issues relating to contribution-based promises (CBPs).

Examples of CBPs are where the employee receives a pension based on the
performance of the assets in the pension plan and the employer provides a
guarantee of the minimum performance of those assets. The employee accordingly
receives a benefit that is the higher of the contributions plus the actual return on the
assets in the plan and the guaranteed amount.

Alternatively, the employee may receive a guaranteed benefit based on a specified

return on ‘notional’ plan contributions by the employer. The IFRS Interpretations
Committee (IFRIC), which issues guidelines for International Financial Reporting
Standards (IFRS), tried to develop a solution for the accounting for such plans but
removed it from its project agenda in May 2014.

Although some schemes may have a few features that bring them into the defined
benefit category of IAS 19, they may be so much closer to a standard defined
contribution plan that full defined benefit accounting does not seem appropriate.
Meanwhile other schemes may be close to defined benefit arrangements, but have
risk-sharing provisions that reduce the sponsor’s exposure.

The IASB considered contribution-based promises in the discussion paper that

preceded its latest revisions to IAS 19. In that paper, the IASB looked at a fair value
measurement basis for such schemes. However, neither the Interpretations
Committee nor the IASB decided that change was needed.

IAS 19 requires an entity to classify post-employment benefits as either defined

contribution plans or defined benefit schemes. A defined contribution scheme is one
where the entity pays specified contributions into a separate entity (a fund) and has
no obligation to pay more contributions if the fund does not have enough assets to
pay all the accrued benefits.

By definition, if a scheme is not defined contribution, then it has to be defined benefit,

and the entity must use ‘the projected unit credit method’ to account for it.

75
Using an actuarial technique with this method, the entity calculates the present value
of defined benefit obligation (DBO), which has been discounted by bond rates. The
discount rate used is determined by reference to market yields at the end of the
reporting period on high-quality corporate bonds, or, if there is no deep market in
such bonds, by reference to market yields on government bonds.

The entity determines the deficit or surplus as the difference between the present
value of DBO and the fair value of its related plan assets. This deficit or surplus is
recognised as a net defined benefit liability (asset) in the statement of financial
position, subject to an asset ceiling test.

IAS 19’s measurement process does not properly reflect risk differences among
plans because the present value of the DBO does not fully reflect the value of risk
relating to future cashflows from the DBO. However, the fair value of the plan assets
reflects the value of risk relating to future cashflows from them by the use of market
prices.

Defined benefit plans are distinguished from defined contribution plans by the fact
that the entity suffers the actuarial and investment risks. The accounting for defined
benefit plans is covered by IAS 19 but the accounting for hybrid plans such as CBPs
under IAS 19 often results in counterintuitive measurement.

Many hybrid plans are classified as defined benefit schemes but their risks are quite
different. For example, in some CBP schemes, the obligation is calculated by the
entity projecting the benefit on the basis of an assumption of future performance of
the plan’s assets, which is potentially higher than bond rates. In CBPs, investment
risk does not always fall entirely on the entity, but is often shared by employees. This
sharing of risk is not dealt with by IAS 19 and thus the entity could show an
excessive plan deficit because the present value of the DBO is much higher than the
fair value of the plan assets. This is because the discount rate is lower than the
projected higher return on plan assets.

The number of hybrid plans is rising as more employers reduce their risk exposure.
Entities are also buying annuities, and using longevity swaps to manage pension
risk.

IAS 19 has been questioned from various other conceptual viewpoints as IAS 19’s

76
measurement basis is quite different from other IFRSs. For example, it is difficult to
reconcile a pension liability with the definition of a liability in the conceptual
framework, and similarly, the requirement to reflect unvested benefits and future
salary increases in the entity’s obligations.

The netting off of the plan assets and defined benefit obligations is also inconsistent
with other IASB pronouncements. IAS 19 has current acceptance because of its
relative ease of use and because issuers and users have found some merit in its
information content. A new model would increase costs and have significant effects
on the business. The general opinion is that frequent changes of pension accounting
are unnecessary and costly.

The IASB feels that the issues relating to CBPs and eliminating diversity in practice
are important, and that costs and benefits should be carefully assessed when
recommending any change to the accounting treatment of pensions.

The main scope of IASB’s current research project is accounting for new pension
plans that incorporate features that were not envisaged when IAS 19 was issued. It
is proposing to fundamentally review the principles of measurement, and
classification in IAS 19. The research will probably revisit such issues as CBPs,
the discount rate for employee benefits, and exemptions for entities participating in
multi-employer defined benefit plans.

Another topic under discussion concerns whether a pension surplus could be

recorded as an asset on the statement of financial position in certain circumstances.
IAS 19 limits the measurement of a net defined benefit asset to the lower of the
surplus in the defined benefit plan and the asset ceiling.

IAS 19 defines the asset ceiling as ‘the present value of any economic benefits
available in the form of refunds from the plan or reductions in future contributions to
the plan’.

IFRIC’s IFRIC 14 interpretation of the requirements in IAS 19 addresses when

refunds or reductions in future contributions should be regarded as available.

IFRIC 14 states that a refund is available if the entity has ‘an unconditional right’ to a
refund. The IASB has undertaken a project to clarify whether a trustee’s power to
augment benefits or wind up a plan affects the employer’s unconditional right to a

77
refund and thus, in accordance with IFRIC 14, restricts recognition of an asset.

Essentially the project is assessing whether an entity could get economic benefit
from a surplus in a scheme and whether there is an unconditional right to a refund.
At present, entities can recognise a surplus as an asset, even though the trustees
could change the benefits and wipe out the surplus. The implications of these
changes appear less severe than previously thought – IFRIC is not seeking to
prohibit recognition of surplus in schemes where there is no future accrual of
benefits. The changes are expected to be made separately from the annual IFRS
improvements process and, once they are confirmed, entities should review the rules
of their scheme and revisit any legal opinion previously obtained about the ability to
recognise a surplus.

Because pension schemes can have infinite variations with differing degrees and
forms of risk-sharing, the IASB may consider the general principle of measurement
of pension schemes with the aim of determining a measurement basis that works for
all types of schemes. The IASB’s work relating to the measurement of insurance
liabilities and discount rates may help here.

Finally, compounding the above potential changes, the economic situation has had
an impact on pension schemes. In 2014, long-term inflation assumptions derived
from the gilt market were about 0.2% a year lower than at the start of the year.
Taking the changes in inflation, discount rates and interest costs into account, a
typical pension obligation could be significantly higher than at the end of 2013.

The degree of change in the net defined benefit liability will depend on whether the
asset performance has kept pace with the change in the size of the obligation.
However, as bond yields are down significantly since the start of the 2014, the value
of liabilities will probably have increased much quicker than scheme assets.

Graham Holt is director of professional studies at the

accounting, finance and economics department at
Manchester Metropolitan University Business School

78
IAS 19 Employee Benefits

IAS 19 uses the principle that the cost of providing employee benefits should be
recognised in the period in which the benefit is earned by the employee, rather than
when it is paid or payable.

The standard identifies several categories of employee benefit including:

 short-term employee benefits, such as sick pay

 post-employment benefits such as pensions
 termination benefits, and
 other long-term employee benefits including long service leave.

Classification of benefit plans

Defined contribution plans occur when a company pays a fixed contribution into a
separate fund and has no legal or constructive obligation to pay further contributions.
Actuarial and investment risks of defined contribution plans are assumed either by
the employee or the third party. Plans not defined as contribution plans are classed
as defined benefit plans.

If an employer is unable to show that all actuarial and investment risk has been
transferred to another party and its obligations are limited to contributions made
during the period, a plan is defined benefit.

Under a defined benefits plan, the benefits payable to employees are not based
solely on the amount of the contributions, but are determined by the terms of the
defined benefit plan. The benefits are typically based on such factors as age, length
of service and compensation. The employer retains the actuarial and investment
risks of the plan.

For example, under the terms of a particular pension plan, a company contributes
6% of an employee’s salary. The employee is guaranteed a return of the
contributions plus interest of 4% a year. The plan would be classified as a defined
benefit plan as the employer has guaranteed a fixed rate of return and as a result
carries the investment risk.

79
Defined-contribution and defined-benefit plans

The accounting for a defined-contribution scheme is relatively straightforward, as the

employer’s obligation for each period is determined by the amount that has to be
contributed to the scheme for that period. There are no actuarial assumptions
required to measure the obligation or expense and there are no actuarial expenses
or losses.

Employers must use the projected unit credit method to determine the present value
of a defined benefit obligation, the current service cost and any past service cost.
This method looks at each period of service, which gives rise to additional units of
benefit and measures each unit separately to build up the final obligation.

All of the post-employment benefit obligation is discounted. Actuarial assumptions

are used, which are the best estimate of the variables that determine the ultimate
cost of providing post-employment benefits. These will include demographic
assumptions such as mortality, turnover and retirement age, and financial
assumptions such as discount rates, salary and benefit levels.

The obligation will include both legal obligations and any constructive obligation
arising from the employer's usual business practices such as an established pattern
of past practice. IAS 19 does not require an annual actuarial valuation of the defined
benefit obligation, but the employer is required to determine the present value of the
defined benefit obligation and the fair value of the plan assets.

This must be done with sufficient regularity so that the amounts recognised do not
differ materially from the amounts that would be determined at the balance sheet
date. A volatile economic environment will require frequent valuations at least
annually.

Plan assets are measured at fair value, which is normally market value. Fair value
can be estimated by discounting expected future cash flows. The rate used to
discount estimated cash flows should be determined by reference to market yields at
the balance sheet date on high-quality corporate bonds. IAS 19 is not specific on
what it considers to be a high-quality bond and therefore this can lead to variation in
the discount rates used.

80
Balance sheet recognition

The amount recognised in the balance sheet could be either an asset or a liability.
The amount recognised will be the following:

 the present value of the defined benefit obligation, plus

 any actuarial gains less losses not yet recognised, minus
 any past service cost not yet recognised, and minus
 the fair value of the plan assets.

If the result of the above is a positive amount then a liability has occurred and it is
recorded in full in the balance sheet.

Any negative amount is an asset that is subject to a recoverability test. The asset
recognised is the lesser of the negative amount calculated above, or the net total of
unrecognised actuarial losses and past service costs, and the present value of any
benefits available in the form of refunds or reductions in future employer
contributions to the plan.

Plan assets and plan liabilities from the different plans are normally presented
separately in the balance sheet.

Actuarial gains and losses

A company should recognise a portion of its actuarial gains and losses as income or
expense if the net cumulative unrecognised actuarial gains and losses at the end of
the previous reporting period, (ie at the beginning of the current financial year)
exceeds the greater of 10% of the present value of the defined benefit obligation at
the beginning of the year, and 10% of the fair value of the plan assets at the same
date.

These limits should be calculated and applied separately for each defined plan. The
excess determined by the above method is then divided by the expected average
remaining lives of the employees in the plan. This method is called the corridor
approach.

81
However, an entity can adopt any other method that results in faster recognition of
actuarial gains and losses as long as it is applied consistently. Additionally, there is
the option of recognising actuarial gains and losses in full in the period in which they
occur, outside profit or loss, in a statement of recognised income and expense.

Delays in the recognition of gains and losses can give rise to misleading figures in
the statement of financial position. Also, multiple options for recognising gains and
losses can lead to poor comparability.

Example A Plc

  01/01/08 31/12/08

  USDm USDm

Fair value plan assets 100 110

Present value defined-benefit 90 96

obligation

Unrecognised actuarial gain 16 26

Average working life of employees 10 years 10 years

82
This entity has decided to use the corridor approach in recognising actuarial gains
and losses.

It must recognise the portion of the net actuarial gain or loss in excess of 10% of the
greater of defined benefit obligation or the fair value of the plan assets at the
beginning of the year.

Unrecognised actuarial gain at the beginning of the year was USD16m. The limit of
the corridor is 10% of USD100m (value of plan assets) ie USD10m, as this is greater
than the present value of the obligation. The difference is USD6m, which divided by
10 years is USD0.6m.

Expense recognition - defined-benefit plans

The amount of the expense or income for a particular period is determined by a

number of factors. The pension expense is the net of the following items:

 current service cost

 interest cost
 the expected return of any plan assets
 actuarial gains and losses to the extent recognised
 past service cost to the extent that the standard requires the entity to
recognise it, and
 the effect of any curtailments or settlements.

The difference between the expected return and actual return on plan assets is an
actuarial gain or loss. The expected return is based on market expectations at the
beginning of the period for returns over the entire life of the related obligation. This
return is a very subjective assumption and an increase in the return can create
income at the expense of actuarial losses, which may not be recognised when
entities use the corridor approach.

Conclusion

83
Accounting for post-employment benefits is an important financial reporting issue. It
has been suggested that many users of financial statements do not fully understand
the information that entities provide about post-employment benefits.

Both users and preparers of financial statements have criticised the accounting
requirements for failing to provide high-quality, transparent information about post-
employment benefits.

Graham Holt is principal lecturer in accounting and finance at

the Manchester Metropolitan University Business School, and
an ACCA examiner

The Shortcomings of IAS 37

IAS 37, Provisions, Contingent Liabilities and Contingent Assets, issued in

1998, substantially improved financial reporting at that time. Prior to its issue,
there was significant scope for earnings manipulation as, for example, entities
could make provisions for future costs that were not present obligations. IAS
37 only allows provisions which meet the definition of a liability. However, the
standard is not perfect and there are concerns about some aspects of it.

84
The International Accounting Standards Board (IASB) is considering amendments to
IAS 37 for several reasons. There has been difficulty in interpreting IAS 37 guidance
on identifying liabilities. Also, the recognition thresholds in IAS 37 have been
questioned, as they are higher than in other international financial reporting
standards (IFRSs). In addition, existing measurement requirements are unclear.

There is also inconsistency in the standard, as some provisions are subject to

outcome uncertainty and some to existence uncertainty. Examples would be
warranty provisions and possible litigation damages.

The Conceptual Framework exposure draft is likely to have significant implications

for any review of IAS 37 because of the change in the definition of a liability. IAS 37
provides guidance in the interpretation of the definition of a liability where, for
example, an obligation is not legally enforceable or is conditional on the future
actions of the entity. The IASB is likely to wait until the publication of the Conceptual
Framework in 2016 before any revisions to IAS 37.

IAS 37 partly defines a liability as a ‘present obligation … arising from past events’.
The guidance it gives as regards the identification of present obligations appears
contradictory.

IAS 37 states that only obligations that exist independently of the future conduct of
the entity’s business are recognised as provisions: if the liability can be avoided, then
a liability is not recognised. On the other hand, IAS 37 defines an obligating event as
one where the entity has no realistic alternative but to settle the obligation. Preparers
have interpreted this statement as the entity having a liability for obligations that
could be avoided through its future actions, where those actions are unrealistic.

As a result, it is often unclear how avoidable an obligation must be for it not to be

recognised, and this can give rise to problems. The IFRS Interpretations Committee
has concluded that an entity does not have a present obligation if it could avoid the
transfer through its future actions, irrespective of whether those actions are realistic.
However, the interpretations have not completely clarified IAS 37.

An entity must recognise a provision where it is more likely than not that a liability
exists; it is probable that an outflow of resources will be required to settle the liability
and a reliable estimate can be made of the amount of the liability. The recognition
criteria in IAS 37 have been the subject of debate, which has focused on the
‘probable outflows’ criterion. The IASB has proposed removing that criterion from

85
IAS 37 to make the standard consistent with other standards, but many feel it serves
a useful purpose. The view of the Conceptual Framework exposure draft is that
consistency with other standards is not a reason for removing the ‘probable outflows’
criterion and states that recognition requirements may vary between standards.

The liabilities falling within the scope of IAS 37 can be distinguished from others as
generally they cannot be measured by reference to an observable current market
price. Moreover, there is normally no exchange transaction that provides a
transaction price for the liability.

Although the Conceptual Framework exposure draft discusses the same recognition
criteria, it does not necessarily imply thresholds as high as the ‘more likely than not’
thresholds in IAS 37. The IASB is only likely to lower existing thresholds if there are
examples in practice of liabilities that are not recognised under the existing IAS 37
but whose recognition would provide useful information at a cost which does not
exceed the benefit of that information.

The ‘more likely than not’ threshold for recognising litigation liabilities is lower than
the threshold applied in US GAAP, which means that entities recognise liabilities for
litigation that they are currently engaged in. Entities in the US are concerned that
valuable information would be given to the plaintiffs if they used IAS 37 recognition
criteria.

IAS 37 discusses how the ‘best estimate’ of a liability can be determined. With large
populations, the obligation is estimated by using a probability weighted expected
value technique. However, for single obligations the most likely outcome may be the
best estimate of the liability. However, even in such a case, the entity considers
other possible outcomes.

There are different views in practice as some think that expected value
measurements should be used for a single obligation that is an estimate of the
amount an entity would rationally pay to settle a liability. This diversity in applying
IAS 37 is currently not readily apparent from disclosures.

Although several existing IFRSs specify the types of costs that should be included in
measuring an item, IAS 37 is completely silent. There is no guidance on how
obligations to provide goods and services should be measured. The implications of
this lack might become more problematical when construction companies start to

86
apply IFRS 15, Revenue from Contracts with Customers, instead of IAS
11, Construction Contracts.

IAS 37 does not state whether provisions should include costs such as legal costs
expected to be incurred in the settlement of a claim. Often entities do not provide for
future legal costs, as the service has not yet been performed. However, some
entities do provide for such costs where it is considered that an outflow of economic
benefits is probable.

IAS 37 states that risks and uncertainty should be taken into account in reaching the
best estimate of a provision, but does not identify the nature of the risk adjustment.
Standards such as IAS 36, Impairment of Assets, and IFRS 13, Fair Value
Measurement, set out the purpose of the risk adjustment, which is to reflect the
uncertainty inherent in the future cashflows. In the case of IAS 37, the risk
adjustment would measure the amount it would cost to be free of risk.

Although IAS 37 requires discounting of future cashflows to present value, it gives no

guidance on non-performance risk by the entity that is the entity’s own credit risk.
Non-performance risk is taken into account by discounting the liability at the entity’s
own borrowing rate instead of a risk-free rate, and the effect can be a significant
reduction in long-term liabilities such as environmental provisions. IFRSs often omit
requirements for recognising and measuring onerous contracts with the result that
IAS 37 applies for the purpose of recognition and measurement of these contracts.
Examples are IFRS 15, and IAS 41, Agriculture.

IAS 37 prohibits recognition of contingent assets, unless the realisation of income is

virtually certain and so the threshold for recognition of contingent assets is higher
than the ‘probable outflows’ threshold for recognition of contingent liabilities.
However, entities have been critical of the timing of recognition of contingent assets.

IAS 37 states that if it has become virtually certain that an inflow of economic
benefits will arise, the asset and the related income are recognised in the financial
statements of the period in which the change occurs. Because of this requirement,
plaintiffs and defendants often account for court settlements that occur after the
year-end differently, with defendants treating them as adjusting events and plaintiffs
as non-adjusting events. Although IAS 10 sets out the way that a defendant should
treat a judgment in a court case, it does not deal with the impact for the plaintiff, who
needs to account for the contingent asset.

87
IAS 37 states that where some or all of the expenditure required for settling a
provision is expected to be reimbursed by another party, the reimbursement shall be
recognised only when it is virtually certain that the reimbursement will be received if
the entity settles the obligation. However, establishing virtual certainty can be quite
difficult.

A car manufacturer may have contractual rights to claim reimbursement for specified
costs of a warranty claim from its component suppliers. However, because the future
claims have not yet occurred, the manufacturer might find it difficult to establish that
reimbursement is virtually certain and as a result may not recognise reimbursement
assets, even though future inflows are both probable and can be measured with a
degree of certainty.

Graham Holt is director of professional studies at the accounting, finance and

economics department of Manchester Metropolitan Business School

IAS 12 income Tax

IAS 12, Income Taxes, deals with taxes on income, both current tax and deferred
tax. Income tax accounting is complex, and preparers and users find some aspects
difficult to understand and apply. These difficulties arise from exceptions to the
principles in the current standard, and from areas where the accounting does not
reflect the economics of the transactions.

88
The current tax expense for a period is based on the taxable and deductible amounts
that will be shown on the tax return for the current year. Current tax assets and
liabilities for the current and prior periods are measured at the amount expected to
be paid to or recovered from the tax authorities, using the tax rates and tax laws that
have been enacted or substantively enacted by the date of the financial statements.

A mismatch can occur because International Financial Reporting Standards (IFRS)

recognition criteria for items of income and expense are different from the treatment
of items under tax law. Deferred taxation accounting attempts to deal with this
mismatch. The IAS 12 standard is based on the temporary differences between the
tax base of an asset or liability and its carrying amount in the financial statements.

The tax base of an asset or liability is the amount attributed to it for tax purposes,
based on the expected manner of recovery. IAS 12 focuses on the future tax
consequences of recovering an asset only to the extent of its carrying amount at the
date of the financial statements. Future taxable amounts arising from recovery of the
asset will be capped at the asset's carrying amount.

For example, a property may be revalued upwards but not sold, creating a temporary
difference because the carrying amount of the asset in the financial statements is
greater than the tax base of the asset. The tax consequence is a deferred tax
liability.

Deferred tax is provided in full for all temporary differences arising between the tax
bases of assets and liabilities and their carrying amounts in the financial statements.
There are exceptions where the temporary difference arises from:

 Initial recognition of goodwill.

 Initial recognition of an asset or liability in a transaction that is not a business
combination and that affects neither accounting profit nor taxable profit.
 Investments in subsidiaries, branches, associates and joint ventures where
certain criteria apply.

Deferred tax assets and liabilities are measured at the tax rates that are expected to
apply to the period when the asset is realised or the liability is settled and
discounting of deferred tax assets and liabilities is not permitted.

The measurement of deferred tax liabilities and deferred tax assets reflects the tax
consequences of the manner in which the entity expects to recover or settle the

89
carrying amount of its assets and liabilities. The expected manner of recovery for
land with an unlimited life is always through sale, but for other assets the manner in
which management expects to recover the asset, either through use or sale or both,
should be considered at each date of the financial statements.

A deferred tax asset is recognised to the extent that it is probable that taxable profit
will be available against which the deductible temporary difference can be used. This
also applies to deferred tax assets for unused tax losses carried forward.

Current and deferred tax is recognised in profit or loss for the period, unless the tax
arises from a business combination or a transaction or event that is recognised
outside profit or loss, either in other comprehensive income or directly in equity in the
same or different period.

For example, a change in tax rates or tax laws, a reassessment of the recoverability
of deferred tax assets or a change in the expected manner of recovery of an asset
have tax consequences that are recognised in profit or loss, except to the extent that
they relate to items previously charged or credited outside profit or loss.

That, at least, is the current position on current and deferred taxation under IFRS.
The proposed amendments to IAS 12 issued in March 2009 would have made
significant changes. However, after considering the unenthusiastic feedback, the
International Accounting Standards Board (IASB) has decided not to proceed with its
proposals but to focus on practical issues with the existing standard.

The IASB and the Financial Accounting Standards Board (FASB) will consider
fundamentally reviewing the accounting for income taxes some time in the future. In
the meantime, the IASB is undertaking a limited-scope project to see which issues
can be addressed in the shorter term.

The project aims to resolve problems without changing the fundamental approach
under IAS 12, and without increasing differences with US GAAP. The project will
cover the following:

 deferred tax arising from property remeasurement at fair value;

 uncertain tax positions;
 introduction of a step to consider whether the recovery of an asset or
settlement of a liability will affect taxable profit;

90
  recognition of a deferred tax asset in full and an offsetting valuation allowance
to the extent necessary;
 guidance on assessing the need for a valuation allowance;
 guidance on substantive enactment of tax laws; and
 allocation of current and deferred taxes within a group that files a consolidated
tax return.

In September 2010, an IASB exposure draft proposed an exception to the existing

principle for measuring deferred tax assets or liabilities arising on certain non-
financial assets measured at fair value. The exception applies to:

 investment property measured using the fair value model in IAS 40;
 property, plant and equipment or intangible assets measured using the
revaluation model in IAS 16 or IAS 38; and
 investment property, property, plant and equipment or intangible assets
initially measured at fair value in a business combination if the fair value or
revaluation model was used when the underlying asset was subsequently
measured.

Deferred tax assets and liabilities are currently measured on the basis of:

 the expected manner of recovery (asset) or settlement (liability); and

 the tax rate expected to apply when the underlying asset (liability) is
recovered (settled).

The expected manner of recovery or settlement may affect the calculation of the tax
base or the applicable tax rate or both. In such cases management's intentions are
key in determining the amount of deferred tax to recognise.

The issue is that it can be difficult and subjective to determine the expected manner
of recovery. The IASB's proposed exception to this measurement principle applies to
investment property, property, plant and equipment, and intangible assets measured
using the fair value or revaluation model in accordance with relevant IFRSs.

Under this exception, the measurement of deferred tax assets and liabilities reflects
a rebuttable presumption that the carrying amount of the underlying asset will be
recovered entirely through sale.

The presumption could be rebutted only when there is clear evidence that the
underlying asset's economic benefits will be consumed by the entity throughout the

91
asset's economic life. The IASB has proposed this exception to the measurement
principle that disregards management's intention unless there is clear evidence to
support consumption through use.

It will affect entities holding investment property, property, plant and equipment or
intangible assets measured at fair value where the capital gains tax rate is different
from the income tax rate, and/or the tax base from sale is different from tax base
from use. The deferred tax liability will be reduced significantly where there is no
capital gains tax. Judgment will be required to determine whether clear evidence
exists. SIC 21, Income Taxes - Recovery of Revalued Non-Depreciable Assets, will
be withdrawn by the amendment.

Assets measured at cost, or other assets measured at fair value such as financial
instruments, are not in the scope of the IASB's exposure draft. However, it is unclear
why the same principles do not apply to these assets. The result is that there will be
a different approach to deferred tax accounting by entities with identical assets and
tax rates but different accounting policies.

The IASB's exposure draft requires full retrospective application, with early adoption
permitted. Complexities might therefore arise if the underlying assets were acquired
in a business combination.

Example

An entity has investment property overseas that is currently out on rental. The entity
has decided that it may sell the property. The property is measured at fair value
under IAS 40. In the overseas country, there are different tax rates depending on
whether an entity recovers an asset through use (30%) or sale (20%). The entity
anticipates that it will recover 40% of the property's economic benefits through use.
The fair value/carrying amount of the property is $5m, $2.5m of which is the land
value. The tax base is $3m, which is split equally over land and buildings.

92
 Temporary Tax Deferred tax
 
difference rate liability

Land $1m 20% $200,000

Building - recover through $400,000 30% $120,000

use

Building - recover through $600,000 20% $120,000

sale

Total $2m   $440,000

Solution

Given that the entity has a dual intention of use and sale with respect to the recovery
of the asset, the deferred tax calculation could reflect that dual intention. Part of the
buildings may be recovered through usage, in which case the deferred tax liability for
that part would be calculated using a 30% tax rate.

Note that the expected manner of recovery for land with an unlimited life is always
through sale.

However, the exposure draft proposals have a rebuttable presumption that the
carrying amount of the property will be recovered through sale, so the deferred tax

93
liability would be calculated in total as $(5-3)m @ 20%, i.e. $400,000. The entity
could use the tax rate applicable for recovery through use of 30% only to the extent it
had clear evidence that it would recover the carrying amount of the investment
property through usage.

It is clear that the exposure draft proposals could result in a significant change in the
deferred tax calculation. A series of piecemeal changes to IAS 12 could have a
significant impact on deferred taxation balances.

Graham Holt is an examiner for ACCA and executive head of

the accounting and finance division at Manchester
Metropolitan University Business School

Recovery position
94
The exception is where the deferred tax asset arises from the initial recognition of an
asset or liability (other than in a business combination), which does not affect
accounting profit or taxable profit. Unlike many International Financial Reporting
Standards (IFRS), IAS 12 determines the value of a deferred tax asset, not on the
basis of fair value or discounted values but at its nominal amount. 

The measurement of a DTA can be a concern simply because of the potentially long
period of time before the net operating losses are recovered. The accuracy of the
estimate of future taxable profits must be questioned in such a case and, as the
amounts cannot be discounted under the standard to reduce any future impact,
entities need to be aware of the inherent limitations in their forecasts.

The availability of sufficient taxable temporary differences and any tax-planning

opportunities that allow the recovery of DTAs are normally dependent on a
jurisdiction’s tax laws and regulations. However, there may still be uncertainty in
relation to available temporary differences and tax planning opportunities, as both
items will need confirmation by the relevant tax authorities. 

The assessment of a DTA is heavily dependent on judgment. The level of judgment

may be dependent on the nature of the tax loss that occurs. If the loss was due to a
non-recurring event then there will be little judgment required, but if the entity has
sustained tax losses for many years, then greater subjectivity may be involved in
predicting future profits. 

Where prior years’ losses are significant, evidence of future taxable profits may be
difficult to verify. IAS 12 states that where an entity has a history of recent losses,
there should be convincing evidence of sufficient future taxable profits before a DTA
can be recognised. A time limit on the carry forward of tax losses may be significant
in the assessment of a DTA.

Probability is the key judgment in this analysis. The nature of the ‘probability’
assessment is not defined in IAS 12. However, IAS 37, Provisions, Contingent
Liabilities and Contingent Assets, defines the term ‘probable’ by stating that this
means ‘more likely than not’ and thus if a deferred tax asset is ‘more likely than not’
to be recovered, then recognition is appropriate. The main judgment is the level of
evidence of future taxable profits, consisting of a breakdown of projected taxable
profits for each taxable entity, and the probability thereof. 

95
Impairment testing

The availability of future taxable profits may be determined by reference to the

entity’s own business-planning forecasts. The process of future forecasting should
be familiar to most entities due to impairment testing carried out on tangible and
intangible assets. 

Impairment tests generally are based on approved budgets, often adjusted for risk
and internal bias. Thus the expectation would be that the assessment of DTAs could
be based on the same information and be broadly consistent with the assumptions
used for impairment testing. However, the forecasting of future taxable profits does
differ from impairment testing in several ways, and some significant adjustments may
need to be made to align this analysis to the requirements for DTA valuation.

IAS 36, Impairment of Assets, defines the recoverable amount of a cash-generating

unit (CGU) as the higher of the value in use and the fair value less the cost to sell. In
order to determine the DTAs of an entity, value-in-use assumptions would be the
relevant basis for evaluating the forecasts of their future taxable income. However,
the forecasts for DTA purposes might include certain events that would be excluded
from impairment calculations under IAS 36.These might include the impact of future
restructuring activities or enhancements in asset performance. 

The cashflow forecasts should be converted to taxable profits using local tax laws.
For example, tax-deductible expenses that may not be included in a
value-in-use calculation will be taken into account in calculating taxable profit, and
non-taxable items should be excluded. Thus, the conclusion may be that the CGU is
not impaired but that the future taxable profits are not sufficient to justify recognising
a DTA.

IAS 12 indicates that the recoverability of DTAs should be assessed with reference
to the same taxation authority and the same ‘taxable entity’. The ‘taxable entity’ may
consist of multiple cash-generating units, or a cash-generating unit may consist of
more than one taxable entity. As can be seen, the ‘taxable entity’ may not be the
same as the cash-generating unit that is the basis for impairment testing. This may
mean that the forecasts used for impairment testing may have to be disaggregated in
order to assess the valuation of carry-forward losses. This could result in no DTA
being recognised, even though the cash-generating unit is profitable.

96
In many jurisdictions, there are time limits on the recovery of tax assets and this will
represent a cut-off for the cashflow projection period in determining the DTA. In
some sectors, special purpose entities (SPEs) are used to hold licences or patents,
and the life of the SPE can be limited to that of the patent or licence. This length of
life will, in turn, be the cut-off for the cashflow projection period in determining the
DTA. 

Conflicts

Projections for DTA purposes must be fairly consistent with the assumptions made in
other areas of the financial statements. An exception arises where IAS 12 conflicts
with other IFRSs. When impairment testing under IAS 36, if the risks are high in
terms of the estimation of future cashflows, the discount rate will be adjusted to take
into account the risk that the future cashflows will differ from the estimates. IAS 12,
however, does not permit the discounting of DTAs (or liabilities), and therefore
entities need to consider how they can appropriately reflect risk in their forecasts of
future taxable profits. 

A possible challenge by regulators, auditors and tax authorities may influence the
behaviour of entities. The information in financial statements must be neutral and
objective. The best form of evidence will be a strong earnings history or existing
long-term contracts that will generate stable future profits. 

The carrying amount of deferred tax assets should be reviewed at the end of each
reporting period and reduced to the extent that it is no longer probable that sufficient
taxable profit will be available to allow the benefit of part or all of that deferred tax
asset to be utilised. 

Recently the IFRS Interpretations Committee identified diversity in practice regarding

the recognition of a deferred tax asset that is related to a debt instrument measured
at fair value. As a result, the International Accounting Standards Board (IASB) issued
an exposure draft (ED), Recognition of Deferred Tax Assets for Unrealised Losses,
in August 2014.

An unrealised loss on a debt instrument does not intuitively seem to fit the definition
of a deductible temporary difference if the entity does not expect to deduct this loss
for tax purposes. However, the IASB confirms its view that unrealised losses on debt
instruments measured at fair value and measured at cost for tax purposes give rise

97
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. 

Further, the IASB proposes to clarify the extent to which an estimate of future
taxable profit includes amounts from recovering assets for more than their carrying
amounts. The recovery of an asset for more than its carrying amount is unlikely to be
probable where, say, the asset was recently impaired, but is probable where it is
measured at cost and used in a profitable operation.

An entity recognises deferred tax assets only if it is probable that it will have
sufficient future taxable profits. Future taxable profits would intuitively seem to mean
that this figure would be the one on the bottom line of the tax return. However, it is
proposed that future taxable profits would be the amount before the reversal of
deductible temporary differences. 

The proposals also clarify that the deductible temporary differences should be
assessed for recognition on a combined basis, taking into account the different types
of income (deductions) under the jurisdiction’s tax law. Tax law may restrict the
sources of taxable profit against which a deductible temporary difference can be
utilised. If there were no such restrictions, then the entity would assess a deductible
temporary difference in combination with others. However, if tax law restricts the
utilisation of losses, then a deductible temporary difference would be assessed only
in combination with other deductible temporary differences of the appropriate type.
The impact of the ED on the financial statements will depend on the tax environment
and how the entity currently accounts for deferred tax. 

Graham Holt is director of professional studies at the accounting, finance and

economics department at Manchester Metropolitan University Business
School 

Giving investors what they need

98
This article looks at how reporting capital structure is challenging,
but markets are keen for the information.

Introduction

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

Back to top 

What is it?

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

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

Back to top 

Investor needs

99
Investors have specific but different needs for information about capital depending
upon their approach to the valuation of a business. If the valuation approach is
based upon a dividend model, then shortage of capital may have an impact upon
future dividends. If ROCE is used for comparing the performance of entities, then
investors need to know the nature and quantity of the historical capital employed in
the business. There is diversity in practice as to what different companies see as
capital and how it is managed.

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

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

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

Back to top 

IAS 1 Disclosures

As a result, IAS 1 requires an entity to disclose information that enables users to

evaluate the entity’s objectives, policies and processes for managing capital. This
objective is obtained by disclosing qualitative and quantitative data. The former
should include narrative information such as what the company manages as capital,
whether there are any external capital requirements and how those requirements are
incorporated into the management of capital.

100
Some entities regard some financial liabilities as part of capital whilst other entities
regard capital as excluding some components of equity for example those arising
from cash flow hedges. The Board decided not to require quantitative disclosure of
externally imposed capital requirements but rather decided that there should be
disclosure of whether the entity has complied with any external capital requirements
and, if not, the consequences of non-compliance. Further there is no requirement to
disclose the capital targets set by management and whether the entity has complied
with those targets, or the consequences of any non-compliance.

Back to top 

Examples

Examples of some of the disclosures made by entities include information as to how

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

If the entity operates in several jurisdictions with different external capital

requirements such that an aggregate disclosure of capital would not provide useful
information, the entity may disclose separate information for each separate capital
requirement.

Besides the requirements of IAS 1, the IFRS Practice Statement Management

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

Back to top 

Companies Act

101
Additionally, some jurisdictions refer to capital disclosures as part of their legal
requirements. In the UK, Section 414 of the Companies Act 2006 deals with the
contents of the Strategic Report and requires a ‘balanced and comprehensive
analysis’ of the development and performance of the business during the period and
the position of the company at the end of the period.

The section further requires that to the extent necessary for an understanding of the
development, performance or position of the business, the strategic report should
include an analysis using key performance indicators. It makes sense that any
analysis of a company’s financial position should include consideration of how much
capital it has and its sufficiency for the company’s needs.

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

Back to top 

Capitalisation table

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

It is normal for an entity to produce a capitalisation table in a prospectus showing the

effects of the transactions on the capital structure. The table shows the ownership
and debt interests in the entity but may show potential funding sources, and the
effect of any public offerings.

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

For example, in the US, the table is used to calculate key operational metrics.
Amedica Corporation announced in February 2016 that it had ‘made significant

102
advancements in its ongoing initiative toward improving its capitalisation table,
capitalisation, and operational structure’.

It can be seen that information regarding an entity’s capital structure is spread

across several documents including the management commentary, the notes to
financial statements, interim accounts and any document required by securities
regulators.

Back to top 

Debt and equity

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

When an entity issues a financial instrument, it has to determine its classification

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

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

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

The Board has undertaken a research project with the aim of improving accounting
for financial instruments that have characteristics of both liabilities and equity. The

103
Board has a major challenge in determining the best way to report the effects of
recent innovations in capital structure.

Back to top 

Diversity and difficulty

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

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

Written by a member of the Strategic Business Reporting examining team

104
The definition and disclosure of capital

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

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

This article is useful to those candidates studying for Strategic Business Reporting. It

is structured in two parts: first, it considers what might be included as the capital of a
company and, second, why this distinction is important for the analysis of financial
information.

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

IAS® 32, Financial Instruments: Presentation sets out the nature of the classification

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

More complexity

The variety of instruments issued by entities makes this classification difficult with the
application of the principles occasionally resulting in instruments that seem like
equity being accounted for as liabilities. Recent developments in the types of
financial instruments issued have added more complexity to capital structures with

105
the resultant difficulties in interpretation and understanding. Consequently, the
classification of capital is subjective which has implications for the analysis of
financial statements.

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

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

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

There are various requirements for entities to disclose information about ‘capital’. In
drafting IFRS® 7, Financial Instruments: Disclosures, the International Accounting
Standards Board (the Board) considered whether it should require disclosures about
capital. In assessing the risk profile of an entity, the management and level of an
entity’s capital is an important consideration. The Board believes that disclosures
about capital are useful for all entities, but they are not intended to replace
disclosures required by regulators as their reasons for disclosure may differ from
those of the Board. As an entity’s capital does not relate solely to financial
instruments, the Board has included these disclosures in IAS 1, Presentation of

106
Financial Statements rather than IFRS 7. IFRS 7 requires some specific disclosures
about financial liabilities; it does not have similar requirements for equity instruments.

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

As a result, IAS 1 requires an entity to disclose information that enables users to

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

The Board decided not to require quantitative disclosure of externally imposed

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

Examples of some of the disclosures made by entities include information as to how

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

Back to top 

107
Trends

Besides the requirements of IAS 1, the IFRS Practice Statement Management

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

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

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

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

It can be seen that information regarding an entity’s capital structure is spread

across several documents including the management commentary, the notes to

108
financial statements, interim accounts and any document required by securities
regulators.

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

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

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

Written by a member of the Strategic Business Reporting examining team

109
The integrated report framework

In 2013, the International Integrated Reporting Council (IIRC)

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

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

for integrated reporting. This followed a three-month global consultation and trials in
25 countries.

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

The primary purpose of an integrated report is to explain to providers of financial

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

Historical financial statements are essential in corporate reporting, particularly for

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

110
The International Integrated Reporting Framework will encourage the preparation of
a report that shows their performance against strategy, explains the various capitals
used and affected, and gives a longer-term view of the organisation. The integrated
report is creating the next generation of the annual report as it enables stakeholders
to make a more informed assessment of the organisation and its prospects.

Principle-based framework

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

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

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

Integrated reporting is built around the following key components:

111
 1. Organisational overview and the external environment under which it operates
2. Governance structure and how this supports its ability to create value
3. Business model
4. Risks and opportunities and how they are dealing with them and how they
affect the company’s ability to create value
5. Strategy and resource allocation
6. Performance and achievement of strategic objectives for the period and
outcomes
7. Outlook and challenges facing the company and their implications
8. The basis of presentation needs to be determined, including what matters are
to be included in the integrated report and how the elements are quantified or
evaluated.

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

Back to top 

Relationship with stakeholders

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

South African organisations have been acknowledged as among the leaders in this
area of corporate reporting with many listed companies and large state-owned
companies having issued integrated reports. An integrated report may be prepared
in response to existing compliance requirements – for example, a management
commentary. Where that report is also prepared according to the framework, or even
beyond the framework, it can be considered an integrated report. An integrated
report may be either a standalone report or be included as a distinguishable part of
another report or communication. For example, it can be included in the company’s
financial statements.
112
The IIRC considered the nature of value and value creation. These terms can
include the total of all the capitals, the benefit captured by the company, the market
value or cash flows of the organisation and the successful achievement of the
company’s objectives. However, the conclusion reached was that the framework
should not define value from any one particular perspective because value depends
upon the individual company’s own perspective. It can be shown through movement
of capital and can be defined as value created for the company or for others. An
integrated report should not attempt to quantify value as assessments of value are
left to those using the report.

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

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

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

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

The IIRC has stated that the prescription of specific KPIs and measurement methods
is beyond the scope of a principles-based framework. The framework contains

113
information on the principle-based approach and indicates that there is a need to
include quantitative indicators whenever practicable and possible. Additionally,
consistency of measurement methods across different reports is of paramount
importance. There is outline guidance on the selection of suitable quantitative
indicators.

A company should consider how to describe the disclosures without causing a

significant loss of competitive advantage. The entity will consider what advantage a
competitor could actually gain from information in the integrated report, and will
balance this against the need for disclosure.

Companies struggle to communicate value through traditional reporting. The

framework can prove an effective tool for businesses looking to shift their reporting
focus from annual financial performance to long-term shareholder value creation.
The framework will be attractive to companies who wish to develop their narrative
reporting around the business model to explain how the business has been
developed.

Written by a member of the Strategic Business Reporting examining team

114
Using the business model of a company to help
analyse its performance

Understanding the business model of an entity is helpful in

analysing and communicating the essence of a business and for
predicting the implications of a change in circumstance on a
business. Strategic Business Reporting (SBR) candidates should use
this technique to improve their answers to SBR questions and this
article should help them to do this.

The business model in the context of Integrated Reporting is a company’s system of

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

Business model information can be fundamental to investor analysis. It provides

context and understanding to the other information in the annual report. The
provision of business model information can demonstrate an entity’s understanding
of its business and key drivers which can create investor trust and reduce risk.
Additionally, investors need to understand the business, how the business has
performed, and how this performance has been affected by various factors. There is
an argument that the information regarding the business model should be presented
outside the financial statements, such as in the management commentary. Investors
will need to know how the business model is responding to market trends and how

115
the strategy supports the key components of the business model. They will wish to
know how management considers the risks and opportunities across the business
model and how money is made and value generated and re-distributed. Investors will
look at the Key Performance Indicators (KPIs) and how they reflect the key
components of the business model. Having the business model play a role in
financial reporting presumes that investors have a good understanding of it prior to
assessing the entity’s financial position and performance.

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

IFRS 9 requires classification and measurement of financial assets based on an

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

It states that an entity should classify financial assets as subsequently measured at

either amortised cost or fair value on the basis of both:

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

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

To qualify for an amortised cost classification, the financial asset must be held  to
collect contractual cash flows rather than be held with a view to selling the asset to
realise a profit or loss. For example, trade receivables held by a manufacturing entity

116
are likely to fall within the 'hold to collect' business model if the trade receivables do
not contain a significant financing component in accordance with IFRS 15 Revenue
from Contracts with Customers.

 A debt instrument is classified as subsequently measured at fair value through other

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

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

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

IAS 40 Investment property distinguishes a property that is held by entities for

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

117
or on the same cost basis as for an owner-occupied property. These different
accounting treatments reflect the different uses of these assets.

If the business model continues to play a significant role in standard-setting, it could

give insight into how the entity’s business activities are managed and help users
assess the resources and liabilities of the entity. Alternatively, it can be argued that
this approach may reduce comparability as it could result in different classification,
measurement or disclosure of the same transaction. This may introduce bias in the
way the financial statements of an entity are reported, and therefore make
comparisons between entities difficult. It could encourage less neutral reporting as
preparers may present the most favourable outcome which creates a conflict with
faithful representation. This approach can make financial statements of entities with
similar business models and in the same industry, more comparable. Thus, the
difficulties with the definition of the business model and its consistent application
should not constitute a reason for excluding it because it has relevance in terms of
the financial decision-making needs of the users of the accounting information. It has
always been the case that different businesses will account for the same asset in
different ways depending on what its role is within the firm’s business model. A
change in the entity’s business model is a significant event, because it implies a
change in how assets and liabilities are used in the cash flow generation process,
that is when and how gains and losses are recognised

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

Written by a member of the Strategic Business Reporting examining team

When does debt seem to be equity?

118
The classification of debt and equity in an entity’s statement of
financial position is not always easy for preparers of financial
statements. Many financial instruments have both features with the
result that this can lead to inconsistency of reporting.

IAS® 32 clarifies the definition of financial assets, financial liabilities and equity. In
doing so, it helps to eliminate any uncertainties when accounting for these financial
instruments. The objective of IAS® 32, Presentation is to establish principles for
presenting financial instruments as liabilities or equity and for offsetting financial
assets and liabilities. The classification of a financial instrument by the issuer as
either debt or equity can have a significant impact on the entity’s gearing ratio,
reported earnings, and debt covenants. Equity classification can avoid such impact
but may be perceived negatively if it is seen as diluting existing equity interests. The
distinction between debt and equity is also relevant where an entity issues financial
instruments to raise funds to settle a business combination using cash or as part
consideration in a business combination.

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

The key feature of debt is that the issuer is obliged to deliver either cash or another
financial asset to the holder. The contractual obligation may arise from a requirement
to repay principal or interest or dividends. Such a contractual obligation may be
established explicitly or indirectly but through the terms of the agreement. For
example, a bond that requires the issuer to make interest payments and redeem the
bond for cash is classified as debt. In contrast, equity is any contract that evidences
a residual interest in the entity’s assets after deducting all of its liabilities. A financial
instrument is an equity instrument only if the instrument includes no contractual
obligation to deliver cash or another financial asset to another entity, and if the
instrument will or may be settled in the issuer's own equity instruments.

For instance, ordinary shares, where all the payments are at the discretion of the
issuer, are classified as equity of the issuer. The classification is not quite as simple
as it seems. For example, preference shares required to be converted into a fixed

119
number of ordinary shares on a fixed date, or on the occurrence of an event that is
certain to occur, should be classified as equity.

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

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

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

 is redemption at the option of the instrument holder?

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

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

The classification of the financial instrument as either a liability or as equity is based

on the principle of substance over form. Two exceptions from this principle are
certain puttable instruments meeting specific criteria and certain obligations arising
on liquidation. Some instruments have been structured with the intention of achieving
particular tax, accounting or regulatory outcomes, with the effect that their substance
can be difficult to evaluate.

The entity must make the decision as to the classification of the instrument at the

120
time that the instrument is initially recognised. The classification is not subsequently
changed based on changed circumstances. For example, this means that a
redeemable preference share, where the holder can request redemption, is
accounted for as debt even though legally it may be a share of the issuer.

In determining whether a mandatorily redeemable preference share is a financial

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

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

121
enforceable on the occurrence of some future event – such as default of a party – do
not meet the offsetting requirements.

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

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

In June 2018, the Board issued a Discussion Paper DP/2018/1 Financial

Instruments with Characteristics of Equity. This was issued to allow the Board to
investigate challenges that have been encountered when IAS 32 has been applied in
practice. Specifically, it addresses issues relating to the classification of both simple
bonds and ordinary shares and the limited disclosures that users are faced with
when such financial instruments are used. It is anticipated that the direction of this
research project will be concluded during 2020.

Written by a member of the Strategic Business Reporting examining team

All Change for accounting for leases

122
In January 2016, the International Accounting Standards Board (IASB)
released IFRS 16, Leases, which supersedes IAS 17, Leases. IFRS 16
eliminates the classification of leases as either operating leases or finance
leases, and introduces a single lessee accounting model. The new standard
requires the lessee to recognise lease assets and any related financial
obligation to make future lease payments. This applies to all leases with a term
of more than 12 months, unless the value is low. 

Leases are measured by recognising the present value of the lease payments
including any directly related costs. They are either shown as lease assets (right-of-
use assets) or included within property, plant and equipment. Further, in the income
statement, depreciation on lease assets should be shown separately from interest on
lease liabilities. In the financial statements of lessors, leases are still classified as
operating or finance leases, and are accounted for separately. The main change for
lessors is the additional disclosure of information on the risks relating to its residual
interest in leased assets.

A lease is defined as part of a contract that conveys to the customer the right to use
an asset for a period in exchange for consideration. A distinction is drawn between a
lease and a service. Under a leasing agreement, the customer obtains control of a
resource that is the right to use an asset whereas, in a service contract, the supplier
retains control. Consequently, the standard focuses on whether a customer controls
the use of an asset. 

The use of the asset is controlled when the customer has the right to substantially all
of the economic benefits and can direct the use of the asset. Just as with IAS 17,
judgment may be required to determine whether a contract contains a lease. The
identification of an asset can arise by being explicitly or implicitly specified in the
contract when the asset is made available for use.

Where an entity previously has a number of leases not recognised on the balance
sheet, there may be a significant change in the nature of expenses related to those
leases, as the operating lease expense will be replaced by the depreciation expense
for the leased asset and the interest expense on the lease liability. Over the life of
the lease, there will be a reduction in the lease expense because the interest
expense naturally reduces.

It is possible for a customer to obtain economic benefits from use of an asset in

many ways, including the sub-letting of the asset. Economic benefits include the

123
assets output, cashflows and any other benefit from a commercial transaction as a
result of using the asset. Control of the asset can be determined by examining such
things as whether the customer has the right to make the decisions about the
purpose for which the asset is used or can use the asset without the supplier having
the right to change the way that the asset is operated. 

Treatment changes

Under IAS 17, off balance sheet leases and services are treated in similar ways but
this will change under IFRS 16. Thus the decision as to whether a contract is a lease
or a service contract is critical because it determines the recognition of related
assets and liabilities. The principle is relatively simple in as much as a lease exists
when the customer controls the use of the asset and a service exists when the
supplier controls the asset’s use.

On first applying IFRS 16, entities need not reassess existing contracts to determine
whether the contract contains a lease. The entity is allowed to apply IFRS 16 to
contracts that were previously identified as leases under IAS 17 and not to apply
IFRS 16 to contracts that were not previously accounted for under IAS 17. Thus the
only initial costs that an entity should suffer are when it chooses to reassess
contracts. 

When new contracts are entered into, entities will have to determine whether they
contain a lease or whether they are service contracts. Often, contracts contain both a
right to use the asset and a service agreement. Where this is the case, entities
can separate the contract » into its component elements, often with the use of
judgment. However, IFRS 16 allows an entity to either capitalise only the amounts
paid for the lease or not separate lease and service elements but account for them
together as a lease. The latter policy choice is only likely where the contract contains
a small service element.

Simplifications

124
Certain measurement simplifications have been introduced by IFRS 16. For
example, variable lease payments are excluded from the measurement of lease
assets and liabilities, with any such costs recognised in profit or loss in the period in
which they are incurred. In addition, inflation-linked payments are measured based
upon current contractual payments, and entities are not required to forecast future
inflation. If a lease contains clauses that may require optional payments, which are
not reasonably certain, then those payments are excluded from the measurement of
lease assets and liabilities.

On first application of IFRS 16, there is no requirement to restate comparative

information and an entity can choose how to measure lease assets relating to off
balance sheet leases either as if IFRS 16 had always been applied or at an amount
based on the lease liability. Entities will have to choose between the costs of prior
application of the standard as opposed to an option that may mean a higher value for
the leased assets. Additionally, a lessee may apply a single discount rate to a
portfolio of leases with similar characteristics when applying IFRS 16 retrospectively.

The impact of IFRS 16 will vary. For entities with significant off balance sheet leases,
IFRS 16 will result in a reduction in reported equity, the degree of which is
dependent upon the significance of leasing to the entity, the time remaining on the
leases and the discount rate applied. These entities may also find that they have a
higher operating profit because operating lease payments are reported as part of
operating costs whereas the implicit interest in lease liabilities is now shown as part
of finance costs. 

There will be no change in total cashflows but, following from the above, there will be
a reduction in operating cash outflows and an increase in financing cash outflows.
The higher asset and liability base will affect ratios such as asset turnover and
gearing, whereas the higher operating profit will affect ratios such as EBITDA, which
excludes the interest element of the lease liability. However, many users of financial
information already make adjustments for the different accounting treatment of
operating and finance leases and view the current treatment as artificial. 

Entities with material off balance sheet leases may incur costs in measuring lease
assets and liabilities at the present value of future lease payments due to the need to
determine a discount rate for each recognised lease. However, when first applying
IFRS 16, entities are permitted to use the incremental borrowing rate for each
portfolio of similar leases.

125
In 2015, the European Financial Reporting Advisory Group (EFRAG) and the
national standard-setters of France, Germany, Italy, Lithuania and the UK carried out
a consultation to understand the impact of IFRS 16 on loan covenants; the IASB also
participated. The results indicated a variation in practice, with some lenders stating
that covenants were often tailored for the particular client. However, most
respondents stated that their loan agreements often included some of the
following features:

1. automatic renegotiation clauses in the case of a change in accounting

principles
2. ‘frozen GAAP’ provisions, or
3. adjustments for operating lease commitments in determining covenants.

The report stated that the requirements of IFRS 16 are not expected, in isolation, to
cause a breach in the case of covenants using the above features. However, a
majority of respondents stated that they would reconsider the terms and conditions
of covenants when IFRS 16 is effective.

The non-lender respondents were almost all preparers of financial statements and
they reported that their covenants were not expected to be impacted or would be
renegotiated if IFRS 16 affects covenant ratios. The majority of lender respondents
stated that different financial covenants are applied depending on the size of the loan
and that the characteristics of clients, including credit quality, could affect the nature
of the covenants. Some indicated that terms might not be based on accounting data
but factors such as the structure of ownership or changes in management. However,
all the lender respondents stated that they use financial covenants based on IFRS or
local GAAP figures. Often agreements that include ‘frozen GAAP’ provisions are
automatically renegotiated where accounting standards change, or are already
adjusted for operating lease commitments.

The survey indicated that IFRS 16 could affect covenants if all of the following
conditions apply:

1. the covenant is based on accounting data from the financial statements

2. the calculation of covenant ratios does not include adjustments for operating
lease commitments
3. the agreement does not include ‘frozen GAAP’ provisions.

126
Those financial institutions with significant off balance sheet leases could find that
their regulatory capital is affected. The nature of the impact will be determined by the
actions of prudential regulators. The application date of the standard is 1 January
2019. An entity can apply IFRS 16 before that date but only if it also applies IFRS
15, Revenue from Contracts with Customers.

Graham Holt is a director of professional studies at the accounting, finance

and economics department at Manchester Metropolitan Business School

IFRS 2, Share-based payment

127
International Financial Reporting Standard (IFRS®) 2, Share-
based Payment, applies when a company acquires or
receives goods and services for equity-based payment.
 Recognition of share-based payment
 Equity settled transactions
 Performance conditions
 Cash settled transactions
 Deferred tax implications
 Disclosure

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

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

Recognition of share-based payment

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

company. The corresponding entry in the accounting records will either be a liability
or an increase in the equity of the company, depending on whether the transaction is
to be settled in cash or in equity shares. Goods or services acquired in a share-
based payment transaction should be recognised when they are received. In the
case of goods, this is obviously the date when this occurs. However, it is often more
difficult to determine when services are received. If shares are issued that vest
immediately, then it can be assumed that these are in consideration of past services.
As a result, the expense should be recognised immediately.

128
Alternatively, if the share options vest in the future, then it is assumed that the equity
instruments relate to future services and recognition is therefore spread over that
period.

Back to top 

Equity settled transactions

Equity-settled transactions with employees and directors would normally be

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

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

The fair value of the options will be calculated at the date the options are granted.

This fair value will be charged to profit or loss equally over the vesting period, with
adjustments made at each accounting date to reflect the best estimate of the number
of options that will eventually vest.

Shareholders’ equity will be increased by an amount equal to the charge in profit or

loss. The charge in the income statement reflects the number of options vested. If
employees decide not to exercise their options, because the share price is lower
than the exercise price, then no adjustment is made to profit or loss. On early
settlement of an award without replacement, a company should charge the balance
that would have been charged over the remaining period.

EXAMPLE 1
A company issued share options on 1 June 20X6 to pay for the purchase of

129
inventory. The inventory is eventually sold on 31 December 20X8. The value of the
inventory on 1 June 20X6 was $6m and this value was unchanged up to the date of
sale. The sale proceeds were $8m. The shares issued have a market value of
$6.3m.

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

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

Back to top 

Performance conditions

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

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

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

130
How will the share options be treated in the financial statements for the year ended
31 December 20X6?

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

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

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

Back to top 

Cash settled transactions

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

As an example, share appreciation rights entitle employees to cash payments equal

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

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

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

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

131
 Back to top 

Deferred tax implications

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

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

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

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

Answer
A deferred tax asset would be recognised of:

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

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

Back to top 

Disclosure

132
IFRS 2 requires extensive disclosures under three main headings:

 Information that enables users of financial statements to understand the

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

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

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

Written by a member of the Strategic Business Reporting examining team 

Get to grips with IFRS 2

133
IFRS 2, Share-based Payment, is currently sitting on the list of research
projects drawn up by the International Accounting Standards Board (IASB),
and is one of the more complex of the IFRS Standards.

Part of this complexity arises from the use of the grant-date fair value measurement
model. This is used in arrangements that are settled in shares or in share options
(equity-settled schemes). To understand the potential issues this causes, we need to
take a step back and review the different elements within IFRS 2.

Share-based payments fall into two categories: transactions with third parties, and
transactions with employees.

For transactions with third parties, such as suppliers, the share-based payment is
recorded at the fair value of the service performed, which is then spread over the
period until the options vest. One well-known example of this transaction related to
David Choe, the graffiti artist who decorated the offices of Facebook in 2005. In
payment for the work, Choe accepted share options, taking the chance that these
might be worth more than the US$60,000 he would normally have charged.

At the date of Facebook’s initial public offering years later, the shares were valued in
the region of US$200m. However, Facebook would have simply expensed the
US$60,000, spread from the period the work was done until the date the options
vested. As this case shows, the amount to be expensed by an entity represents the
value of the service received rather than the value of the options given to the third
party. 

A similar principle applies to share-based payment transactions with employees.

These are calculated by looking at the value of the service given by the employee.
Under IFRS 2, this is valued using the fair value of the option granted to the
employee.

Potential issues arise because two different types of transaction can be used to
remunerate employees:

 equity-settled schemes, where the employee receives the benefit in the form
of equity, such as shares or share options
 cash-settled schemes, where the employee receives cash linked to the share
price of the entity at a certain period.

134
According to IFRS 2, all share-based payments should be recognised in financial
statements using fair value over the period in which the entity received the service.
However, the two types of transaction use different fair value measures (see box).

Criticisms of 'grant date'

There have been numerous criticisms of the use of the grant-date fair value, such as:

 It produces less relevant information, as it is not updated to reflect the

changes in the option value. It does not reflect the value that will be given to
the employee at the vesting of the scheme.
 Issues arise when dealing with ‘underwater’ share options. If the exercise
price of an option exceeds the fair value, this will give these options a
negative intrinsic value and they are unlikely to be exercised. The fair value is
still expensed over the period based on the original fair value at the grant
date, despite these items having no value at the reporting date.
 It is inconsistent with the treatment of cash-settled schemes and other
employee-based accounting, such as IAS 19, Employee Benefits, which
update the service costs annually while also remeasuring liability at each
reporting date (see box).

The IASB addressed these issues when deciding on the model to be applied at the
introduction of IFRS 2. Some of the key reasons for applying the grant-date fair value
model are given below:

It reflects the value of the service, rather than the option – the fair value of the
services received is not affected by subsequent changes in the fair value of the
equity instrument received in exchange. A change in the value of an option in year
two is unrelated to the value of the service provided by the employee in year one. 

 Equity being transferred is conceptually different from the payment of cash.

The IASB decided to use the principles that apply to equity transactions under
the Conceptual Framework for Financial Reporting – this means that equity is
not remeasured but remains at the fair value initially applied to it.
 Using the grant-date fair value model introduces less volatility into the
financial statements than using a reporting-date fair value model, as the fair
value is fixed and therefore produces a more predictable annual expense.

135
Alternative models

If the grant-date fair value model were to be removed, current accounting practices
applied in IFRS 2 and IAS 19 provide us with two alternatives, which are already in
existence.

One alternative could be to apply the reporting-date fair value model, as used in
cash-settled schemes. The use of a reporting-date fair value model would appear to
reduce the inconsistency between the two valuations, making the numbers more
comparable. While the IASB has chosen to apply the grant-date fair value, giving the
reasons above, this decision could be revisited in the future with a view to providing
a consistent accounting practice across IFRS 2.

Another option could be to apply the service-date measurement model, in a manner

similar to IAS 19. Under this model, the service cost would be measured at the
reporting date, but there would be no remeasurement of expenses recognised in
previous periods. The annual expense (but not the cumulative expense) would be
recorded considering the reporting-date fair value.

The table above shows how applying these alternatives to a three-year equity-settled
scheme would alter the amounts recognised if the fair value of 1,000 options were
$120 at grant date, $150 at the end of year one, $180 at the end of year two, and
$225 at the end of year three.

The IASB acknowledges the complexity of IFRS 2, while believing it is working

adequately. It has stated that it will be difficult to reduce this complexity without
looking at the use of the grant-date fair value model. 

Due to the challenging nature of the application of IFRS 2, the IASB has said it will
not make minor, narrow-scope amendments, suggesting that this will result in IFRS
either remaining in its current form, or having significant changes to the grant-date
fair value. No changes are expected any time soon, but it will be interesting to see if
this issue remains on the IASB research agenda following the completion of the
Financial Instruments with Characteristics of Equity project. 

Adam Deller is a financial reporting specialist and lecturer

136
Measuring fair value

  Equity-settled schemes Cash-settled schemes

Fair Grant-date fair value Reporting-date fair value

value
model
used

The fair value of the option
How it at the grant date is
works calculated to work out the
total expense relating to the
option.
The fair value is remeasured at the end of
each reporting period. The cumulative
expense recognised is based on the
reporting-date fair value, spread over the
vested period to date.

This is spread over the

vesting period.

Impact of different measures of fair value

Year 1 Year 2 Year 3 Cumulative

 
expense expense expense expense

40 40 40 120
Grant date 
(120 x 1/3) (120 x 1/3) (120 x 1/3)

137
 Year 1 Year 2 Year 3 Cumulative
 
expense expense expense expense

50 70 105 225

Reporting
(150 x 1/3) (180 x 2/3 – (225 x 3/3 –
date
50) 120)

Service date 50 60 75 185

(150 x 1/3) (180 x 1/3) (225 x 1/3)

138
Business Combinations – IFRS 3 (Revised)

This article provides an introduction to IFRS® 3, Business

Combinations and IFRS, 10 Consolidated Financial Statements,
including piecemeal acquisitions and disposals.
 Purchase consideration
 Goodwill and non-controlling interests (NCI)
 Fair valuing assets and liabilities
 IFRS 10, Consolidated financial statements
 Disposal of controlling interest while retaining associate holding

Purchase consideration

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

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

Contingent consideration is also recognised at fair value even if payment is not

deemed to be probable at the date of the acquisition.

EXAMPLE 1
Josey acquires 100% of the equity of Burton on 31 December 2008. There are three

139
elements to the purchase consideration: an immediate payment of $5m, and two
further payments of $1m if the return on capital employed (ROCE) exceeds 10% in
each of the subsequent financial years ending 31 December. All indicators have
suggested that this target will be met. Josey uses a discount rate of 7% in any
present value calculations.

Requirement:
Determine the value of the investment.

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

All subsequent changes in debt-contingent consideration are recognised in the

statement of profit or loss, rather than against goodwill, as they are deemed to be a
liability recognised in accordance with IFRS 9, Financial Instruments. An increase in
the liability for good performance by the subsidiary results in an expense in the
statement of profit or loss, and under-performance against targets will result in a
reduction in the expected payment and will be recorded as a gain in the statement of
profit or loss. These changes were previously recorded against goodwill.

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

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

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

140
The standard clarifies accounting for employee share-based payments by providing
additional guidance on valuation, as well as on how to decide whether share awards
are part of the consideration for the business combination or are compensation for
future services.

Back to top 

Goodwill and non-controlling interests (NCI)

Goodwill is 'an asset representing the future economic benefits arising from other
assets acquired in a business combination that are not individually identified and
separately recognised' (IFRS 3 Appendix A). In simple terms, goodwill is measured
as the difference between:

 the consideration paid plus any NCI, and

 the acquisition–date fair value of identifiable net assets acquired

Thus, the measurement of NCI impacts on the calculation of goodwill. IFRS 3 gives
entities the option, on an individual transaction basis, to measure NCIs at the fair
value of their proportion of identifiable assets and liabilities (partial method), or at full
fair value (full method).

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

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

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

141
Partial goodwill $m

Purchase consideration 2,145

Fair value of identifiable net (2,170)

assets

NCI (30% x 2,170) 651

Goodwill 626

Full goodwill $m

Purchase consideration 2,145

NCI 683

142
 Partial goodwill $m

  2,828

Fair value of identifiable net (2,170)

assets

Goodwill 658

It can be seen that goodwill is effectively adjusted for the change in the value of the
NCI, which represents the goodwill attributable to the NCI of $32m ($658m –
$626m). Choosing this method of accounting for NCI only makes a difference in an
acquisition where less than 100% of the acquired business is purchased. The full
goodwill method will increase reported net assets on the statement of financial
position, which means that any future impairment of goodwill will be greater.
Although measuring NCI at fair value may prove difficult, goodwill impairment testing
is likely to be easier under full goodwill, as there is no need to gross-up goodwill for
partially owned subsidiaries.

Fair valuing assets and liabilities

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

143
previously. Acquirers are required to recognise brands, licences and customer
relationships, and other intangible assets.

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

The ability of an acquirer to recognise a liability for terminating or reducing the

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

An acquirer has a maximum period of 12 months from the date of acquisition to

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

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

Back to top 

IFRS 10, Consolidated financial statements

The objective of IFRS 10 is to establish principles for the presentation and

preparation of consolidated financial statements. These are the financial statements
of a group where the parent and its subsidiaries are presented as those of a single
economic entity. The economic entity approach treats all providers of equity capital
as shareholders of the entity, even when they are not shareholders in the parent
company.

144
For example, disposal of a partial interest in a subsidiary in which the parent
company retains control, does not result in a gain or loss but in an increase or
decrease in equity under the economic entity approach. Purchase of some or all of
the NCI is treated as a treasury transaction and accounted for in equity. A partial
disposal of an interest in a subsidiary in which the parent company loses control but
retains an interest as an associate, creates the recognition of gain or loss on the
entire interest. A gain or loss is recognised on the part that has been disposed of,
and a further holding gain is recognised on the interest retained, being the difference
between the fair value of the interest and the carrying amount of the interest. The
gains are recognised in the statement of comprehensive income. Amendments to
IAS 28, Investments in Associates, extend this treatment to associates and joint
ventures.

EXAMPLE 3

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

  $m $m

1 January 2008 consideration 60  

Fair value of interest held  24  

    84

145
   $m $m

NCI   40

    124

Fair value of identifiable net   (110)

assets 

Goodwill   14

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

EXAMPLE 4

Acquisition of part of an NCI

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

146
December 2008 for a cash consideration of $85m. The carrying amount of the net
assets of Pin was $535m at 31 December 2008.

  $m $m

Fair value of consideration for 70% interest 36  

0

Fair value of NCI 21  

0

    570

Fair value of identifiable net assets    (480)

Goodwill   90

Acquisition of further interest

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

147
  $m

Pin NCI, 1 January 2008 210

Share of increase in net assets in post-acquisition 16.5

period

Net assets, 31 December 2008 226.5

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

Balance at 31 December 2008 – NCI 151

Fair value of consideration 85

Charge to NCI (75.5)

148
   $m

Negative movement in equity 9.5

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

EXAMPLE 5

Disposal of part of holding to NCI

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

  $m  

Pin net assets at 1 January 2008 480  

Increase in net assets 55  

Net assets at 31 December 2008 535  

149
   $m  

Fair value of consideration 65  

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

goodwill)) )

Positive movement in equity 2.5  

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

Disposal of controlling interest while retaining

associate holding

IFRS 10 sets out the adjustments to be made when a parent loses control of a
subsidiary:

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

150
  Recognise the fair value of any residual interest.

EXAMPLE 6

Disposal of controlling interest

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

  $m  

Fair value of consideration 65  

NCI 6.9  
(6+(10%x(83-74)))

Fair value of residual interest to be recognised as an 25  

associate

Gain reported in comprehensive income 3  

151
   $m  

  99.9  

Less net assets and goodwill derecognised:     

net assets (83)  

goodwill (80 + 6 – 74) (12)  

Gain on disposal to profit or loss 4.9  

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

Issues associated with both IFRS 3 and IFRS 10 will be tested regularly in SBR and
candidates should be comfortable with the numerical examples provided above.
Candidates should also be able to provide an explanation of the principles that
support these calculations.

152
Written by a member of the Strategic Business Reporting examining team

The challenge of implementing IFRS 5

Over the last few years, the Interpretations Committee of the International
Accounting Standards Board (IASB) has been considering certain issues
relating to IFRS 5, Non-current Assets Held for Sale and Discontinued
Operations. This article discusses some of those issues.

IFRS 5 requires an entity to classify non-current assets as held for sale when the
assets' carrying amount will be recovered principally through a sale transaction
rather than through continuing use. The standard further sets out more detailed
conditions that an entity has to meet within the context of a typical sale transaction. 

These conditions include: a commitment to a plan to sell the asset; the asset being
available for immediate sale; and the sale being highly probable within a 12-month
time period. When an assets is classified as held for sale, the entity has to measure
the asset at the lower of its carrying amount and fair value less costs to sell. At first
sight these conditions and accounting practices seem straightforward but several
issues have arisen since the standard was introduced.

One issue relates to whether loss of control other than through outright sale can
result in a held-for-sale classification. For example, an entity could lose control
through dilution of the shares held by the entity or due to call options held by a non-
controlling shareholder.

The question therefore is whether ‘loss of control' is a factor that brings the event
within the scope of IFRS 5, or whether there also needs to be a disposal. The loss of
control is a significant economic event that meets the IFRS 5 requirements, and
triggers the held-for-sale classification, provided the other relevant criteria are met.
This is regardless of whether the entity will retain a non-controlling interest in its
former subsidiary after the sale. This means that the recovery of the carrying amount
of non-current assets or disposal group has changed to a method other than
continuing use. 

153
It is argued that the current objective of IFRS 5 is to capture non-current assets (or
disposal groups) over which an entity is committed to lose control, irrespective of the
form of the transaction other than abandonment. Additionally, the non-current assets
(or disposal group) must be available for immediate disposal, and it must be highly
probable that the entity will lose control. The loss of control is a significant economic
event and information about the event helps users to assess the timing, amount and
uncertainty of an entity's future cashflows.

Another issue relates to whether an impairment loss recognised for a disposal group
should be allocated to non-current assets in the group to the extent that it reduces
the carrying amount of such assets to below their fair value less costs to sell. The
Interpretations Committee has discussed this issue and noted that in determining the
order of an impairment allocation to non-current assets, IFRS 5 does not refer to IAS
36, Impairment of Assets, which states that an impairment loss for a CGU (cash-
generating  unit) should not reduce the carrying amount of an
asset below the highest of:

 its fair value less costs of disposal (if measurable)

 its value in use (if determinable)
 zero.

As a result, the Interpretations Committee has tentatively stated that IAS 36 does not
affect the allocation of an impairment loss for a disposal group. However, it is still
unsure as to whether the amount of impairment losses should be limited to: the
carrying amount of the non-current assets measured under IFRS 5; the net assets of
a disposal group; the total assets of a disposal group; or the non-current assets with
the possible recognition of any liability for the excess. 

The interpretation of the definition of ‘discontinued operation' has come under

scrutiny, particularly with regard to the concept in IFRS 5 of ‘separate major line of
business or geographical area of operations'. IFRS 5 says that a discontinued
operation is a component of an entity that either has been disposed of, or is
classified as held for sale and meets certain conditions, two of which are part of a
single coordinated plan, and that the discontinuance ‘represents separate major line
of business or geographical area of operations'. 

This latter concept can be interpreted differently depending on how the entity
determines its operating segments. Generally speaking, the disposal of a reportable
segment will be the type of strategic shift that qualifies as a discontinued operation.

154
The definition of discontinued operations is an area that the IASB has attempted to
revise, but the issue has not yet been resolved. 

There are different practices as regards how transactions between continuing and
discontinued operations are treated. Some entities eliminate the transactions in full
without any adjustments, while others eliminate with adjustments to reflect how
transactions between continuing or discontinued operations will be reflected in
continuing operations going forward.

Finally, some entities do not eliminate such transactions. IFRS 5 attempts to address
this issue by requiring an entity to ‘present and disclose information that enables
users of the financial statements to evaluate the financial effects of discontinued
operations and disposals of non-current assets (or disposal groups)'.

The standard itself does address how to reflect the impact of transactions between
continuing and discontinued operations, but some believe that IFRS 5 requires
adjustments to reflect the anticipated impact of the disposal to be included on the
income statement itself rather than providing additional information in the notes. 

The Interpretations Committee discussed this issue and concluded that there were
no requirements or guidance in IFRS 5 or IAS 1, Presentation of Financial
Statements, in relation to the presentation of discontinued operations that could
override the consolidation requirements in IFRS 10, Consolidated Financial
Statements. At this point, the committee agreed that an entity was required to
eliminate intra-group transactions in full prior to determining the presentation of
continuing and discontinued operations. However, subsequently the committee felt
that this and other issues were too broad for it to address, which indicated that a
broad-scope project on IFRS 5 was necessary. 

Clarification

In 2013, IFRS 5 was amended to clarify the situation where a disposal group or non-
current asset ceases to be classified as held for sale and is a subsidiary, joint
operation, joint venture, associate or a portion of an interest in a joint venture or an
associate (subsidiary et al). However, for a non-current asset (or a disposal group)
that is not a subsidiary et al, ceasing to be classified as held for sale results in the
inclusion of any measurement adjustment in profit or loss in the current period. 

155
In contrast, if a change to a sale plan involves a subsidiary et al, then IFRS 5
requires retrospective amendments. Questions have arisen as to why there is
inconsistency between the two treatments and whether retrospective amendment
applies not only to measurement but also to presentation. The Interpretations
Committee felt that the retrospective amendment should apply to both measurement
and presentation aspects of financial statements but because there was no
observable diversity in practice, it has not taken this any further. 

Another issue relates to a situation in which an impairment loss recorded for a

disposal group that is classified as held for sale subsequently reverses. IFRS 5
requires the recognition of a gain for a subsequent increase in fair value less costs to
sell of a disposal group.  However, specifically, the question focuses on whether an
impairment loss relating to goodwill can be reversed. 

Guidance on the reversal of an impairment loss for goodwill generally is set out in
IAS 36, which states that an impairment loss recognised for goodwill should not be
reversed in a subsequent period. IFRS 5 includes multiple references to IAS 36 but
omits any reference to the above requirement. By not recognising a reversal of an
impairment loss for goodwill, it essentially means that the disposal group is seen as
comprising separate assets and liabilities, which are subject to different
measurement requirements within IFRS.

No consensus

If the disposal group is seen as a single asset or liability, then the recognition and
measurement requirements should be applied to the disposal group as a whole,
rather than the individual assets and liabilities. The Interpretations Committee has
discussed this issue three times at its past meetings and could not reach a
consensus.

Another issue is whether IFRS 5 applies to a disposal group that consists mainly, or
entirely, of financial instruments. IFRS 5 states that financial assets are excluded
from its scope for measurement purposes. This issue is particularly relevant where
the disposal group is expected to be sold at a loss. In applying the requirement of
IFRS 5, it is possible that the loss is recognised only when the sale effectively occurs
and this conflicts with the measurement principles in IFRS 5, which require
measurement at fair value less costs to sell at the date of a ‘disposal group'

156
classification. The Interpretations Committee noted that this was another example of
the IFRS 5 measurement challenges.

Discontinuing a business operation or deciding to sell a major asset are important

commercial events, which are likely to have a significant effect on an entity's results
and net assets. IFRS 5 can have a significant effect on a company's profit or loss,
the carrying values of its assets and on the presentation of results.

Implementation of IFRS 5 can be a complex and time-consuming exercise with

significant judgment required especially in the areas above.

Graham Holt is director of professional studies at the accounting, finance and

economics department at Manchester Metropolitan Business School

157
Vexed Concept (Equity accounting: how does it
measure up?

Equity accounting was originally used as a consolidation technique for subsidiaries

at a time when acquisition accounting was considered inappropriate because it
showed assets and liabilities not owned by the reporting entity.

The equity method evolved as a basis of reporting the performance of subsidiaries

partly as it was seen as more appropriate than cost.

International consensus on the equity method eventually led to an amended EU

directive to require the use of equity accounting for associates of an investor. Some
European countries questioned this amendment on the basis that it did not use
acquisition accounting principles to account for subsidiaries.

What's the point?

In short, equity accounting has a long history and is currently used to account for
associates and joint ventures. However, IAS 28, Investments in Associates and Joint
Ventures, does not state what equity accounting is trying to portray. Under the equity
method, on initial recognition the investment in an associate or a joint venture is
recognised at cost, and the carrying amount increased or decreased to recognise the
investor’s share of the profit or loss of the investee after the date of acquisition.

"equity accounting... is currently used to account for associates and joint ventures"
Many of the principles applied in the equity method are similar to the consolidation
procedures described in IFRS 10, Consolidated Financial Statements. For example,
under equity accounting, profits are eliminated on intergroup transactions only to the
extent of an investor’s interest. This reflects a proprietary perspective to
consolidation, as opposed to the entity perspective of IFRS 10.

158
Although IAS 28 does not specifically state that IFRS 3, Business Combinations,
should be applied to an acquisition of an investee, it does refer to the acquisition
accounting principles in IFRS 3. For example, IAS 28 requires that goodwill relating
to an associate or a joint venture is included in the carrying amount of the
investment. Amortisation of goodwill is not permitted.

Dual approach

Equity accounting reflects a measurement approach as well as a consolidation

approach. For example, losses in excess of carrying value are not recognised in
most circumstances - after the investor or joint venturer’s interest is reduced to zero,
a liability is recognised only to the extent that the investor or joint venturer has
incurred legal or constructive obligations or made payments on behalf of the
investee.

The basis for conclusions in IAS 28 refers to the equity method as a way to measure
an investment in an associate and a joint venture. Thus, questions can be raised as
to whether equity accounting is a type of financial instruments valuation accounting
or a one-line consolidation.

"questions can be raised as to whether equity accounting is a type of financial

instruments valuation accounting or a one-line consolidation"
There are a number of differences between consolidation and equity accounting that
may give a different result, including acquisition costs and loss-making subsidiaries.
In the consolidated financial statements, acquisition costs on a business combination
are expensed in the period they are incurred, but included in the cost of investment
for equity accounting. The consolidated financial statements include full recognition
of losses of a subsidiary, but under equity accounting an entity discontinues
recognising losses once its share of the losses equals or exceeds its interest.

Recent developments have helped preparers understand the thinking behind the
equity method. In December 2012, the International Accounting Standards Board
(IASB) published two exposure drafts for amending IAS 28 - IAS 28, Equity Method:
Share of Other Net Asset Changes, and IAS 28, Sales or Contributions of Assets
between an Investor and its Associate or Joint Venture. The first dealt with how an
investor should recognise its share of changes in net assets of an investee not
recognised in comprehensive income, while the second dealt with the inconsistency

159
between IFRS 10 and IAS 28 dealing with the sale or contribution of assets between
an investor and its investee.

There appears to be significant diversity in the way the equity method is applied in
practice mainly because of the two different concepts of measurement and
consolidation underpinning the method. The proposed amendments did not address
this issue and were seen as a short-term measure. Respondents felt it was important
for the IASB to establish a clear conceptual basis for the equity method.

Separate statements

Some jurisdictions require equity accounting to be used in the separate financial

statements of the parent company for investments in associates, joint ventures and
subsidiaries. IAS 27, Separate Financial Statements, does not currently permit this
as the option was removed for investments in separate financial statements in 2003.
The IASB has been asked to restore this option and issued an exposure draft in
December 2013 entitled Equity Method in Separate Financial Statements (Proposed
amendments to IAS 27). The draft also requires the change to be applied
retrospectively if the entity elects to use the equity method.

Retrospective application for associates and joint ventures may not be a problem as
the equity accounting used in an entity’s separate financial statements would be
consistent with its consolidated financial statements. However, there may be a
problem with investments in subsidiaries in areas such as impairment testing and
foreign exchange.

There is some doubt about the objective of separate financial statements, as they
are not required in International Financial Reporting Standards (IFRS). In general,
they are required by local regulations or other financial statement users. IAS 27
points out that the focus of such statements is on the financial performance of the
assets as investments.

IAS 27 does not mandate which entities must produce separate financial statements
for public use. It applies when an entity prepares separate financial statements that
comply with IFRS.

Currently, financial statements in which the equity method is applied are not
separate financial statements. Similarly, the financial statements of an entity that

160
does not have a subsidiary, associate or joint venturer’s interest in a joint venture are
not separate financial statements.

When an entity prepares separate financial statements, investments in subsidiaries,

associates and jointly controlled entities are accounted for at cost or in accordance
with IFRS 9, Financial Instruments.

Investments accounted for at cost and classified as held for sale are accounted for in
accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued
Operations.

If an entity elects, as permitted by IAS 28, to measure its investments in associates

or joint ventures at fair value through profit or loss in accordance with IFRS 9, it has
to account for them in the same way in its separate financial statements. At present,
therefore, companies have to elect under IFRS to measure their investments in
associates, joint ventures and subsidiaries either at cost or to treat the investment as
a financial instrument. The proposed third option will lead to diversity in practice but
perhaps more importantly, it raises the question about the nature and purpose of
equity accounting.

"raises the question about the nature and purpose of equity accounting"
Respondents to the IASB exposure drafts are generally not in favour of introducing
accounting policy options in IFRS. The proposed change to IAS 27 will align the
accounting principles across boundaries but some respondents feel that the use of
the equity method in separate financial statements is inappropriate because the
proposed amendment lacks a conceptual basis.

If the main objective of the proposals is to improve the relevance of information, then
the IASB should first clarify what the equity method purports to achieve. The basis of
the argument of respondents opposing the introduction of the equity method is that it
simply reflects information already given in the consolidated financial statements and
the introduction of additional accounting policy options reduces the comparability of
financial information. Further it is felt that the IASB should investigate current
practice in countries with experience in applying the equity method before approving
the change.

Sowing confusion

161
The proposals could be seen as creating confusion about the purpose and nature of
the separate financial statements. Apart from the single-line presentation,
consolidation rules would apply, so additional questions are raised about the
purpose and the nature of the equity method.

The IASB feels including this option in IAS 27 would not involve any additional
procedures because the information can be obtained from the consolidated financial
statements by applying IFRS 10 and IAS 28.

Under the present proposals in the exposure draft, an entity could account for its
investments in subsidiaries using the equity method, its associates under IFRS 9 and
its joint ventures at cost. The proposed amendment affects IAS 28, which makes it
imperative to consider whether any consequential amendments reflect the intention
of the amendment to IAS 27.

Graham Holt is director of professional studies at the

accounting, finance and economics department at
Manchester Metropolitan University Business School

162
IAS 21 – does it need amending?

This article examines the issues raised by IASB research that

referred to a KASB study into whether IAS 21 needs amending.
 Long-term liabilities
 Average exchange rate

The International Accounting Standards Board (IASB) initiated a research project

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

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

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

IFRS® 7, Financial Instruments: Disclosure requires disclosure of market risk, which

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

The financial/non-financial distinction determines whether an item is subject to

foreign currency risk under IFRS 7, whereas translation in IAS 21 uses
monetary/non-monetary distinction, thereby possibly causing potential conceptual
confusion. Foreign currency risk is little mentioned in IAS 21 and on applying the
definition in IFRS 7 to IAS 21, non-financial instruments could be interpreted as

163
carrying no foreign currency risk. Under IAS 21, certain monetary items include
executory contracts, which do not meet the definition of a financial instrument. These
items would be translated at the closing rate, but as such items are not financial
instruments, they could be deemed not to carry foreign currency risk under IFRS 7.

Foreign currency translation should be conceptually consistent with the conceptual

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

There is little conceptual clarification of the translation requirements in IAS 21. The
requirements of IAS 21 can be divided into two main areas: the reporting of foreign
currency transactions in the functional currency; and the translation to the
presentation currency. Exchange differences arising from monetary items are
reported in profit or loss in the period, with one exception which is that exchange
differences arising on monetary items that form part of the reporting entity’s net
investment in a foreign operation are recognised initially in other comprehensive
income, and in profit or loss on disposal of the net investment. 

However, it would be useful to re-examine whether it is more appropriate to

recognise a gain or loss on a monetary item in other comprehensive income instead
of profit or loss in the period and to define the objective of translation. Due to the
apparent lack of principles in IAS 21, difficulty could arise in determining the nature
of the information to be provided on translation.

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

There are cases where an exchange rate change is likely to be reversed, and thus it
may not be appropriate to recognise foreign exchange gains or losses of all
monetary items as realised gains or losses. Thus there is an argument that
consideration should be given as to whether foreign exchange gains or losses

164
should be recognised in profit or loss or in other comprehensive income (OCI) based
on the distinction between current items and non-current items. 

Any potential fluctuation in profit or loss account would be reduced by recognising in

OCI those foreign exchange gains or losses of non-current items with a high
possibility of reversal. Furthermore, the question would arise as to whether these
items recognised in OCI could be reclassified.

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

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

Conversely, when a gain or loss on a non-monetary item is recognised in profit or

loss, any exchange component of that gain or loss shall be recognised in profit or
loss. 

Long-term liabilities

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

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

As stated already, IAS 21 requires all foreign currency monetary amounts to be

reported using the closing rate; non-monetary items carried at historical cost are
reported using the exchange rate at the date of the transaction and non-monetary
items carried at fair value are reported at the rate that existed when the fair values
were determined. As monetary items are translated at the closing rate, although the
items are not stated at fair value, the use of the closing rate does provide some fair
value information. However, this principle is not applied to non-monetary items as,

165
unless an item is measured at fair value, the recognition of a change in the exchange
rate appears not to provide useful information.

A foreign operation is defined in IAS 21 as a subsidiary, associate, joint venture, or

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

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

Back to top 

Average exchange rate

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

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

Written by a member of the Strategic Business Reporting examining team

166
Cashflow statements
IAS 7, Statement of Cash Flows, is the standard that prescribes the presentation of a
statement of cashflow disclosing information about the historical changes in cash
and cash equivalents of an entity over the reporting period.

The cashflow statement is an integral part of an entity's financial report for each
period for which a financial report is presented. Cashflow information provides an
insight into an entity's ability to generate cash and its needs to utilise these
cashflows.

Classification

Cashflows are classified as relating to operating, investing and financing activities in

a manner that is most suited to the nature of the business.

Cashflows from operating activities are primarily derived from the main revenue
activities of the entity and generally result from the transactions and other events that
determine profit or loss. They are a key indicator of the extent to which the entity's
operations have generated sufficient cashflows to repay loans, maintain operating
capability, pay dividends and make new investments without recourse to external
sources of financing. Cashflows from investing activities are important because they
represent the extent to which expenditures are made to generate future income and
cashflows. Examples include cash payments to acquire investments and property,
plant and equipment.

Cashflows from financing activities help to predict the claims on future cashflows by
providers of capital to the entity. Examples include cash proceeds from share issues,
and cash payments to owners to acquire and/or redeem the entity's shares.

Some cashflow items may differ in classification as a result of specific industry and
entity practices, so IAS 7 permits some flexibility here. For example, cashflows from
interest and dividends received and paid can be classified as operating or investing
activities, as long as the classification is consistent. IAS 7 permits entities to show
dividends paid in operating activities as this lets users determine the entity's ability to
pay dividends out of operating cashflows.

167
Reporting methods

IAS 7 requires cashflows from operating activities to be reported using either the
direct or the indirect method. With the direct method, major classes of gross cash
receipts and gross cash payments from operating activities are disclosed.
Information about major classes of gross cash receipts and payments may be
obtained from the accounting records of the entity or by adjusting sales, cost of
sales, expenses and other items reported in the income statement, as appropriate.
Entities are encouraged to report cashflows from operating activities using the direct
method.

In the indirect method, profit or loss is adjusted to take account of the effects of
transactions of a non-cash nature, any deferrals or accruals of past or future
operating cash receipts or payments, and items of income or expense associated
with investing or financing cashflows.

A statement of cashflow is required as part of a complete set of financial statements

prepared in conformity with International Financial Reporting Standards (IFRS). IAS
7 lays down a formal structure for the statement of cashflow. The classification of
cashflows from operating, investing and financing activities is essential to the
analysis of cashflow data. Net cashflow (the change in cash and equivalents during
the period) has little informational content in itself; it is the classification and
individual components that are informative.

Although the classification of cashflows into the three main categories is important,
classification guidelines are arbitrary. Additionally, issues arise because there is no
standard definition of operating activities. The International Accounting Standards
Board (IASB) has taken the position that operating activities are not investing or
financing activities. At the same time the opinion that the association of a cashflow
with profit is the primary criterion for classifying the flow as operating is expressed.

Operating activities

Both the direct and indirect methods require cashflows to be classified according to
operating, investing and financing activities. The different presentation affects the
operating section only. The investing and financing sections do not differ between
the two presentations.
168
The direct method reports major classes of operating cash receipts and payments.
Proponents of the direct method argue that it is more revealing of a company's ability
to generate sufficient cash from operations to pay debts, reinvest in operations, and
make distributions to owners. Detractors point out that many corporate providers of
financial statements do not currently collect information that would allow them to
determine the information necessary to prepare the direct method.

The indirect method focuses on the difference between net income and net cashflow
from operations. Advocates of the indirect method say it provides a useful link
between the statement of cashflows, the income statement, and the statement of
financial position.

Research has shown that a relationship exists between the presentation of financial
information and users' decisions. Cashflow information is integral to investment and
credit decisions. With IAS 7, IASB has provided better access to cashflow
information. While earnings information is extremely important, cashflow items have
value to financial analysts as well. Investors' appreciation of the value of the
cashflow information has increased significantly and it is useful in the assessment of
investment decisions.

Direct versus indirect

There is debate over the respective virtues of the direct and indirect format.
Advocates for the direct format claim it better fulfils clients' information needs
because of the breakdown of major classes of cash inflows and outflows. In addition,
the format is simpler to understand and provides performance evaluation via the
expected and actual cashflows.

Those in favour of the indirect method say it helps users determine the reasons for
the difference between net income and associated cash receipts and payments to
provide a basis for evaluating the quality of income. However, only the direct method
reports actual sources and amounts of cash inflows and outflows which are needed
to understand the liquidity, solvency and the long-term viability of a company.

The indirect method is derived from reprocessing and reclassifying data from the
income statement and statement of financial position to filter out non-cash items and
other adjustments. It is thought that the direct method offers analysts better insights

169
into the current cash position by specifically recording operating cash inflow and
outflow items, which allows for realistic projections of future operating cashflow.
Another perceived benefit is greater transparency and the resulting market
confidence based on the cashflow position.

Users relying on the direct method to project future operating cashflow are in a better
position to balance the timing of payments and allocating upcoming earnings
because they possess specific information on the current cash position. The way in
which components of the direct method are recorded suits cashflow projections
better, whereas indirect method disclosures are derived from the mathematical
conversion of adjusted data. Thus, there are further issues about the margin of error
with the indirect method.

The vast majority of companies use the indirect method for the preparation of
statements of cashflow even though it provides the least useful information for
investment decisions. Most companies justify this on the grounds that the direct
method is too costly.

The complicated adjustments required by the indirect method are difficult to

understand and provide entities with more leeway for manipulation of cashflows. The
adjustments made to reconcile net profit before tax to cash from operations are
confusing to users. In many cases these cannot be reconciled to observed changes
in the statement of financial position. Thus users will only be able to understand the
size of the difference between net profit before tax and cash from operations.

Classification abuse

An issue for users is the abuse of the classifications of specific cashflows.

Misclassification can occur within the sections of the statement. Cash outflows that
should have been reported in the operating section may be classified as investing
cash outflows to enhance operating cashflows.

The complexity of the adjustments to net profit before tax can lead to the
manipulation of cashflow reporting. Cashflow information should help users
understand the operations of the entity, evaluate its financing activities, assess its
liquidity or solvency and interpret earnings information. A problem for users is that
entities can choose the method and there is not enough guidance on the

170
classification of cashflows in the operating, investing and financing sections of the
indirect method used in IAS 7.

Graham Holt, ACCA examiner and principal lecturer in

accounting and finance, Manchester Metropolitan University
Business School.

171
Cash equivalents or not cash
IAS 7, Statement of Cashflows, requires the reporting of movements of cash and
cash equivalents, which are classified as arising from three main activities:
operating, investing and financing. No specific format is prescribed by the standard
but cashflows must be presented under these three main headings. In practice, most
entities follow this disclosure format.

In April 2009 IAS 7 was amended so that only expenditure resulting in a recognised
asset in the statement of financial position is eligible for classification as an investing
activity. Financing cashflows include cashflows relating to obtaining, servicing and
redeeming sources of finance. Operating cashflows comprise all cashflows during
the period that do not qualify as investing or financing.

Operating cashflows may be presented using the direct method, which shows the
gross cash receipts or payments from operations. Alternatively, the entity can
calculate the cashflows indirectly by adjusting net profit or loss for non-operating and
non-cash transactions and for changes in working capital. Entities are encouraged to
report cashflows using the direct method because it is said to be more useful.
However, most entities use the indirect method. This raises the question as to which
profit or loss figure should be used.

The illustration in IAS 7 starts with profit before tax. There are alternatives that start
with operating profit, which is not defined in International Financial Reporting
Standards (IFRS) and so requires judgment, or start with the final profit or loss figure
at the foot of the income statement.

The profit before tax figure relates only to continuing operations and so needs to be
adjusted for relevant operating cashflows relating to any discontinued operation if it
is used as the starting point in the statement of cashflows. The net cashflows relating
to discontinued operations should be disclosed as well as significant non-cash
transactions such as depreciation, amortisation, and income statement charges for
provisions.

172
Classification in practice

The actual classification of cashflows must reflect the nature of the activities of the
entity and so some cashflows, which may look similar, may be classified differently
by different entities because the nature and purpose of their business is different. For
example, dividends received by an investment company are likely to be classified as
operating cashflows but a manufacturing entity is more likely to classify them as
investing cashflows.

An individual transaction may include cashflows that are classified differently. For
example, when a loan repayment includes both interest and capital, the interest
element may be classified as an operating cashflow while the capital element is
classified as a financing cashflow.

The resulting cashflow total is the movement in the balance of cash and cash
equivalents from the start of the period to the end.
Cash equivalents are defined as ‘short-term, highly liquid investments that are
readily convertible to known amounts of cash and which are subject to an
insignificant risk of changes in value’. IAS 7 does not define ‘short-term’ but does
state that ‘an investment normally qualifies as a cash equivalent only when it has a
short maturity of, say, three months or less from the date of acquisition’.

The three-month time limit is a little arbitrary but consistent with the concept of
insignificant risk of changes in value and the purpose of meeting short-term cash
commitments. Any investment or term deposit with an initial maturity of more than
three months does not become a cash equivalent when the remaining maturity
period reduces to under three months. However, in limited circumstances, a longer-
term deposit with an early withdrawal penalty may be treated as a cash equivalent.
With an investment in a money market fund, it is not sufficient that the investment
can readily be realised in cash as the investment must be readily convertible to cash
that is subject to an insignificant risk of change.

Bank overdrafts are generally classified as borrowings but IAS 7 notes that if a bank
overdraft is repayable on demand and forms an integral part of an entity’s cash
management then it is a component of cash and cash equivalents. Restricted cash
balances should be disclosed in a note, including a narrative explanation of any
restriction.

173
Tax cashflows

It is often impracticable to identify tax cashflows with individual transactions and tax
cashflows often arise in a different period from the cashflows of the underlying
transactions. As a result, taxes paid should generally be classified as operating
cashflows. However, where specific cashflows can be identified with either investing
activities or financing activities, then it is appropriate to classify that element of the
tax cashflows as investing or financing respectively.

The cashflows arising from dividends, and interest receipts and payments, should be
classified in the cashflow statement in a consistent manner from period to period and
under the activity appropriate to their nature. These items must be disclosed
separately on the face of the cashflow statement. IAS 7 does not dictate how
dividends and interest cashflows should be classified but allows an entity to
determine the classification appropriate to its business.
In May 2012, the International Accounting Standards Board (IASB) issued an
exposure draft proposing that payments relating to interest capitalised under IAS 23
should be classified in accordance with the classification of the underlying asset on
which those payments were capitalised. This would mean, for example, that
payments of interest capitalised as part of the cost of property, plant and equipment
would be classified as investing activities, and payments of interest capitalised as
part of the cost of inventories would be classified as operating activities.

Generally cashflows should be shown gross. There are exceptions such as when
cash receipts and payments are made on behalf of a customer and therefore
represent the customer’s transactions rather than those of the reporting entity.
Additionally, the calculation of operating cashflows using the indirect method also
results in some netting of cashflows.

In consolidated financial statements, cashflows arising from changes in the

ownership of a subsidiary that does not result in a loss of control are classified as
cashflows from financing activities. Also, consideration paid in a business
combination is treated as an investing activity. However, in more complex scenarios
the guidance in IAS 7 is not always clear.

174
In the case of deferred consideration, the acquiring entity will record the fair value of
the deferred consideration as a liability at the acquisition date in accordance with
IFRS 3, Business Combinations. This liability will increase as the discount unwinds
and is reflected as a finance charge in profit or loss. When the liability is settled at a
later date, the payment will reflect both the amount initially recognised as
consideration plus the interest element.

IAS 7 does not deal directly with how this payment should be classified and so it can
be classified as an investing cashflow or as a financing cashflow. Alternatively it can
be disaggregated into the amount initially recognised as consideration (investing or
financing) and the interest element resulting from the unwinding of the discount,
which should be treated as a financing or operating cashflow according to the entity’s
policy.

When a subsidiary joins or leaves the group, its cashflows should be included in the
consolidated statement of cashflows for the same period as the results are reported
in the consolidated statement of profit or loss and other comprehensive income. The
aggregate cashflow includes any cash consideration paid or received and the
amount of cash and cash equivalents in the subsidiary over which control is gained
or lost. The net of these latter amounts is included in investing activities. The net
assets excluding cash and cash equivalents of the subsidiary at the acquisition or
disposal date need to be eliminated from other cashflow headings to avoid double
counting as the related amounts are already included.

FX movements

Foreign currency movements on cash and cash equivalents should be reported

separately in the cashflow statement to allow the reconciliation of the opening and
closing balances of cash and cash equivalents. Cashflows that result from derivative
transactions undertaken to hedge another transaction should be classified under the
same activity as cashflows from the subject of the hedge.
When the reporting entity holds foreign currency cash and cash equivalents, these
are monetary items that will be retranslated at the reporting date in accordance with
IAS 21. Any exchange differences arising on this retranslation will have increased or
decreased these cash and cash equivalent balances.

As these exchange differences do not give rise to any cashflows, they should not be
reported as any part of the cashflow activities presented in the statement of
175
cashflows. Their net impact should be disclosed as a reconciling item between
opening and closing balances of cash and cash equivalents.

A weakness of statements of cashflow is that they do not distinguish between

discretionary and mandatory cashflow. By disclosing the mandatory cashflow, users
can see the available free cashflow. Additionally, the nature of the definition of cash
equivalents can make comparison of the cashflows difficult. Further comparison of
cashflows can be made even more difficult by the fact that entities can show
cashflows using the direct method or indirect method. The results of these two
methods give different operating cashflow reports.

Graham Holt is an examiner for ACCA, and associate dean

and head of the accounting, finance and economics
department at Manchester Metropolitan University Business
School

176
Reconciliation?
IAS 7, Statement of Cashflows, was first published in 1992 and has barely
changed since that date. It allows users of financial statements to assess how
different types of activity affect a company’s financial position by classifying
cashflows as operating, investing and financing activities. 

By requiring companies to consider transactions this way, the cashflow statement is

thought to support various methods of analysing the present value of future
cashflows and of making company comparisons. However, there are issues with the
current standard. For example, cashflows from the same transaction may be
classified differently. A loan repayment would see the interest classified as operating
or financing activities, whereas the principal will be classified as a financing activity.

The operating activities in the cashflow statement can be presented in one of two
ways: the direct method or the indirect method. The direct method is seldom used,
as it displays major classes of gross cash receipts and payments.

Companies’ systems often do not collect this type of data in an easily accessible
form. Basically, the direct method of accounting tracks cash changes from the
bottom up to arrive at net income, rather than starting with net income and making
adjustments. 

The indirect method is more commonly used to present operating activities. Under
this method, a statement reconciling profit or loss with operating cashflows is shown,
instead of a statement of cash inflows and outflows. This reconciliation allows users
to determine the effect of accruals of profit or loss items and to obtain an indication
of ‘earnings quality’. 

For example, if an entity’s net income is higher than its operating cashflow, a user
would seek further explanations as to the reasons for this occurrence. A reason
could be an accounting policy choice, for example. The presentation of operating
profit under the indirect method of the cashflow statement can start with either profit
or loss before
or after tax. A user’s ability to make comparisons may be affected if different starting
points are presented in the reconciliation by entities.

Free cashflow is used by analysts in various valuation models and is thought to be a

better measure than using the figure for operating cashflow. Free cashflow is often

177
taken as the excess of a company’s operating cashflows over its capital expenditure,
which essentially reflects the cashflows available to owners. Entities have been
encouraged to disclose cashflows that increase operating capacity and the
cashflows required to maintain it. This information can be used as an indicator of the
financial strength of an entity.

Classification concerns

There are concerns over the current classification of items in the statement of
cashflows. For example, dividends and interest paid can be classified as either
operating or financing activities. As a result, users have to make appropriate
adjustments when comparing different entities, particularly when calculating free
cashflow for valuation purposes. Additionally, when a user is assessing an entity’s
ability to service debt, interest paid would be reclassified from operating activities to
financing activities. 

Research and development expenditure is classified as cash from operating

activities, but is often considered to be a long-term investment. Some argue that
such cash outflows should be included within investing activities, because they relate
to items that are intended to generate future income and cashflows. IAS 7 takes the
view that to be classified as an investing cash outflow, the expenditure must result in
an asset being recognised in the statement of financial position.

Some items of property, plant and equipment are purchased from suppliers on
similar credit terms to those for inventory and for amounts payable to other creditors.
As a result, transactions for property, plant and equipment may be incorrectly
included within changes in accounts payable for operating items. 

Consequently, unless payments for property, plant and equipment are separated
from other payments relating to operating activities, they can be allocated incorrectly
to operating activities.

There are currently different views as to how to show lessee cashflows in the
statement of cashflows. Some users would like the statement of cashflows to reflect
lessee cash outflows in a way that is comparable to those of a financed purchase
where the entity buys an asset and separately finances the purchase. Other users
take the view that lease cash payments are similar in nature to capital expenditure
and should be classified within investing activities in the statement of cashflows.

178
Some users would like all lease cash outflows to be included within the free cashflow
measure, which would require lease cashflows to be classified within either operating
or investing activities. 

Finally, there is concern about the current lack of comparability under International
Financial Reporting Standards (IFRS) because of the choice of treatment currently
allowed. A lessee can classify interest payments within operating activities or within
financing activities.

Many issuers recognise that current cashflow disclosures are inadequate, as they
give an incomplete picture. Investors and analysts need a better understanding of
the economics of their business and so voluntarily supplement the cashflow
information required by IAS 7. In addition, some issuers provide a reconciliation of
net debt from the end of one accounting period to the end of the subsequent period.
The net debt reconciliation discloses information such as acquired debt and the
inception of finance leases, as well as any fair value adjustments made to debt and
the impact of foreign exchange movements.

Partly as a result of the above practices, the International Accounting Standards

Board (IASB) published an exposure draft (ED) in December 2014 that proposes
amendments to IAS 7. The main objective of the ED is to improve information about
changes in an entity’s liabilities that relate to financing activities and the availability of
cash and cash equivalents, including any restrictions on their use. 

This latter situation could arise from existing economic restrictions where, for
example, the cash and debt are in different jurisdictions and using the cash to settle
debt would trigger a tax payment, or from legal restrictions on the ability of the entity
to freely use the cash. 

IAS 7 already requires the disclosure of significant cash and cash equivalent
balances that are not available for use. However, this requirement does not address
the situation where cash and cash equivalents are available but, because of
restrictions, the entity would find it more economical to use other sources of finance. 

The ED results from the IASB’s Disclosure Initiative, which comprises smaller
projects to improve presentation and disclosure requirements in existing IFRSs. As
part of the initiative, the IASB has already issued proposed amendments to IAS
1, Presentation of Financial Statements. The initiative also complements the current
review of the Conceptual Framework. The proposed amendments require an entity

179
to provide a reconciliation of the opening and closing amounts in the statement of
financial position for each liability for which cashflows are classified as financing
activities.

The ED would not prohibit disclosures on a net basis – that is, liabilities relating to
finance activities less cash and cash equivalents. The reason behind this view is that
some entities manage debt on a net basis and there was no intention on the part of
the IASB to limit management’s ability to explain its financial and risk management
strategies. IFRS 12, Disclosure of Interests in Other Entities, already requires
disclosure of significant restrictions on the access and use of assets and settlement
of liabilities. However, the IASB felt that current disclosure does not address
economic restrictions.

For a number of years, users have been requesting the IASB to require companies
to provide a net debt reconciliation. Although the proposed amendment to IAS 7
does not include net debt reconciliation, it will help users by providing them with
sufficient information to prepare net debt reconciliation themselves. The problem
facing the IASB is that there is no definition of net debt in IFRS. The proposed
changes will require companies to reconcile the movement in debt from one period
to another and, together with the existing information from the statement of
cashflows, this will facilitate a net debt reconciliation.

Because many entities already voluntarily provide a net debt reconciliation, the
proposed changes should theoretically not impose any additional burden on issuers.
The proposals also require issuers to provide information to help users better
understand any liquidity issues. The understanding of limitations on the use of liquid
resource is important, and some users would like additional disclosures to better
understand the different types of debt financing by the entity. The changes should
help users in making investment decisions.

Where’s the need?

However, there is currently no general agreement about the need for the ED.
Although a reconciliation of ‘debt’ or ‘net debt’ is a common feature of reporting,
some feel it is not appropriate to make such disclosure compulsory prior to
establishing a conceptual basis for requiring reconciliations in general. Also, there
has been comment that the practicality of implementing such a requirement has not
been sufficiently analysed to merit an amendment to IAS 7. 
180
Finally, it is thought by some that additional disclosure requirements of this type
should not be added in advance of the IASB’s conclusions on relevant elements of
its Principles of Disclosure project.

Graham Holt is director of professional studies at the accounting, finance and

economics department at Manchester Metropolitan University Business
School

181
Additional performance measures

For many years, regulators and standard-setters have debated how

entities should best present financial performance and not mislead
the user.
 Introduction
 Common practice
 Evaluating the aims

Introduction

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

Although financial statements are prepared in accordance with applicable financial

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

Back to top 

Common practice

It is common practice for entities to present APMs, such as normalised profit,

earnings before interest and tax (EBIT) and earnings before interest, tax,
depreciation and amortisation (EBITDA). These alternative profit figures can appear
in various communications, including company media releases and analyst briefings.
Alternative profit calculations normally exclude particular income and expense items

182
from the profit figure reported in the financial statements. Also, there could be the
exclusion of income or expenses that are considered irrelevant from the viewpoint of
the impact on this year’s performance or when considering the expected impact on
future performance. 

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

These APMs can help enhance users’ understanding of the company’s results and
can be important in assisting users in making investment decisions, as they allow
them to gain a better understanding of an entity’s financial statements and evaluate
the entity through the eyes of the management. They can also be an important
instrument for easier comparison of entities in the same sector, market or economic
area. 

However, they can be misleading due to bias in calculation, inconsistency in the

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

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

APMs include: 

 all measures of financial performance not specifically defined by the applicable

financial reporting framework
 all measures designed to illustrate the physical performance of the activity of an
issuer’s business
 all measures disclosed to fulfil other disclosure requirements included in public
documents containing regulated information. 

An example demonstrating the use of APMs is the financial statements of Telecom

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

183
EBITDA. Used by Telecom Italia as the financial target in its internal presentations
(business plans) and in its external presentations (to analysts and investors). The
entity regarded EBITDA as a useful unit of measurement for evaluating the operating
performance of the group and the parent.

Organic change in revenues, EBITDA and EBIT. These measures express

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

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

Adjusted net financial debt. A new measure introduced by Telecom Italia to

exclude effects that are purely accounting in nature resulting from the fair value
measurement of derivatives and related financial assets and liabilities.

Back to top 

Evaluating the aims

The International Accounting Standards Board (IASB) is undertaking an initiative to

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

In the UK, the Financial Reporting Council supports the inclusion of APMs when
users are provided with additional useful, relevant information. In contrast, the

184
Australian Financial Reporting Council feels that such measures are outside the
scope of the financial statements. In 2012, the Financial Markets Authority (FMA) in
the UK issued a guidance note on disclosing APMs and other types of non-GAAP
financial information, such as underlying profits, EBIT and EBITDA. 

APMs appear to be used by some issuers to present a confusing or optimistic picture

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

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

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

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

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

185
ESMA believes that the costs will not be significant because APMs should generally
not change over periods. Therefore, ongoing costs will relate almost exclusively to
updating information for every reporting period. ESMA believes that the application
of these guidelines will improve the understandability, relevance and comparability of
APMs.

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

Written by a member of the Strategic Business Reporting examining team

186
The Sustainable Development Goals

The Sustainable Development Goals (SDGs) are 17 goals tackling

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

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

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

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

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

 the increased future government focus on sustainable business

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

Investors realise that the SDGs will not all be equally relevant to all companies, with
boilerplate disclosures having little relevance at all. Good disclosure will qualitatively

187
show how the company’s SDG related activities affect the primary value drivers of
the business. It would be natural to assume that SDG reporting should be based
around the disclosure of information to mitigate business risk and the drive for
improved predictability of investment decisions. However, if there is to be fair
presentation, then there should also be disclosure of any negative and positive
impacts on society and the environment.

Investors’ expectations will still be focused on companies realising their core

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

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

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

Investors seek SDG information produced in line with widely-accepted

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

Companies should disclose to investors how they have decided on their SDG
strategy, philosophy and approach. The approach should be capable of measurable

188
impacts and have a clear description of the material issues and a narrative that links
the sustainability issues back to the business model and future outlook of the entity.

For investors, it is important that SDG-related reporting is presented in the context of

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

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

However, if an investor wants to have a positive impact on working conditions for

example, they cannot assume that any investment in this area is relevant. The
investor would need to be provided with additional information such as data on the
lowest income workers, any potential income increase and how confident the
company is that an increase in income will occur.

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

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

189
opportunities in those companies that address the risks to people and the
environment and those companies that develop new beneficial products, services
and investments that may mitigate the business risks related to the SDGs.

Written by a member of the Strategic Business Reporting examining team

190
Changing face of additional performance
measure in UK
There are some significant changes to previous ASB proposals in the standards
body’s latest plans to reshape financial reporting in the UK and Ireland, says Graham
Holt

For many years, regulators and standard-setters have grappled with the issue of how
entities should best present financial performance and not mislead the user. Many
jurisdictions have enforced a standard format for performance reporting, with no
additional analysis permitted on the face of the income statement. Others have
allowed entities to adopt various methods of conveying the nature of ‘underlying’ or
‘sustainable’ earnings.

Although financial statements are prepared in accordance with applicable financial

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

Common practice

It is common practice for entities to present APMs, such as:

 normalised profit
 earnings before interest and tax (EBIT)
 earnings before interest, tax, depreciation and amortisation (EBITDA).   

These alternative profit figures can appear in various communications, including

company media releases and analyst briefings. Alternative profit calculations
normally exclude particular income and expense items from the profit figure reported
in the financial statements. Also, there could be the exclusion of income or expenses
that are considered irrelevant from the viewpoint of the impact on this year’s
performance or when considering the expected impact on future performance.

191
An example of the latter has been gains or losses from changes in the fair value of
financial instruments. The exclusion of interest and tax helps to distinguish between
the results of the entity’s operations and the impact of financing and taxation.

These APMs can help enhance users’ understanding of the company’s results and
can be important in assisting users in making investment decisions, as they allow
them to gain a better understanding of an entity’s financial statements and evaluate
the entity through the eyes of the management. They can also be an important
instrument for easier comparison of entities in the same sector, market or economic
area.

"These APMs can help enhance users’ understanding [but] can

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

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

APMs include:

 all measures of financial performance not specifically defined by the

applicable financial reporting framework
 all measures designed to illustrate the physical performance of the activity of
an issuer’s business
 all measures disclosed to fulfil other disclosure requirements included in
public documents containing regulated information.

Case study

An example demonstrating the use of APMs is the financial statements of Telecom

Italia Group for the year ended 31 December 2011. These contained a variety of
APMs as well as the conventional financial performance measures laid down by

192
International Financial Reporting Standards. The non-IFRS APMs used in the
Telecom Italia statements were:

EBITDA. Used by Telecom Italia as the financial target in its internal presentations

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

Organic change in revenues, EBITDA and EBIT. These measures express

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

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

Adjusted net financial debt. A new measure introduced by Telecom Italia to

exclude effects that are purely accounting in nature resulting from the fair value
measurement of derivatives and related financial assets and liabilities.

Evaluating APMs

The International Accounting Standards Board (IASB) is undertaking an initiative to

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

193
In the UK, the Financial Reporting Council supports the inclusion of APMs when
users are provided with additional useful, relevant information. In contrast, the
Australian Financial Reporting Council feels that such measures are outside the
scope of the financial statements. In 2012, the Financial Markets Authority (FMA) in
the UK issued a guidance note on disclosing APMs and other types of non-GAAP
financial information, such as underlying profits, EBIT and EBITDA.

"APMs appear to be used by some issuers to present a confusing or

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

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

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

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

However, these guidelines may not be practicable when the cost of providing this
information outweighs the benefit obtained or the information provided may not be
useful to users. Issuers will most likely incur both implementation costs and ongoing
194
costs. Most of the information required by the guidelines is already collected for
internal management purposes, but may not be in the format needed to satisfy the
disclosure principles.

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

Application of the guidelines will enable users to understand the adjustments made
by management to figures presented in the financial statements. ESMA believes that
this information will help users to make better-grounded projections and estimates of
future cashflows and assist in equity analysis and valuations.

The information provided by issuers in complying with these guidelines will increase
the level of disclosures, but should lead issuers to provide more qualitative
information. The national competent authorities will have to implement these
guidelines as part of their supervisory activities and provide a framework against
which they can require issuers to provide information about APMs.

Graham Holt is director of professional studies at the

accounting, finance and economics department
at Manchester Metropolitan University Business School

195
IFRS for SMEs

The principal aim when developing accounting standards for small

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

In July 2009, the International Accounting Standards Board (the Board) issued the
IFRS for SMEs Standard (the SMEs Standard) and amended in 2015. This standard
provides an alternative framework that can be applied by eligible entities in place of
the full set of International Financial Reporting Standards (IFRS ® standards).

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

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

 earnings per share

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

In addition, there are certain accounting treatments that are not allowable under the
SMEs Standard. An example of these disallowable treatments is the capitalisation of
borrowing and development costs – under IFRS for SME’s they would be expensed
to profit or loss. Generally, there are simpler methods of accounting available to
SMEs than those accounting practices required by full IFRS Standards.

Additionally the SMEs Standard requires that all basic financial instruments are
measured at amortised cost using the effective interest method except for
investments in non-convertible and non-puttable ordinary and preference shares that
are publicly traded or whose fair value can otherwise be measured reliably are

196
measured at fair value through profit or loss. All amortised cost instruments must be
tested for impairment. At the same time the standard simplifies the derecognition and
disclosure requirements. The SME Standard separates basic and other financial
instruments eg hedging instruments, swaps, options. However, the SME Standard
still offers significant simplifications even for more complex financial instruments.
SMEs can choose to apply the recognition and measurement requirements of IAS 39
if they so wish.

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

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

There is no universally agreed definition of an SME. No single definition can capture

all the dimensions of  small and medium-sized business, or cannot be expected to
reflect the differences between firms, sectors, or countries at different levels of
development.

Most definitions based on size use measures such as number of employees, net
assets total, or annual revenues. However, none of these measures apply well
across national borders. The SMEs Standard is intended for use by entities that have
no public accountability (ie its debt or equity instruments are not publicly traded or
holds assets in a fiduciary capacity eg most banks and financial institutions).

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

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

197
needs or to the needs of their users. It is often thought that small business managers
perceive the cost of compliance with accounting standards to be greater than their
benefit.

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

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

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

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

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

198
The SMEs Standard and full IFRS Standards are separate and distinct frameworks.
Entities that are eligible to apply the SMEs Standard, and that choose to do so, must
apply that standard in full and cannot chose the most suitable accounting policy from
full IFRS Standards or the SMEs Standard.

The Board are expected to limit revisions to the SME Standard to once every three
years although the process means in reality the time frames are longer. The IASB
are currently (2021) in the process of consulting on whether and how to align the
IFRS for SME standard with the full IFRS standards to better serve the users and
preparers of financial statements without causing undue cost and effort to SMEs.

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

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

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

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

199
There may be some important tax issues arising for SMEs that adopt the SMEs
Standard and this has been cited as one of the main reasons why some SMEs have
not adopted the SME Standard.

The SMEs Standard is a response to international demand from developed and

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

Written by a member of the Strategic Business Reporting examining team

200
Setting the standards for SMEs
Financial reporting requirements for SMEs vary according to the jurisdiction.
Sometimes they have to comply with the same requirements as other limited
companies; on other occasions they are subject to very few requirements. The
variety of approaches to SME financial reporting seems to reflect the wide
variety of economic contexts in which they conduct business. 

Within the SME category there are arbitrary distinctions. Currently in the European
Union (EU), the distinguishing characteristics for SMEs and micro entities are based
on turnover, gross assets and number of employees. There is an argument that the
publication of SME financial reports is the price of limited liability but this is not
universally accepted. In some countries, limited liability SMEs make minimal public
accounting disclosures with no audit requirement. The protection of creditors is
dependent on the owners of the business and therefore there is an argument that
there should be disclosure by these entities irrespective of whether they have limited
liability.

In some quarters, it is felt that there should be limited financial reporting

requirements for SMEs because of their size and the costs of meeting regulation.
Generally, SMEs are owner-managed with a narrow ownership interest, and their
shares are not traded by the public. However, SMEs interact with many different
parties, some of whom benefit from the disclosure of financial information. It is
therefore not surprising that a range of outcomes has emerged worldwide as regards
the requirements of SME financial reporting.

IFRS for SMEs, International Financial Reporting Standard for Small and Medium-
Sized Entities, was issued by the International Accounting Standards Board (IASB)
in 2009. The concepts and principles of IFRS for SMEs are based on the framework
document and therefore are very similar to full IFRS. 

The most significant difference in the presentation of financial statements for SMEs,
as opposed to full IFRS, is that there are fewer disclosure requirements. There are
also a number of differences in the accounting treatment of items in the statement of
financial position. Some topics in full IFRS are omitted because they are not relevant
to typical SMEs, and there is simplification of many of the recognition and
measurement principles in full IFRS.  

201
Reduce the burdens

IFRS for SMEs also permits some of the statements required to be omitted or
merged with other statements under certain circumstances. The standard is aimed at
private companies, regardless of size, that are not public interest entities. It was
developed to reduce the undue burdens placed on firms by full IFRS.

The decision as to which entities apply IFRS for SMEs is left up to individual
governments and regulators. The standard has been adopted or adapted in many
countries – sometimes with additional modifications such as in the UK, for example. 

The IFRS Foundation is developing profiles of application of full IFRS and the IFRS
for SMEs in individual jurisdictions. At present, 77 of the 140 jurisdictions being
profiled require or permit IFRS for SMEs. There are many notable exceptions
including France and Germany. However, of the 77, 52 allow SMEs to choose IFRS
for SMEs or full IFRS and 19 allow them to additionally choose local GAAP. Sixty-
nine out of the 77 jurisdictions do not allow any modifications to IFRS for SMEs.

In May 2015, the IASB completed its first comprehensive review of IFRS for SMEs
and issued limited amendments; these are effective on 1 January 2017 with early
application permitted. The most significant amendments are permitting SMEs to
revalue property, plant and equipment and aligning the main recognition and
measurement requirements for deferred tax with IAS 12, Income Taxes.

Additionally, the amendments allow exemptions from certain requirements when

application would cause undue cost or effort. These include measurement of
investments in equity instruments at fair value, recognising intangible assets
separately in a business combination and offsetting income tax assets and liabilities.

There is guidance as regards the application of this amendment. The entity must
determine the potential effect of applying this exemption on users of its financial
statements and compare this with the cost or effort of complying with the
requirement. The reasons behind the use of the exemption must also be disclosed.
Other notable changes include the option to use the equity method for investments in
subsidiaries, associates and jointly controlled entities in separate financial
statements, and the use of management’s best estimate if the useful life of goodwill
or another intangible asset cannot be established reliably. The maximum life must

202
not exceed 10 years whereas previously there was a presumption of a 10-year life in
the above circumstances. 

Radical change

In 2015, a radical change occurred to UK GAAP and therefore to SME accounting.

All previous financial reporting standards (FRS), statements of standard accounting
practice and Urgent Issues Task Force abstracts, apart from the Financial Reporting
Standard for Small Entities (FRSSE), were replaced by five new standards. FRS 100
sets out the overall framework for financial reporting under UK GAAP and explains
which standards apply to which types of entity. 

Additionally, the standard sets out when an entity can apply the reduced disclosure
framework and when it should follow a statement of recommended practice. FRS
101 sets out a reduced disclosure framework that is available in the individual
financial statements of qualifying entities provided certain criteria are met. FRS 102
sets out the accounting requirements for those entities that are neither required nor
elect to apply EU-adopted IFRSs, FRS 101’s reduced disclosure framework or
the FRSSE. There are significant differences between this version of
the FRSSE (effective January 2015) and the FRSSE (effective April 2008) because
of the revised reporting framework introduced into the UK. 

FRS 103 applies to insurance contracts of entities that apply FRS 102 including
reinsurance contracts that the entity holds, and to other financial instruments that the
entity issues with a discretionary participation feature. FRS 104 sets out the financial
reporting requirements for interim financial reports although it does not in itself
require an entity to prepare such a report.

In 2015, significant changes to UK company law were introduced, including changes

to the disclosures required within small company accounts. In addition, the
accounting thresholds relating to SMEs were increased significantly, which allowed
more entities to use the accounting requirements of the small companies regime. 

In the UK, financial reporting for small and micro-entities is also going through a
period of significant change. As a result, the FRSSE is being withdrawn and, from
2016, small entities will utilise FRS 102 or a new standard, FRS 105, The Financial
Reporting Standard Applicable to the Micro-entities Regime. Additionally a new
section 1A, Small Entities, has been added to FRS 102 outlining the disclosure and

203
presentation requirements for such entities. Changes have been made to the new
UK GAAP standards to ensure compliance with company law. 

For some entities currently applying the FRSSE, the recognition and measurement
of certain assets and liabilities may change dependent on whether the entity adopts
FRS 102 or FRS 105. FRS 105 can be the best option for micro-entities that wish to
avoid the more complex accounting treatments of FRS 102. It is unlikely that many
micro-entities will see a significant effect when they move to the new standard but,
because FRS 105 is drawn from FRS 102, albeit with some significant recognition
and measurement simplifications, there may be a case for these entities to appraise
themselves of the potential impact.

Differing approaches

Questions can be raised over the type of financial reporting requirements that should
apply to SMEs. Some of the major world powers have differing approaches to
SME accounting. The Chinese Accounting Standard for Small Entities was issued by
the Ministry of Finance (MoF) in 2011, having used the IFRS for SMEs as a
reference point when developing the standard. However, the MoF in Russia has said
that recent public discussions on the use of the IFRS for SMEs have suggested that
the cost of transition outweighs the benefits to be gained by the entities and users.  

In the US, there is no financial reporting framework that SMEs are either required or
permitted to use for preparing their financial statements. There is no organisation
that would make a centralised ‘adoption’ decision for the use of IFRS for SMEs in the
US.  

SMEs in the US are categorised as ‘private companies’ and, as such, can select the
accounting framework that fits the purpose of its financial statements. These
frameworks can include US GAAP, IFRS as issued by the IASB, or another basis of
accounting such as the US income tax basis. However, the American Institute of
Certified Public Accountants (AICPA) is in the process of considering comments on
its proposed financial reporting framework for privately held small and medium-sized
entities. 

Thus there can be a wide variation in the national accounting requirements for
SMEs. Questions such as whether SMEs should be required to produce

204
financial statements, what information they should contain and whether they should
be publicly available still need to be answered on a global scale. 

Graham Holt is director of professional studies at the accounting, finance and

economics department at Manchester Metropolitan Business School

205
Accounting for cryptocurrencies

There are many issues that accountants may encounter in practice

for which no accounting standard currently exists; one example is
cryptocurrencies. For example, as no accounting standard currently
exists to explain how cryptocurrency should be accounted for,
accountants have no alternative but to refer to existing accounting
standards. This article demonstrates to Strategic Business Reporting
(SBR) candidates how this can be done using cryptocurrencies as an
example.

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

What is cryptocurrency?

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

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

These tokens are owned by an entity that owns the key that lets it create a new entry
in the ledger. Access to the ledger allows the re-assignment of the ownership of the
token. These tokens are not stored on an entity’s IT system as the entity only stores

206
the keys to the Blockchain (as opposed to the token itself). They represent specific
amounts of digital resources which the entity has the right to control, and whose
control can be reassigned to third parties.

What accounting standards might be used to

account for cryptocurrency?

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

IAS 7 defines cash equivalents as ‘short-term, highly liquid investments that are
readily convertible to known amounts of cash and which are subject to an
insignificant risk of changes in value’. Thus, cryptocurrencies cannot be classified as
cash equivalents because they are subject to significant price volatility. Therefore, it
does not appear that digital currencies represent cash or cash equivalents that can
be accounted for in accordance with IAS 7.

Intuitively, it might appear that cryptocurrency should be accounted for as a financial

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

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

accordance with IAS 38, Intangible Assets. This standard defines an intangible asset
as an identifiable non-monetary asset without physical substance. IAS 38 states that
an asset is identifiable if it is separable or arises from contractual or other legal

207
rights. An asset is separable if it is capable of being separated or divided from the
entity and sold, transferred, licensed, rented or exchanged, either individually or
together with a related contract, identifiable asset or liability. This also corresponds
with IAS 21, The Effects of Changes in Foreign Exchange Rates, which states that
an essential feature of a non-monetary asset is the absence of a right to receive (or
an obligation to deliver) a fixed or determinable number of units of currency. Thus, it
appears that cryptocurrency meets the definition of an intangible asset in IAS 38 as it
is capable of being separated from the holder and sold or transferred individually
and, in accordance with IAS 21, it does not give the holder a right to receive a fixed
or determinable number of units of currency.

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

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

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

IAS 38 states that a revaluation increase should be recognised in other

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

208
Where the revaluation model can be applied, IFRS 13, Fair Value Measurement,
should be used to determine the fair value of the cryptocurrency. IFRS 13 defines an
active market, and judgement should be applied to determine whether an active
market exists for particular cryptocurrencies. As there is daily trading of Bitcoin, it is
easy to demonstrate that such a market exists. A quoted market price in an active
market provides the most reliable evidence of fair value and is used without
adjustment to measure fair value whenever available. In addition, the entity should
determine the principal or most advantageous market for the cryptocurrencies.

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

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

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

 held for sale in the ordinary course of business

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

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

As there is so much judgement and uncertainty involved in the recognition and

measurement of crypotocurrencies, a certain amount of disclosure is required to

209
inform users in their economic decision-making. IAS 1, Presentation of Financial
Statements, requires an entity to disclose judgements that its management has
made regarding its accounting for holdings of assets, in this case cryptocurrencies, if
those are part of the judgements that had the most significant effect on the amounts
recognised in the financial statements. Also IAS 10, Events after the Reporting
Period requires an entity to disclose any material non-adjusting events. This would
include whether changes in the fair value of cryptocurrency after the reporting period
are of such significance that non-disclosure could influence the economic decisions
that users of financial statements make on the basis of the financial statements.

So, accounting for cryptocurrencies is not as simple as it might first appear. As no

IFRS standard currently exists, reference must be made to existing accounting
standards (and perhaps even the Conceptual Framework of Financial Reporting).
SBR candidates should be prepared to adopt this approach in an exam situation
because it allows them to substantiate their conclusion which is an approach that will
be expected by employers in practice.

Written by a member of the Strategic Business Reporting examining team

210
Crowdfunding and impairment of financial
instruments

This article addresses the application of accounting principles in

contemporary contexts (an exam technique issue) and the
impairment of financial instruments (a technical knowledge issue).

Applying accounting principles to different contexts

Many candidates perceive accounting to be a technical practice and believe that

SBR tests ‘how you do accounting’. While some of this is true, SBR also tests the
application of accounting principles in different contexts because accounting is
fundamentally a social practice, which guides and influences the behaviour of people
in organisations and society. As such, accounting needs to be studied and
understood in the contexts within which it operates. The SBR syllabus therefore
focuses on the concepts, principles and practices that underpin the preparation and
interpretation of corporate reports in different contexts (including ethical contexts).
This is because the application of knowledge is a skill that employers’ value and
therefore seek… after all, an employer will not present you with a problem that has
already been solved or one that you have seen before. Understandably, candidates
struggle with this because they are expected to be able to use knowledge in new
situations, make connections, explore outcomes and generate ideas.

Crowdfunding

SBR candidates should be prepared for exam questions to test accounting concepts
within different accounting contexts that they may not necessarily have encountered
before. This section considers crowdfunding as one such context and describes the
process that candidates should go through to apply their knowledge to this particular
context.

Crowdfunding is the funding of a new start-up or project by collecting cash from a

variety of individuals/entities often via the Internet. There are 4 common ways of
raising funds:

211
  Equity-based crowdfunding: The equity-based approach is targeted at investors who
receive shares in the new company.
 Debt-based crowdfunding: With debt-based crowdfunding, a contributor makes a
loan to a business that’s looking to crowdfund, with the intention of subsequently
being repaid with interest.
 Reward-based crowdfunding: This involves promising specific items (rewards) to
contributors before the launch of a new project, product, or business. A reward-based
campaign isn’t generally targeted at contributors who are looking to profit from their
investment but at those who want to own a new product.
 Donation-based crowdfunding: Contributors make 'donations' to a project or company
and may receive existing ‘rewards’ in return. Some forms of donation-based
crowdfunding don’t involve any sort of reward as donors wish to contribute to further
a particular cause.

Considerations
Using the question scenario, candidates would be expected to breakdown a scenario
and understand the information provided – ie candidates may not have considered
the crowdfunding context before, however, they should be able to understand the
accounting implications of the four options above. They should be able to apply their
knowledge to the context provided; for example, if the crowdfund is considered to be
a debt instrument it will fall within the scope of IFRS 9, Financial Instruments,
whereas if it gives rise to an issue of capital, it will fall within the scope of IAS
32, Financial Instruments Presentation.

If the crowdfunding campaign involves the issuing of ‘rewards’, then IFRS

15, Revenue from Contracts with Customers, should be used to determine when to
recognise revenue. For each performance obligation, the company will need to
determine whether the performance obligation is satisfied over time (ie control of the
good or service transfers to the customer over time). If one or more of the criteria in
IFRS 15 are met, then the company recognises revenue over time. If none of the
criteria is met, then control transfers to the customer at a point in time and the
company recognises revenue at that point in time. However, if the company cannot
reasonably measure the outcome but expects to recover the costs incurred in
satisfying the performance obligation, then it recognises revenue to the extent of the
costs incurred.

EXAMPLE
On 1 September 20X9, Burnett Co decided to undertake a crowdfunding campaign
to finance the production of a new racing bike, the Cracken. They made a short film

212
with famous cyclists which set out the qualities of the Cracken bike and posted it on
the PeddleStarter crowdfunding platform. The campaign raised $4 million on which
PeddleStarter charged 7% commission. The contributors to the crowdfunding
campaign were promised a reward of 1 Cracken bike for every $4,000 dollars
contributed. At the financial year end of 31 December 20X9, Burnett Co had
manufactured only 50 Cracken bikes at a total cost of $240,000 but none had been
delivered to contributors. There was some doubt as to the capability of the company
to develop, manufacture, and deliver the bikes promised but Burnett Co is sure that
the funding will cover any costs incurred.

Suggested answer:
IFRS 15, Revenue from Contracts with Customers, should be used to determine
when to recognise revenue. At 31 December 20X9, it is difficult to know what the
outcome will be as only 50 bikes have been manufactured out of a promised 1000
bikes ($4 million/$4000) and there is a doubt as to whether the company has the
capability to develop, manufacture, and deliver the bikes promised. However, Burnett
Co expects to recover the costs incurred in satisfying the performance obligation,
thus it will recognise revenue to the extent of the costs incurred to date $520,000
($240,000 + commission $280,000) as at 31 December 20X9. The balance
remaining from the crowd funded amount will be shown as accrued revenue in the
financial statements ($3,480,000). The commission ($280,000) would be charged
against profit or loss for the period.

Guidance
Many SBR candidates may now have some extra time to reflect and rethink values,
concerns and routines, one of which may be their approach to study. It may be a
time to not focus on accounting techniques but on accounting principles, to maybe
read around the subject and gain an understanding of what lies behind it. Remember
the following:

 The importance of a robust conceptual framework

 An understanding that rules will not be able to cover all situations
 Use of reasonable judgement is always needed in the decision-making process

To further help understand what is expected of you, SBR candidates should read all
of the examiner’s reports that are available at each exam diet; for example, the
examiner’s report for March 2020 observed that there was a lack of knowledge of
some basic accounting concepts and many candidates did not have an
understanding of ‘equity accounting’. A significant number of candidates did not

213
know that ‘the investment is initially recognised at cost and adjusted thereafter for
the post-acquisition change in the investor's share of the investee's net assets.’ If
candidates do not understand the basics, it will be almost impossible to apply that
knowledge to different accounting contexts. Therefore, it is important that the basic
principles of Financial Reporting (FR) are understood by
candidates before attempting the SBR exam. See ‘Stepping up from Financial
Reporting’ for more information.

The impairment of financial instruments

One technical area of the SBR syllabus that candidates often struggle with is the
impairment rules of IFRS 9, Financial Instruments. IFRS 9 uses an Expected Credit
Loss (ECL) model which requires a calculation of the expected value decrease in a
financial asset. Essentially, a provision is required for expected credit losses on the
financial asset over a period of time. Expected losses should be discounted to the
reporting date using the effective interest rate of the financial asset that was
determined at initial recognition.

The impairment model of IFRS 9 introduces a three-stage approach:

 Stage 1 deals with financial instruments that have not had a significant increase in
credit risk since they were first recognised or that have low credit risk at the financial
year end. For these assets, 12-month ECL are recognised which means that the
entity has to calculate the expected losses in the next 12 months taking into account
the risk of default. Any interest revenue is calculated on the gross carrying amount of
the asset without the deduction of the credit loss.

 Stage 2 deals with financial instruments that have had a significant increase in credit
risk since they were first recognised unless the credit risk is still low at the financial
year end. These instruments are not credit-impaired. The expected losses over the
life of the financial instrument are recognised (lifetime ECL) taking into account the
risk of default. Interest revenue is still calculated on the gross carrying amount of the
asset.

 Stage 3 deals with financial assets that are credit-impaired, which is where events
have occurred that have a detrimental impact on the estimated future cash flows from
the financial asset. For these assets, lifetime ECL are also recognised. However,
interest revenue is calculated on the carrying amount less the ECL allowance.

214
EXAMPLE
On 1 January 20X6, Lunar Co granted Skyzer Co a $5 million secured loan
repayable on 31 December 20X9 with an interest rate of 3% payable annually at the
reporting date.
Stage 1
On 31 December 20X6, there
has been no increase in credit
risk and the probability of
default in the next 12 months
is 5%. The present value of
the cash shortfalls expected
over the life of the
instrument if the default
occurs in the next 12 months
is $200,000.
12-month ECLs = $10,000
($200,000 × 5%).
Interest revenue = $150,000
(3% × $5m – ie no adjustment
for any loss allowance).
Stage 2
On 31 December 20X7, the
credit risk of the loan has
increased significantly.
The probability of default
occurring over the remaining
life of the loan is 45%. The
present value of ECLs from
default events over the life of
the loan are expected to be
$400,000.
Lifetime ECLs = $180,000
($400,000 × 45%)
The change of $170,000 in
the cumulative impairment
allowance is recognised in
profit or loss.
Interest revenue = $150,000
(3% × $5m – ie no adjustment
for any loss allowance).
215
Stage 3
On 31 December 20X8, the
loan is credit impaired. The
estimated present value that
is expected to be recovered
(less costs) is $4 million.
The gross carrying amount of
the loan is $5,150,000 which
is the loan plus unpaid
interest for the year.
Lifetime ECLs = $1.15 million
($5.15 – $4) million
The change of $970,000
($1.15–$0.18)m in the
cumulative impairment
allowance is recognised in
profit or loss.
20X9 interest revenue =
$120,000 (3% × $4 million)
which is based on gross
 carrying amount minus loss
allowance.

For trade receivables or contract assets that do not contain a significant financing
component, the loss allowance should be measured, at initial recognition and
throughout the life of the receivable, at an amount equal to lifetime ECL. As an
exception to the general model, if the credit risk of a financial instrument is low at the
reporting date, management can measure impairment using 12-month ECL, and so it
does not have to assess whether a significant increase in credit risk has occurred.

Guidance
If you are struggling with a technical issue in the SBR syllabus, try to pair it back to
basic principles that you can use in any context. For example, the suggested solution
above relies on an understanding of the accounting principles that apply at each
stage of credit impairment. Understanding and applying these principles in an exam
context will demonstrate a deep understanding of the issue and an ability to apply it
to the question scenario. It is these skills that employers are looking for and
examiners will award marks for.

Conclusion

This article addresses two issues that SBR candidates have struggled with in recent
exam diets; one relates to exam technique and the other a more technical issue.

Finally, a plea for SBR candidates to answer all parts of all questions. Please help

the examining team to pass you!

216
Business combinations, share-based payments
and accounting considerations of a pandemic or
natural disaster

This article identifies the kinds of 'control' issues that candidates

should be considering when constructing their response to such
exam questions. It also reflects upon how share-based payments
should be accounted for when they are made as part of the purchase
consideration for a subsidiary in a business combination.

Finally, it uses the Covid-19 pandemic as a context within which to

consider what IFRS standards might be applicable to reporting
entities and why.

Recent examiner reports have stated that SBR candidates often do not provide an
effective consideration of whether or not control has been obtained by the acquirer in
a business combination.

This article therefore identifies the kinds of 'control' issues that candidates should be
considering when constructing their response to such exam questions. It also reflects
upon how share-based payments should be accounted for when they are made as
part of the purchase consideration for a subsidiary in a business combination.

Finally, it uses the Covid-19 pandemic as a context within which to consider what
IFRS standards might be applicable to reporting entities and why.

Business combinations

Revision of the basic principles of consolidation

When answering SBR exam questions that test control, candidates don’t often focus
on the inter-related principles of control despite the fact that the requirement asks

217
them to do so. Control is not simply a matter of owning more than 50% of the voting
share capital of an entity and consideration of the individual elements of control in
isolation can give rise to the conclusion, incorrectly, that almost any ‘involvement’
with another entity creates a controlling relationship. However, it is important to note
that the three criteria that define control (considered below) are inter-related and that
all three must be present to conclude that the acquirer (investor) has control of the
subsidiary.

IFRS 10 Consolidated Financial Statements (para 7) states that an investor controls

an investee when the investor has all of the following:

i. Power over the investee

ii. Exposure, or rights, to variable returns from its involvement with the investee, and

iii. The ability to use its power over the investee to affect the amount of the investors
returns

The following table considers each of the control criteria and identifies issues that
candidates need to apply to the SBR exam question scenario to identify whether (or
not) control has been transferred to the acquirer:

Control criteria (IFRS 10) Considerations to apply to the SBR exam question
scenario:

 owning a majority of the voting rights is not

Power over the investee
always necessary to have control. Instead,
control requires that the investor’s power/rights
are sufficient for it to unilaterally direct the
relevant activities that most affect the investee’s
returns. For example, SBR candidates should
consider who makes the operating, financing and
capital decisions, and who appoints key
management personnel.

218
  more analysis and judgement is required to
determine whether an investor with a significant
minority of voting or other rights has control. For
example, power over an investee can still exist
even when another entity has significant
influence and SBR candidates must be prepared
to consider this.

Exposure or rights to variable  returns should be interpreted broadly, for

returns example, to include synergy benefits as well as
financial returns

 returns can be negative or positive

 a right to returns that is fixed is not normally

consistent with control

The ability to use its power to affect  in more complex control assessments, IFRS 10
returns requires identification of the activities that most
affect the investee’s returns and how they are
directed

 in simple assessments, it is sufficient to consider

activities at the financial and policy level.

If, after applying these considerations to the SBR exam question scenario, the
outcome of the assessment of control is still unclear, other evidence must be
considered, including:

 ability to direct investee to act on investor’s behalf

 key management personnel or the majority of governing body are related parties of
investor
 special relationships between investee and investor

219
EXAMPLE
Joo Co and Cat Co hold 40% each of the voting rights of Door Co. The remaining
20% are held by Hag Co. A shareholders’ agreement states that the purpose of Door
Co is to generate capital gains from buying and selling properties. All decisions
concerning buying and selling properties, and their financing require the unanimous
agreement of both Joo Co and Cat Co.

Joo Co is responsible for all management activities for which it receives payment
and additionally has the final decision on appointments to the board of directors.

Suggested answer
The major finance and management activities will both affect Door Co’s returns.
Therefore, Joo Co and Cat Co should evaluate which set of activities has the
greatest effect on returns.

Given the purpose of Door Co is to achieve capital gains, this may indicate capital
investment activities have the most significant impact. If so, the conclusion would be
that Joo Co and Cat Co have joint control because these activities are directed by
joint decision-making. The deemed significant influence of Hag Co would not change
this assessment of which entity has power over Door Co. If however management
activities and key management personnel appointments are considered more
significant, the conclusion would be that Joo Co has control of Door Co because it
solely directs these relevant activities.

Guidance
Different exam question scenarios will provide different amounts of information and
sometimes it won’t be possible to consider all of the control criteria that has been
identified in the table above. However, SBR candidates should ensure that their
response considers more than just the 50% ownership criteria. In doing so, they can
demonstrate that they are aware that other criteria exist and that they know how to
apply them. Such an approach is likely to produce an answer that has both breadth
and depth.

Share-based payment – replacement awards on acquisition

Another issue that SBR candidates appear to struggle with is the accounting
treatment required when an entity includes a share-based payment as part of the
consideration paid for a subsidiary in a business combination; for example, when the

220
acquirer agrees to take over any existing share-based payment awards that have
already been issued to the employees of the acquiree. Alternatively, the acquirer
may change the terms of the share-based payment awards to provide an incentive
for key employees to remain an employee of the acquired entity. Such transactions
are included within the scope of IFRS 2, Share-based Payment.

Such an arrangement needs to be analysed to determine whether it represents

compensation for services in the pre-combination/acquisition period, the post-
combination/acquisition period, or both. Amounts attributable to the pre-acquisition
period should be accounted for as part of the purchase consideration. Amounts
attributable to the post-acquisition period should be recognised as a cost of that
period. Amounts attributable to both the pre- and post- acquisition periods should be
allocated to the purchase consideration and post-acquisition costs accordingly.

Transactions that benefit the acquiree before the acquisition are included as part of
the purchase consideration. If the transaction was arranged for the economic benefit
of the acquirer, the transaction is not deemed to be part of the purchase
consideration.

EXAMPLE
On 1 April 20X3, Natural Co granted equity share-based payment awards to its
employees. These shares awards had a fair value of $20 million and were subject to
the employees remaining in employment for the next 3 years.

On 1 April 20X5, Digital Co purchased all of the share capital of Natural Co for cash
of $80 million. A condition of the acquisition is that Digital Co is required to issue
replacement equity share awards to the employees of Natural Co that will vest on 31
March 20X6.

On 1 April 20X5, the fair value of Natural Co’s net assets was $90 million, the fair
value of the original share award was $24 million and that of the replacement share
awards was $28 million.

The financial year end is 31 March each year.

Required: calculate the impact of the share-based payment awards when

accounting for the acquisition, including goodwill.

Suggested answer
The amount of the replacement share award that is attributable to pre- acquisition

221
services is determined by multiplying the fair value of the original award by the ratio
of the vesting period completed at the date of the business combination to the
greater of:

 The total vesting period, as determined at the date of the business combination, and
 The original vesting period

The period before the date of acquisition is (a) 2 years [1 April 20X3 to 31 March
20X5].

The vesting period of the replacement awards is (b) 1 year (b) [1 April 20X5 to 31
March 20X6].

The original vesting period is (c) 3 years [1 April 20X3 to 31 March 20X6].

Therefore, the total vesting period at 1 April 20X5 is 3 years (a+b) which is the same
as the original vesting period.

The pre-acquisition service amount is $24 million x 2 years/3 years = $16 million –
this is accounted for as part of the purchase consideration (see below).

The post-acquisition service amount therefore is ($28-$16) million – $12 million – this
is accounted for as a cost for the year ended 31 March 20X6.

Goodwill at 1 April 20X5 $m

Cash consideration 80

Equity-share based awards 16

222
   96

Net assets of Natural Co (fair value) 90

Goodwill 6

   

At 31 March 20X6 (vesting date) $m

Remuneration cost (PL) 12

Equity-share based awards (SFP- Equity) 12

The above approach is a sensible one which is also logical and clear to mark.
Therefore, it is an approach that the SBR examining team recommends that you
follow when answering similar such questions.

223
The accounting considerations of a pandemic or other natural
disaster

Learning outcome F1(c) of the SBR syllabus states that candidates should be able
to:

Discuss the impact of current issues in  corporate reporting. This learning outcome
may be tested by requiring the application of one or several existing standards to an
accounting issue. It is also likely to require and explanation of the resulting
accounting implications (for example, accounting for cryptocurrency in the Digital
Age or accounting for the effects of a natural disaster and the resulting
environmental liabilities). 

The Covid-19 pandemic is an example of a natural disaster which has undoubtedly

had an impact on the financial reporting practices of many entities in different
business contexts. Indeed, many entities are experiencing conditions that are often
associated with a significant economic downturn. However, there is no one particular
IFRS standard that is more relevant than any other.

The SBR examining team has often commented that candidates incorrectly think that
only one IFRS standard can be used to provide an answer to an exam question
scenario. Such an approach is likely to produce a response that is very narrow in its
consideration of the issues applicable to the exam question scenario. By using the
context of the Covid-19, the following table demonstrates the wide number of IFRS
standards that are impacted by this pandemic which would also apply to other
situations like economic downturns.

The following tables consider some of the existing accounting requirements that
should be considered when addressing the financial effects of the Covid-19
outbreak:

IFRS Standards Issues for discussion

224
IAS 1, Presentation of Assessment of an entity’s ability to continue as a going concern at
Financial Statements the dates the financial statements are approved.

Disclose uncertainties – significant judgements and sources of

estimation/uncertainty need to be appropriately disclosed. This
will also have impacts on the going concern assessments if judged
material.

If going concern is at issue consider preparation of financial

statement on net realizable basis/net settlement value.

IAS 2, Inventories Inventory must be stated at the lower of cost or net realisable
value (NRV) however NRV calculation may be challenging (no
market prices or no demand for products).

Entities may need to reassess their practices for fixed overhead

cost allocation as production levels fall materially.

Obsolete inventory considerations, especially perishable inventory.

IAS 10, Events after the The evaluation of Covid-19 information that becomes available
reporting period after the end of the reporting period but before the date of
authorisation of the financial statements.

Entities will need to judge how much of the impact of Covid-19

should be considered to arise from adjusting or non-adjusting events
given the dates when knowledge of the pandemic became known
and events like travel bans, lockdowns and similar took effect.

225
IAS 12, Income Taxes Recovery of deferred tax (DT) assets arising from accumulated tax
losses and therefore assess probable future taxable profits or tax
planning opportunities or whether sufficient DT liabilities which are
expected to reverse.

Will entities have to restrict the Dt Asset recognised?

Consequences of adjustments to the carrying amounts of assets

and liabilities will have DT impact. Some examples will include the
Impact of impairment losses or decreases in the value of a pension
surplus.

IAS 19, Employee Benefits Adjustments/provisions for severance.

Falls in interest rates and plan asset portfolios may require

significant adjustments requiring the services of actuaries to reflect
changes in any defined benefit schemes.

IAS 20, Accounting for Government assistance to help entities that are experiencing
Government Grants and financial difficulty.
Disclosure of Government
Assistance Reimbursement of employment costs is recognised in profit or
loss. Disclosure of aid such as short-term debt facilities.

IAS 23, Borrowing Costs Suspension of capitalisation of borrowing costs if Covid-19 has

interrupted the acquisition, construction or production of a
qualifying asset. Any borrowing costs incurred during such periods
should be expensed through P/L.

IAS 36, Impairment of Assess whether the impact of Covid-19 has potentially led to an
Assets asset impairment (tangible, intangibles and financial assets) –
effectively Covid-19 is a trigger event that indicates an impairment

226
 review is required.

Management may face significant challenges in preparing the

budgets and forecasts necessary to estimate the recoverable
amount of an asset (or CGU) because of decreased demand,
business interruptions, cancelled orders and similar issues.

Difficulty assessing fair values when no active market or market

participants

IAS 37, Provisions, Potential restructuring provisions and onerous contract provisions

Contingent Liabilities and may need measured and recognised and insurance recoveries
Contingent Assets disclosed (need to assess certainty of these recoveries).

If material expenses or income for example restructuring and

onerous contract provisions and impairment losses) should they be
disclosed separately?

IFRS 2, Share-based Vesting conditions for share-based payments with performance

Payment conditions may not be met.

IFRS 5, Non-current Assets An asset (or a disposal group) no longer meets the conditions for
Held for Sale and ‘held for sale’ for example an entity may now face difficulties in
Discontinued Operations identifying a buyer or in completing the sale within the 12-month
period from classification.

Ceased operations that meet the definition of discontinued

operations will require separate presentation and disclosure.

IFRS 9, Financial Allowance for expected credit losses (ECL) - reductions in forecasts
Instruments in economic growth increase the probability of default and entities
will need to revisit the provision matrix approach for trade

227
 receivables.

Classification of financial assets – consider whether there has been

a change in the entity’s business model. An entity may decide or
need to sell receivables classified as ‘held to collect’ which will
therefore change classification.

Hedge accounting – entities may need to consider whether the

transaction is still a 'highly probable forecasted transaction'.

There will be many more considerations with IFRS 9 regarding

interest rate changes/debt covenants/modifications to payment
terms.

IFRS 13,  Fair Value Companies need to look at the decisions, assumptions and inputs
Measurement to fair value measurement as market-based measures are likely to
change significantly and perhaps in unpredictable ways. If using
level 2 or 3 inputs will require more extensive disclosure.

IFRS 15,  Revenue from Contract enforceability - may not be able to approve a contract
contracts with customers under an entity’s normal business practices

Collectability – may be a significant deterioration of a customer’s

ability to pay.

Contract modifications – entity may grant a price concession to a

customer.

Variable considerations – an entity may need to consider updating

its estimated transaction price

Significant financing component -an entity may provide extended

payment terms.

228
 Revenue recognition - an entity may need to reconsider the timing
of revenue recognition if it is unable to satisfy its performance
obligations on a timely basis.

IFRS 16,  Leases Impairments to right-of use assets.

Economic stimulus measures have led to lower interest rates and

changes to lease terms – lease liabilities may need remeasured.

Impairments of lease receivables for lessors.

Other non-IFRS  
considerations

Discount rates Many central banks have cut their base rates – this will affect the
measurement of many assets and liabilities

Alternative Entities may consider providing new alternative performance measures

performance (APMs) or adjust existing APMs – adequate/extensive disclosures will be
measures required to ensure they do not mislead

While the SBR examining team is not stating that consideration of all of these IFRS
standards would be required, or could be expected, to answer an SBR exam
question, the table does demonstrate that the accounting context of Covid-19

229
requires the consideration of a range of accounting standards and has wide and
varied implications. Likewise, an SBR exam question is unlikely to require the
consideration of only one IFRS standard in isolation. 

SBR candidates should use the signposts and clues contained in the question
scenario to identify which IFRS standards that they should consider.

Conclusion

This article should be used to stimulate thoughts about how these issues might
impact on responses when practicing SBR exam questions. However, this article
should not be interpreted as a signpost to the content of future SBR exam
questions. 

ACCA candidates should focus on wider reading including making use of the
learning resources that ACCA have available such as technical articles and
the examiner reports. By using these resources now, exam technique can be refined
and improved.

230
Onerous lease contracts and impairments, and
investor issues

This article addresses the technical matter of onerous lease contracts

and their impairment and then considers two types of approach to
SBR exam questions:
(i) investors issues in SBR questions and
(ii) the application of knowledge to SBR question scenarios.

This article addresses the technical matter of onerous lease contracts and their
impairment and then considers two types of approach to SBR exam questions:

(i) investors issues in SBR questions and

(ii) the application of knowledge to SBR question scenarios

Specifically, question 3 from the March 2020 exam is used to illustrate this point.

Onerous lease contracts and impairments

IFRS 16, Leases has brought significant change to the accounting treatment of

leases, the most important of these changes being that lessees now have to
recognise operating leases as a right-of-use (ROU) asset and a lease liability. As
with other assets, this ROU asset may have to be tested for impairment. Since the
ROU asset is a non-financial asset, the requirements of IAS 36 apply. However,
there are two exemptions to the IAS 36 impairment model.

Firstly, when a lessee applies the fair value model in accordance with IAS 40 for its
investment properties, it also applies the fair value model to the ROU asset.
Secondly, if a ROU asset relates to a class of PPE to which the lessee applies the
revaluation model, then the lessee can elect to apply the revaluation model to all of
the ROU assets that relate to that class of PPE.

231
In accordance with IAS 36, the ROU asset is tested for impairment on a standalone
basis unless it forms part of a cash-generating unit (CGU). If the ROU asset is tested
for impairment as a part of the CGU then it should be included in the CGU’s carrying
amount. IAS 36 requires entities to consider whether a buyer would be required to
assume any liabilities, which could include the lessee’s lease liability. In such a case,
the lease liability needs to be included in the recoverable amount of the CGU and in
the carrying amount of CGU as well.

When considering onerous contracts, these are governed by IAS 37, Provisions,

Contingent Liabilities and Contingent Assets and this IFRS standard is applied to any
contract for which unavoidable costs of meeting the contract obligations exceed the
economic benefits expected to be received under that contract. However, it is
interesting to consider whether IAS 37 and IFRS 16 can co-exist.

The International Accounting Standards Board (the Board) decided not to specify
any particular requirements in IFRS 16 for onerous contracts. The Board made this
decision because:

(a) for leases that have already commenced, no requirements are necessary. After
the commencement date, an entity can appropriately reflect an onerous lease
contract by applying the requirements of IFRS 16. A lessee will determine and
recognise any impairment of right-of-use assets applying IAS 36, Impairment of
Assets.

(b) for leases that have not already commenced, the requirements for onerous
contracts in IAS 37, Provisions, Contingent Liabilities and Contingent Assets are
sufficient. The requirements in IAS 37 apply to any contract (and hence any lease
contract) that meets the definition of an onerous contract in that standard.

The question also arises as to how to deal with onerous contracts when initially
applying IFRS 16. A company can either:

 apply IAS 36 to its right-of-use assets, or

 not apply IAS 36 on the date of initial application, but instead rely on its assessment
of whether any of its leases are onerous under IAS 37. Any onerous lease provision
is derecognised and an equal amount is deducted from the carrying amount of the
relevant right-of-use asset.

This choice can also be applied on a lease-by-lease basis.

232
Thus, candidates should carefully read the question before answering to determine
whether IAS 36 or IAS 37 should be applied to the onerous leasing contract. If the
examining team wants candidates to consider the matter under a specific IFRS
standard (ie IAS 37 or IFRS 16), then that standard will be specifically referred to in
the requirement. However, candidates should also appreciate that marks will be
awarded for any discussion that is rational and logical, even though it doesn’t appear
in the suggested solution.

Investors issues in SBR

Every SBR exam will include a question that tests an investor’s perspective.
Although the nature of the question will vary, it will normally include 2 professional
marks. The question may require candidates to comment upon the usefulness of
certain types of information to investors and their needs. When answering a question
on a specific IFRS standard, candidates should use their knowledge of that
accounting standard to discuss how this could impact on the investment decisions of
investors. For example, there may be a need for a clear explanation of deferred tax
balances in financial statements and an analysis of the expected timing of reversals
so that investors can see the time period over which deferred tax assets arising from
losses might reverse.

As a general rule, the principles of good disclosure would be useful to investors.

Thus, candidates can use these principles as a framework for answering generic
questions which involve an investor perspective. The Board has received feedback
from investors along the following lines:

 Investors are concerned about ineffective communication. In particular, they highlight

the importance of proper application of materiality by entities when deciding what to
disclose and how best to communicate that information.
 Investors consider comparability and entity-specific information to be particularly
important but note that there is potential for conflict between these two principles.
 Many investors think that the inclusion of IFRS information outside the financial
statements could be useful in some circumstances but have some concerns about
understandability, assurance and the on-going availability of information.
 Many investors agree that the Board should not prohibit the inclusion of non-IFRS
standard information in financial statements. However, investors have concerns
about the risk of entities providing misleading information, or clouding IFRS standard
information.

233
  Investors think that the Board should require an entity to clearly identify, label,
explain and reconcile any non-IFRS standard information presented in the financial
statements.
 Many investors feel that the Board should define performance measures. Many
investors have encouraged the Board to define one or more of the following: EBIT,
EBITDA and other performance measures such as operating profit.
 Most investors support the suggestion to develop definitions of, and requirements for
the presentation of, unusual or infrequently occurring items. Investors think that this
would help to avoid misleading or inconsistent use of those terms.
 Investors think that useful accounting policy disclosures are those that relate to
material items, transactions or events or provide insight into how an entity has
exercised judgement in selecting and applying accounting policies.

The above principles could be used when SBR candidates answer several types of
investor related questions but would only gain marks if applied to the scenario.

The application of SBR knowledge to question scenarios

It is important to explore this latter point further. The SBR exam requires candidates
to answer questions using the application of knowledge to a question scenario.
However, in SBR, candidates often fail to gain valuable marks through not using the
scenario in their answer.

The verb used in the question requirement and the number of marks allocated to it
gives the candidate an idea about the nature and degree of detail required. A purely
discursive answer will lose marks if computations are required and no marks will be
awarded to calculations that have not been asked for. Simply repeating facts from
the scenario or an accounting standard without any further explanation or application
of that knowledge is insufficient. This is because markers are looking for evidence of
analysis and professional judgment.

There is some evidence that some candidates practice poor time management.
Often, these candidates do not attempt all of the questions with the result that
relatively easy marks, particularly in the final parts of question 4 are lost. Some
candidates spend a disproportionate amount of time addressing the issues in
question 1 with the result that there is little time left to answer question 4. There
needs to be a balance between the time spent on all of questions and an

234
understanding that spending too much time on any one question will affect
performance.

If candidates forget the principles in a particular accounting standard, a good

strategy is to refer to the Conceptual Framework. If candidates feel that they cannot
answer part of a question, then the principles in the Conceptual Framework, applied
correctly, will always gain some marks. This is the case even if the Conceptual
Framework is not mentioned in the suggested solution. Candidates are advised to
structure and present their answer in a way that assists the marking process and so
it is not advisable to merge many parts of an answer into one.

SBR consciously includes challenging and contemporary question scenarios.

Candidates will be awarded marks for discussion of issues which do not appear in
the suggested solution but are relevant to the scenario. Additionally, extra marks
may be gained if a candidate discusses a point particularly well.

A good example of this approach can be seen in question 3 March 2020, which you
can find here.

The question required candidates to discuss how to account for contingent

performance conditions where individual football players are paid bonuses which
represent additional contract costs. Candidates needed to be able to discuss when
the bonuses would be recognised. There is no existing IFRS standard to refer to in
this question, therefore candidates were required to use accounting principles. There
is diversity in practice where accounting for contingent performance conditions is
concerned.

So, how should SBR candidates have answered this question?

There are several ways in which this question could have been answered and
candidates could either refer to the Conceptual Framework or other existing
accounting standards. For example, candidates could use the definition of a liability
in the Conceptual Framework to help: 'a liability is a present obligation of the entity to
transfer an economic resource as a result of past event'. So, the entity should have
an obligation. When a player’s contract is signed, management should make an
assessment of the likely outcome of performance conditions in order to determine if
there is an obligation.

235
Secondly, there needs to be an obligation to transfer an economic resource. The
economic resource being transferred will be a cash amount.

Thirdly, the obligation needs to be a present obligation that exists as a result of past
event. Hence, any contingent amounts will only be recognised from the date
management believes that the performance conditions will be met. Before this date,
an obligation will not exist and the past event can be argued as the signing of the
contract.

Alternatively, the definition of a provision in IAS 37 could be used to answer the

question. A provision is a present obligation that has arisen as a result of a past
event, payment is probable, and the amount can be estimated reliably.

Leicester City Football Club states in its financial statements that ‘Contractual
obligations are recognised when they become payable with prepayments/accruals
recognised at each period end. However, Manchester United Football Club states
the following re bonus payments to players – 'Any performance bonuses are
recognised when the Company considers that it is probable that the condition related
to the payment will be achieved.' The suggested solution to Q3 March 2020 is written
in accordance with this accounting policy.

However, there is an argument that there is a possible financial liability which should
be recognised at the acquisition of the player. The examining team do not
necessarily agree with this view as players can leave the football club or become
injured and not trigger the payments. However, if candidates argued this point
coherently, then marks would have been awarded accordingly.

It is worth remembering that the examining team give credit for answers that are not
included in the suggested solution at every exam. This is because corporate
reporting is not an exact science! It requires judgement and is subjective… it is your
judgement and opinions that employers want to see and so these are the skills that
the SBR examining team is attempting to develop. Therefore, SBR candidates
should be prepared to apply their corporate reporting knowledge to many different
business contexts and contemporary SBR questions.

This article discusses the asset ceiling test in IAS 19, Employee

Benefits, and explains how many IFRS standards and principles

236
might be relevant to an accounting issue for which there is no
existing IFRS standard (in this case Initial Coin Offering (ICO)).

Finally, it examines some non-financial performance measures that

have been reported in practice in a global digital entity.

This article explains a complex area of the SBR syllabus, the asset ceiling test in IAS
19, Employee Benefits, and explains how many IFRS standards and principles might
be relevant to an accounting issue for which there is no existing IFRS standard (in
this case Initial Coin Offering (ICO)). Finally, it examines some non-financial
performance measures that have been reported in practice in a global digital entity.

However, first it is worth reiterating that candidates will not be able to successfully
answer SBR questions by rote learning and reproducing textbook answers.
Candidates should always explain the relevant principles which underpin their
answers because in SBR, marks are awarded first for an explanation of the
principles and then for their application to the scenario. An understanding of the
principles will allow candidates to deal with the many accounting issues that arise in
practice and to cope with the changes and developments in the business
environment, such as ICO’s. In addition, candidates will not be awarded professional
marks if there is no reference to the scenario.

Asset ceiling test IAS 19

Defined benefit pension accounting is generally acknowledged to be a complex area

of accounting and asset ceiling test is possibly one of the more complex aspects of
IAS 19, Employee Benefits that might be examined. A pension asset exists when a
defined benefit pension plan has a surplus of plan assets over its liabilities. IAS 19
requires the employer to consider the recoverability of any such surplus and there
must be economic benefit (for example reduced contributions or a cash refund)
available to the company to enable this recovery. An entity should recognise a net
pension asset in such cases because the entity controls a resource, and that control
is a result of past events. This is in the form of contributions paid by the entity and
service rendered by the employee. Future economic benefits are available to the
entity in the form of a reduction in future contributions or a cash refund, either directly

237
to the entity or indirectly to another plan in deficit. The asset ceiling is the present
value of those future benefits.

IAS 19 states that, when an entity has a surplus in a defined benefit plan, it should
measure the net defined benefit of the asset at the lower of:

i. the surplus in the defined benefit plan, and

ii. the asset ceiling.

Note: the asset ceiling will be provided as part of the question scenario in the SBR
exam but in practice is determined using the discount rate based upon market yields
at the end of the reporting period on high quality corporate bonds

A further issue can arise when a plan amendment, curtailment or settlement occurs.
An entity should recognise any past service cost, or a gain or loss on settlement in
profit or loss. In doing so, the entity should not consider the effect of the asset
ceiling. After the plan amendment, curtailment or settlement has been accounted for,
the entity should then determine the effect of the asset ceiling.

A plan amendment, curtailment or settlement might reduce or eliminate a surplus,

which could impact on how the asset ceiling is measured. Any changes in the value
of the asset ceiling is recognised in other comprehensive income, as opposed to
being recognised in the statement of profit or loss.

Illustrative example
Apolline Co manages a defined benefit scheme for its employees. At 1 January
20X8, the fair value of the pension scheme assets were estimated to be $137 million
and the present value of the pension scheme liabilities were $122 million. The asset
ceiling has been calculated at $4 million. The discount rate on high quality corporate
bonds is 4%. The following are the details of the scheme for the year to 31
December 20X8.

$m

238
 Cash contributions 7

Benefits paid 6

Current service cost 5

At 31 December 20X8, the asset ceiling has been calculated at $11 million. During
the year, there was a scheme curtailment which resulted in a gain on settlement of
$3 million. Immediately after the scheme curtailment the actuary valued the
scheme’s assets as $148 million and the scheme’s liabilities as $136 million.

Suggested answer
At 1 January 20X8, the surplus of the scheme/net plan asset is $15 million ($137
million – $122 million). However, the asset ceiling is $4 million so the net defined
benefit pension asset is restricted to this figure. Interest on the opening asset will be
based upon this figure at $160,000 (4% X $4 million) and will be recorded in profit or
loss. The cash contributions of $7 million will be added to the scheme assets, and
the current service cost of $5 million charged to profit or loss. The benefits paid of $6
million are deducted from both the schemes assets and the schemes liabilities and
therefore have a nil effect.

As any past service cost does not consider the effect on the asset ceiling, a gain on
settlement of $3 million should therefore be recognised in profit and loss.

The pension scheme surplus at 31 December 20X8 is summarised here.

At 31 December 20X8, the scheme is now valued at the lower of the:

 surplus of the scheme, $12 million ($148 million – $136 million), and
 the present value of the economic benefits in the form of refunds from the plan or
reductions in the future combinations (the asset ceiling) – ie $11 million.

239
This means that there is a net gain of $1.84 million being the difference between the
net plan asset in the scheme ($9.16 million) and the asset ceiling ($11 million). This
gain is credited to other comprehensive income.

If the effect of the asset ceiling had not been taken into account, there would have
been a remeasurement loss of $8.6 million ($20.6 million – $12 million) at 31
December 20X8 which would have been recognised in other comprehensive income.

Understanding the context of Initial Coin Offering (ICO)

tokens

SBR will often provide candidates with a scenario that they have not encountered
before. These scenarios allow candidates to demonstrate their ability to apply
accounting principles and show how more than one IFRS standard might be
relevant. The next few paragraphs use an ICO to demonstrate how candidates
should use accounting principles (such as control) and existing IFRS standards to
suggest potential accounting treatments.

In an ICO (also called a ‘token sale’), instead of receiving shares, participants (also
known as supporters) receive ‘tokens’ and, instead of paying cash, participants often
pay in cryptocurrency. They are similar in many ways to crowdfunding but for their
‘support’ they receive a reward – ie the tokens. The tokens are a digital asset based
on the same logic as cryptocurrencies, like Bitcoin. Although the tokens have no
inherent value, if the ICO is successful, these new tokens will become valuable and
a market to trade them will subsequently develop. If unsuccessful, then the tokens
would have no value. ICOs raise money by issuing a ‘white paper’ that provides
details of the proposed venture. This may be the development of a new app or
product or service; for example, the development of an app to subsequently support
the trade of the tokens. 

The tokens are usually issued in exchange for either conventional currency or
cryptocurrency. As the ICO issues a token, rather than shares, they are not
considered to be a securities offering, so the associated regulation and controls have
not been applied.

There are ethical issues for accountants because the white paper may not properly
represent the nature of the offer. For example, unrealistic forecasts or factual
inaccuracies.

240
During the preparation for the ICO, the costs should be recognised as expenses if
they don’t satisfy the requirements for recognition of intangible assets in accordance
with IAS 38, Intangible Assets. Following the circulation of the tokens, the issuing
company generally loses control of the market of these tokens. However, if the
issuer is able to get further economic benefits from token holders by providing them
with intermediary or similar services that are not related to the subsequent sale of
uncirculated tokens, then the costs may satisfy the requirements of IAS 38.
Examples may be the management of the platform supporting the market of
circulated tokens by annulling purchased tokens or changing the content of smart
contracts (a computer program that executes, controls and documents legal events).

If all inflows received for tokens are in excess of the expenses of the initial ICO and
are not related to further commitments to holders of tokens, such further inflows are
considered as revenue by the issuer.

Sometimes the rights given to the token holders may be similar to the rights of the
holders of debt, equity instruments or other financial instruments. For example, the
issuer may contract to pay a fixed amount of annual profits to the token holder but
not to redeem the tokens. At the initial recognition, such a right is recorded as a
contingent liability, the value of which depends on a future uncertain event – ie the
annual profit margin. During the reporting period, the liability should be increased as
the issuer earns profits.

Alternatively, the issuer may commit to the holders of tokens to pay annual interest
based upon the fair value of a cryptocurrency. Such a liability should be recognised
as a financial derivative.

Revenue recognition in accordance with IFRS 15, Revenue from Contracts with

Customers is based on the transfer of control. Control is defined as the ability to
direct the use of and obtain substantial control over the remaining benefits
associated with the asset. The issuer therefore needs to determine if the transfer of
control happens over time.

If control happens over time, revenue cannot be recognised in full at the time of the
initial ICO sale. Instead, it must be recognised as the performance obligation is
satisfied. This will most likely occur if the token is presented to the issuer for
redemption into goods or services, such as granting access to software.

241
A useful background article can be found within the SBL technical articles here.
Please note that this article is not examinable but is purely for additional reading.

Non-GAAP/non-financial performance measures and

quarterly press releases

Finally, SBR candidates need to be able to understand additional performance

measures (APMs) that are produced by companies in the context of their different
business models. This final part of the article uses a social media company to
demonstrate the range of APMs reported in practice.

Some companies issue quarterly press releases which contain forward-looking

statements regarding the future expectations of the business. Often, they will
supplement the consolidated financial statements with some non-GAAP financial
measures. For example, some social media companies will report advertising
revenue excluding foreign exchange effect and free cash flow. Investors are often
cautioned that there are material limitations associated with the use of non-GAAP
financial measures as an analytical tool. In addition, they state that these measures
may be different from non-GAAP financial measures used by other companies,
limiting their usefulness for comparison purposes. These non-GAAP measures are
reported because they provide investors with useful supplemental information and
allow for greater transparency with respect to key metrics used by management in
operating their business.

SBR candidates need to be aware how these additional performance measures

might be useful to users when provided in conjunction with financial statements that
are compliant with IFRS standards. These measures are usually derived from the
business model of the company; for example, a social media company will often
publish ‘Operational and Other Financial Highlights’ which include a range of metrics
that the directors feel are important to investors. They may include conventional
profitability ratio’s such as earnings per share but also such things as:

 Social media monthly active users

 Family daily and monthly active people
 Family average revenue per person
 Revenue by user geography
 Advertising revenue by user geography
 Effective tax rate

242
  Free cash flow reconciliation

Well known social media companies are quick to point out the limitations of some of
the above ratios. For example, Facebook states that the numbers for their key
metrics are calculated using internal company data based on the activity of user
accounts. They try and eliminate the number of 'duplicate' and 'false' accounts
among their users as many people use more than one of their products, and some
have multiple user accounts within an individual product. The data regarding the
geographic location of their users is estimated based on a number of factors, such
as the user's IP address and self-disclosed location. These factors do not always
accurately reflect the user's actual location.

It seems that for some digital companies, conventional financial accounting ratios
cannot account for the importance of other effects such as the network or the
increase in the value of a resource with its use. Hence, some companies will use
ratios which are particular to their type of digital business model.

SBR candidates must be able to discuss the issues raised by the increasing demand
by various stakeholders for non-financial additional performance measures including
transparency, consistency and comparability. There is a technical article that
discusses additional performance measures which can be found here.

SBR candidates must be able to discuss the ethical issues associated with regards
non-GAAP/non-financial performance measures being used, for instance conflicts of
interests between managements interests and the investor perspective. The
examples provided above raise many of these issues on the tensions between
demand for more information from stakeholders and how it should be calculated and
presented alongside IFRS standard disclosures.

243
Climate-related disclosures and investor focus
Climate change is impacting both society and companies alike. Corporations are
responding to its impact, and one of the reasons is that investors are demanding
actions. Investors need to know how a company is considering the impact of climate
change on its business model, risk strategy, and also the effect on its financial
statements. Investors want to understand the future challenges that the company
faces, and what the company’s plans are to deal with these challenges.

The Paris Agreement (United Nations) is a legally binding international treaty on

climate change which will require a significant reallocation of company resources if
the agreed goals are to be met. Therefore, companies could be exposed to a wide
range of risks and opportunities as they aim to meet these goals. Companies will
need to disclose the financial implications of climate-related challenges that face
them.

An increasing number of companies are providing narrative reporting on climate-

related issues. Where minimum legal requirements are being met, investors are
calling for additional disclosure to inform their decision making. Some companies
have set strategic goals such as ‘net zero’ (or carbon neutral), but it is often unclear
from their reporting how progress towards these goals will be achieved, monitored or
assured. Climate-related narrative reporting requirements and expectations cover
both the potential impact on the future of a business and the company’s impact on
the environment.

As the demand for climate-related disclosure by investors and other stakeholders

increases, many companies are developing their climate governance in line with
reporting frameworks, principally ‘The Task Force on Climate-related Financial
Disclosures’ (TFCD).

Some of the information that investors may require is set out below:

 the arrangements in place and strategy for assessing and considering

climate-related issues
 the metrics used to monitor climate-related goals and targets
 the opportunities and risks concerning climate-related issues which are most
relevant and material to the company’s business model and strategy
 the potential effects on the company’s profitability, net assets, products,
customers, suppliers etc of different climate scenarios
244
  are the risks and opportunities reflected in the financial statements, for
example the effect of assumptions used in impairment testing, depreciation
rates, decommissioning etc
 the assessment of the company’s viability over the longer-term taking into
account climate-related issues
 the viability of the company’s business and business model.

Climate change and International Financial Reporting

Standards (IFRS® standards)

There is no single IFRS standard which addresses climate change. However, IFRS
standards provide a framework for incorporating the risks of climate change into
companies’ financial reporting. Companies must consider climate-related matters
when the effect is material on the financial statements.

IAS® 1, Presentation of Financial Statements

IAS 1 requires disclosure of information not specifically required by IFRS standards

and not presented elsewhere in the financial statements, but that is relevant to an
understanding of the financial statements. In addition, IAS 1 requires a company to
consider whether any material information is missing from its financial statements
such as the impact of climate-related matters on the company’s financial position
and performance.

Disclosure of assumptions about climate-related matters may be required, where

assumptions have been affected by climate change. For example, estimates of
future cash flows for impairment testing purposes or the calculation of
decommissioning obligations. The disclosure may include the nature of the
assumptions or the sensitivity of the calculations.

In addition, IAS 1 requires disclosure of the judgements that have a significant effect
on the amounts recognised in the financial statements.

IAS 1 requires management to assess a company’s ability to continue as a going

concern. Climate-related matters may create material uncertainties that cast
significant doubt upon a company’s ability to continue as a going concern. IAS 1
requires disclosure of those uncertainties.

245
IAS 2, Inventory

Climate-related matters may cause a company’s inventories to become obsolete, or

the value to decline or costs of completion to increase. IAS 2 requires inventories to
be valued at the lower of cost and net realisable value (NRV). NRV is the estimated
selling price in the ordinary course of business, less the estimated cost of completion
and the estimated costs necessary to make the sale. Estimates of NRV will be based
on the most reliable evidence available of the amount which the inventories are
expected to realise.

IAS 12, Income Taxes

IAS 12 requires companies to recognise deferred tax assets for deductible temporary
differences and unused tax losses and credits, to the extent it is probable that future
taxable profit will be available against which those amounts can be utilised. Climate-
related matters may affect a company’s estimate of future taxable profits which may
result in potential deferred tax assets not being recognised or the derecognition of
already recognised deferred tax assets.

IAS 16, Property, Plant and Equipment

IAS 16 requires companies to review the residual value and the useful life of an
asset at least at each financial year end and, if expectations differ from previous
estimates, any change should be accounted for prospectively as a change in
estimate. Climate-related matters may affect the estimated residual value and
expected useful lives of assets because of obsolescence or legal restrictions on their
use.

IAS 36, Impairment of Assets

Climate-related matters may give rise to an indication that assets are impaired. A
decline in demand for products that are not environmentally friendly could indicate
impairment of that product or the manufacturing unit making the product. An adverse
change in the business environment of a company is an indication of impairment.

246
In assessing value in use, a company is required to calculate cash flow projections
based upon reasonable and supportable assumptions that are the best estimate of
the future economic conditions. Thus, companies will need to consider whether
climate-related matters affect those assumptions.

Companies are required to disclosure the events, circumstances and assumptions

that led to the recognition of an impairment loss, which could include climate-related
events.

IAS 37, Provisions, Contingent Liabilities and Contingent

Assets

Climate-related matters may affect the recognition, measurement and disclosure of

liabilities related to such things as penalties imposed by governments for not meeting
climate-related targets or causing environmental damage. In addition, contracts may
become onerous due to a change in inventory purchasing strategy or redesign of
products.

Companies should disclose major assumptions about any future events that have
affected a provision or contingent liability.

IFRS 9, Financial Instruments

Climate-related matters may affect a lender’s exposure to credit losses, caused by

environmental disasters or regulatory change, and also a borrower’s ability to meet
its debt obligations to the lender. Climate-related matters may, therefore, affect the
calculation of expected credit losses if there is an impact on the different potential
future economic scenarios or the assessment of a significant increase in credit risk.

The classification and measurement of loans may be affected as lenders may

include terms linking contractual cash flows to an entity’s achievement of climate-
related targets. The lender would need to assess whether the contractual terms of
the financial asset give rise to cash flows that are solely payments of principal and
interest on the principal amount outstanding. Additionally, climate-related targets
may create an embedded derivative that needs to be separated from the host
contract.

247
Climate change may reduce the probability of a hedged forecast transaction
occurring or affect its timing. In this case, the hedge accounting relationship may
need to be terminated or there may be hedge ineffectiveness. Similarly, a reduction
in the volume of highly probable forecast transactions may lead to partial termination
under IFRS 9.

IFRS 13, Fair Value Measurement (FVM)

When making the critical assessments and judgements for measuring fair value, the
entity should consider what conditions and the corresponding assumptions were
known or knowable to market participants. The impact of climate change on FVM
would depend on the evaluation of whether the climate change would have impacted
market participants’ valuation assumptions at the reporting date.

The information such as climate-related legislation available to the market at the

reporting date may be relevant in making this evaluation. This would include any
corroborative or contrary evidence such as the timing and trajectory of observable
market price movements of related assets in the relevant markets, as well as
information from other sources of market data up to the reporting date.

Depending on the facts and circumstances of each case, disclosure may be needed
to enable users to understand whether or not climate change has been considered
for the purpose of FVM. Users should understand the basis for selecting the
assumptions and inputs that were used in the FVM and the related sensitivities.

The above examples from IFRS standards are not exclusive but are indicative of the
far-reaching impact climate change will have on business reporting. This area of
business reporting is evolving as the investor, and wider stakeholder, demand for
both financial and non-financial disclosures increases generally.

Written by a member of the Strategic Business Reporting examining team

248
Sustainability reporting
In April 2021, the IFRS Foundation published two documents in relation to their
project on sustainability reporting. The first summarises the significant matters raised
by respondents to their Consultation Paper on Sustainability Reporting. The second
document was an Exposure Draft with proposed targeted amendments to the IFRS
Foundation Constitution to accommodate an International Sustainability Standards
Board (ISSB). This would allow the ISSB to set IFRS sustainability standards.

The IFRS Foundation reviewed the feedback on their Consultation Paper on

Sustainability Reporting and set out a strategy that proposed the creation of a new
board, the ISSB, under the Foundation’s current governance structure. The IFRS
Foundation reached the following conclusions:

 the new board would focus on information that is material to the decisions of
investors and other participants in the world’s capital markets
 the new board would initially focus on climate-related reporting while also
moving quickly to work towards meeting the information needs of investors on
other environmental, social and governance (ESG) matters
 the new board would build on the well-established work of the Financial
Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD),
as well as work by the alliance of leading standard-setters in sustainability and
integrated reporting focused on enterprise value
 by working with standard-setters from key jurisdictions, standards issued by
the new board would provide a globally consistent and comparable
sustainability reporting framework.

There is broad stakeholder support for globally recognised sustainability reporting

standards. Currently it can be argued that there are diverse approaches to and
objectives for sustainability standard-setting which could result in increasing global
fragmentation. This demonstrates the need to promote comparable reporting and
reduce the complexity in approaches and objectives.

Because of the International Accounting Standards Board’s (IASB ®) relationships

with global governance bodies and industries, and its expertise in international
standard-setting ,it could play an important role in global sustainability reporting by
creating a new board that would operate under its existing governance structure.

249
A set of comparable and consistent standards would allow companies to create
public trust through greater transparency of their sustainability initiatives, which
would be helpful to investors. Investors require better disclosure of such information
as climate risks and sustainability indicators.

The objective of the ISSB would be to develop and maintain a global set of
sustainability reporting standards. Such standard setting could make use of existing
sustainability frameworks and standards. The development of a framework for
sustainability reporting could be coherent with IFRS standards and the IASB’s
mission to serve investors and primary users of financial statements. The ISSB could
adapt the existing standard setting process and use the experience of the IASB in
promoting the consistent use and application of sustainability standards. The IFRS
Foundation has established expertise in standard-setting which would benefit both
the new ISSB and investors. This would help investors to use sustainability reporting
to inform their decisions by giving them comparable and verifiable information.

The standards would benefit from the interconnectedness between financial

reporting and sustainability reporting. In addition, investors would benefit if a single
organisation developed requirements in financial reporting and sustainability
reporting.

The IFRS Foundation is well positioned to develop an appropriate institutional and

governance framework. However, there is a risk of reducing the current momentum
created by other frameworks and standard setting bodies. As an alternative, the
IFRS Foundation could encourage regulators to mandate the use of sustainability
reporting standards globally. In addition, it could be argued that the GRI standards
already have created global sustainability reporting standards that regulatory
authorities could mandate. Also, as the EU is already taking the lead in developing
sustainability standards and has a very ambitious timescale to develop and issue
them, the IASB could contribute its expertise in financial reporting to find consistency
between financial and sustainability reporting.

There is demand from investors for international coordination of an agreed set of

sustainability reporting standards. Currently, investors are often struggling with
incomplete and inconsistent data on companies. The ISSB would assist in providing
a level playing field for companies that prepare reports and also international
comparability for investors.

250
SBR candidates need to be aware of progress in this area of business reporting as it
is a dynamic, fast-paced and developing subject area.

Written by a member of the Strategic Business Reporting examining team

251
The need for judgment in assessing materiality
In September, the International Accounting Standards Board (IASB) issued a
practice statement on making materiality judgments. The statement is
intended as guidance that helps preparers rather than a standard that has to
be applied to demonstrate compliance with IFRS Standards.

The IASB has also released an exposure draft that proposes minor amendments to
the definition of ‘material’. The definition of material information, currently included in
the Conceptual Framework for Financial Reporting, is as follows: information is
material if omitting it or misstating it could influence decisions that users make on the
basis of financial information about a specific reporting entity.

The exposure draft proposes the following minor amendment: information is material
if omitting, misstating or obscuring it could reasonably be expected to influence
decisions that the primary users of a specific reporting entity’s general purpose
financial statements make on the basis of those financial statements.

One of the key elements to this change is the introduction of the term ‘primary users’
rather than the existing definition’s ‘users’.

In the practice statement, the IASB explains who it means by primary users: existing
and potential investors, lenders and other creditors – in other words, users who
cannot require entities to provide information directly to them and so must rely on
financial statements for much of their information.

Information needs

The financial statements cannot conceivably provide all the information that primary
users need, and an entity should aim to meet the common information needs of its
primary users. Thus, in applying its materiality judgments, an exemplar entity called
Grimtown FC (see box on the next page) would not need to consider the specific
information needs of a single investor (Example 1 in the box), and could rightly
conclude that a particular item of information is immaterial for its primary users as a
group. It would therefore not need to furnish this information in its financial
statements.

252
When assessing whether information is material to the financial statements, an
entity’s decision should not be affected by that information being available from other
sources (see Example 2 in the box). The public availability of information does not
relieve an entity of the obligation to provide material information in its financial
statements.

An entity may also consider the requirements of local laws and regulations in its
materiality judgments. It can provide more information than required by IFRS
Standards, as long as that does not obscure items deemed material by IFRS
Standards. An entity may not provide less information than required under IFRS
Standards, even if local regulation allows it.

The IASB’s practice statement also presents the following four steps that an entity
may follow in making materiality judgments when preparing financial statements. We
will look at each step using the Grimtown FC examples cited.

Step 1: Identify

Identify information that could be material. The entity should also consider the
common information needs of its primary users. In our example, Grimtown will have
identified a set of potentially material information.

Step 2: Assess

Assess whether the information identified in step 1 is in fact material. This

assessment involves quantitative and qualitative considerations.

Quantitative factors include the size of the impact on the transaction or event, as well
as the size of any unrecognised items, such as contingent assets or liabilities. There
could also be factors that do not have a significant size impact on the financial
statements, but might have an impact on similar entities in the industry (see Example
3).

Qualitative factors are those that make information more likely to influence the
decisions of the primary users. These can include transactions with related parties,
uncommon transactions or unexpected variations in trends.

253
While there is no hierarchy among materiality factors, it may be efficient to consider
an item from a quantitative perspective before assessing the presence of qualitative
factors.

In highlighting these issues, the IASB is reinforcing the idea that judgment is required
in the assessment of materiality. Items such as Example 5 also reassert the IASB’s
position that IFRS Standards requirements need only be applied if their effect is
material in the complete set of financial statements. The output of step 2 is a
preliminary set of material information.

Step 3: Organise

Organise the information identified as material in a way that communicates clearly

and concisely to primary users. The output of step 3 is the draft financial statements.

Step 4: Review

Review the draft financial statements to determine if all material information has
been identified. An entity needs to assess whether information is material both
individually and in combination with other information in the context of its financial
statements as a whole. This review gives the entity the opportunity to step back and
consider the information from a wider perspective and in aggregate. The output of
step 4 is the final financial statements.

In producing this practice statement and an exposure draft on the definition of

materiality, the IASB has attempted to clarify the need for judgment in conjunction
with the specific requirements of individual IFRS Standards. It reinforces the current
focus of the IASB to look at disclosures within the financial statements as much as
looking at specific accounting standards.

Comments on the exposure draft on the definition of materiality must be submitted

by January 2018.

Adam Deller is a financial reporting specialist and lecturer

254